Money Supply Process: Simple Model Assumptions: 10% required reserve ratio. Banks hold no excess reserves. No currency. What happens to the money supply when the Fed purchases $100 of Treasury securities?
Three Tools of Monetary Policy Open market operations Discount rate Reserve requirements
Open Market Operations 2 Types 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB, typically uses repos Advantages of Open Market Operations 1.Fed has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly
Discount Loans 3 Types 1.Primary Credit 2.Secondary Credit 3.Seasonal Credit Lender of Last Resort Function 1.To prevent banking panics FDIC fund not big enough Example: Continental Illinois 2.To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident
How Primary Credit Facility Puts Ceiling on i ff Rightward shift of R s to R s 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2
Discount Policy Advantages 1.Lender of Last Resort Role Disadvantages 1.Fluctuations in discount loans cause unintended fluctuations in money supply 2.Not fully controlled by Fed
Reserve Requirements Advantages 1.Powerful effect Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks 3.Frequent changes cause uncertainty for banks 4.Tax on banks
Goals of Monetary Policy Goals 1.High Employment 2.Economic Growth 3.Price Stability 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict
Money Supply Target 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i' and i''
Interest Rate Target 1.M d fluctuates between M d' and M d'' 2.To set i-target at i* M s fluctuates between M' and M''