1. Today’s Warm Up
Based on the functions of the Fed you studied yesterday, which do you think is most important and why?

2. Monetary Policy Tools
Today’s LEQ: How do Federal Reserve decisions impact the stability of the economy?

3. Monetary Policy Tools
Used to combat the instability of inflation and recession, the Fed uses tools of monetary policy
Goals are to promote economic growth, full employment, and price stability

4. Monetary Policy Used to combat inflation: Decrease money supply
Contractionary
Expansionary
Used to combat inflation:
Decrease money supply
Decrease amount of credit available
Used to combat deflation:
Increase money supply
Increase amount of credit available

5. Money Creation
The Fed is responsible for putting dollars into circulation
This process is called Money Creation
Not just printing paper currency or minting coins!

6. Pause: Money Supply Activity
Refer to your chart…
Use pages and page 422 to answer the questions on money supply
Be prepared to compare/contrast M1, M2, and M3

7. Three Monetary Policy Tools
Reserve Requirement
Setting Rates
Open Market Operations

8. Tool 1: Reserve Requirement
The Required Reserve Ratio (RRR) determines the fraction of deposits that must be kept on reserve & how much a bank can lend
Set by the Fed to ensure banks have enough funds to supply customers’ withdrawal needs

9. RRR Example Let’s say the RRR = .1 or 10%
You deposit $1,000 into your checking account
This means that of your $1,000 demand deposit balance, the bank is allowed to lend $900

10. RRR Example
Let’s say the bank lends that $900 to Bob and he deposits it into his checking account – Bob now has $900 he didn’t have before and it’s now included in M1
You still have your $1,000 demand deposit account balance
Your initial deposit to the bank and the subsequent loan have caused the money supply to increase by $1,000 + $900 for a total of $1900

11. The Money Multiplier Initial cash deposit x 1/RRR
This process continues until the loan amount, and hence the amount of new money that can be created, becomes very small
How much can we increase the money supply? This is given by the money multiplier formula
Initial cash deposit x 1/RRR
$1,000 x 1/.1 = $10,000

12. PAUSE: Money Creation Practice
Complete the activity on the bottom of page 426
Figure 16.5: Money Creation
Suppose Joshua deposited only $500 of Elaine’s payment into his account. How much would the money supply increase then?

13. Excess Reserves
Sometimes banks hold excess reserves which are greater than required amounts
As a result, sometimes funds “leak out” of the money multiplier process & it’s impact is a bit lower in reality

14. Tool 1: Reserve Requirements
Reserve requirements & the money supply have an inverse relationship

15. Tool 1: Reserve Requirements
An increase in reserve requirements causes banks to increase reserves
Money Supply
Banks reduce lending, causing the money supply to contract

16. Tool 1: Reserve Requirements
Money Supply
Banks increase lending, causing the money supply to expand
Reserve Requirement
A decrease in reserve requirements causes banks to decrease reserves

17. Tool 2: Setting Rates
Interest rates can be adjusted to encourage or discourage lending
This will expand or contract the money supply

18. Tool 2: Setting Rates
Discount Rate – interest charged by the Fed on loans to banks
Federal Funds Rate – interest charged by banks on loans to other banks
Prime Rate – interest charged by banks on short-term loans to their best companies

19. Tool 2: Setting Rates
When the Fed makes its decisions on monetary policy, it does so by setting a target for the federal funds rate
The discount rate rises and falls with the funds rate; these changes are then reflected in the prime rate
PAUSE: Which rate do you think is set higher – the discount rate or the federal funds rate and why?

20. Tool 2: Setting Rates Discount Rate > Funds Rate
The Fed is the lender of last resort and wants banks to borrow from each other first
These are short-term rates and changes have a limited impact on long-term growth of the economy

21. Tool 2: Setting Rates Federal Funds Rate Money Supply
An increase in the federal funds rate makes banks less willing to borrow from other banks
Money Supply
Banks reduce lending in order to build reserves, causing money supply to contract

22. Tool 2: Setting Rates Money Supply Federal Funds Rate
Banks increase lending, causing the money supply to expand
Federal Funds Rate
A decrease in the federal funds rate makes banks more willing to borrow from other banks

23. Tool 3: Open Market Operations
The buying and selling of gov’t securities to alter the supply of money
Considered the most important and most-used tool

24. What is a Government Bond?
IOU
Represent debt the gov’t must repay to an investor
Typically pays fixed amount of interest for a fixed amount of time
Safe investment but low rate of return

25. Bond Purchases
To increase the money supply, the Fed will purchase gov’t securities on the open market
Bought with a check drawn on Federal Reserve funds
Bond seller then deposits the money and it becomes part of the money creation process

26. Bond Sales
To decrease the money supply, the Fed will sell gov’t securities back to bond dealers
Bought with checks drawn on the bond dealers’ own banks
The Fed processes these checks & the money is out of circulation

27. Bond Sales
This operation reduces reserves & banks will lend less to keep reserves at required level
The money multiplier process works in reverse & money supply declines more than the value of the initial securities purchase

28. Tool 3: Open Market Operations
Bond Circulating
Through bond sales, the Fed removes reserves from the banking system
Money Supply
Banks reduce lending, causing the money supply to contract

29. Tool 3: Open Market Operations
Money Supply
Banks increase lending, causing the money supply to expand
Bond Circulating
The Fed’s purchase of bonds increases reserves in the banking system

30. Extension Activity You will be working in groups of 2 or 3
Each group will be given a set of economic statistics: inflation, GDP, and unemployment
You must analyze these statistics then summarize the appropriate monetary policy actions that should be taken

31. Presentations Explain where your economy is on the business cycle
Recommend a monetary policy of expansion or contraction
Explain what action should be taken for each monetary policy tool
Select which tool you feel would be most effective and explain why