2. 15 - 1 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show THE FEDERAL RESERVE AND THE BANKING SYSTEM Open Market CommitteeAdvisoryCouncils Board of Governors 12 Federal Reserve Banks CommercialBanks Thrift Institutions (Savings & loan associations, mutual savings banks, credit unions) The Public (Households and businesses)

3. 15 - 2 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show Monetary Policy FEDERAL RESERVE BANK OF THE U.S. 15 C H A P T E R

4. 15 - 3 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show Fed Functions- Money Supply 1. Issuing Currency—Federal Reserve Notes—paper currency—issued by districtbanks. Money identifies what district it came from on upper left of front of bill. 2. Setting Reserve Requirements 3. Lending Money to banks/thrifts 4. Provides for check collection 5. Acts as fiscal agent—gov’ts bank!

5. 15 - 4 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show Fed Functions-Money Supply 6. Supervising banks 7. Controlling Money Supply –-To stabilize –-To influence expansion/contraction of economy.

6. 15 - 5 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show GOALS OF MONETARY POLICY …to assist the economy in achieving a full-employment, noninflationary level of total output

7. 15 - 6 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANKS ASSETS Securities Loans to Commercial Banks LIABILITIES Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes

8. 15 - 7 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show TOOLS OF MONETARY POLICY Open Market Operations Buying Securities From commercial banks... Bank gives up securities FED pays bank Banks have increased reserves From individuals... Individual gives up securities Individual deposits check in bank Banks have increased reserves

9. 15 - 8 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show New reserves $800 Excess Reserves $4000 Bank System Lending FEDERAL RESERVE PURCHASE OF BONDS Purchase of a $1000 bond from a bank... $200 Required reserves $1000 Initial Deposit Total Increase in Money Supply ($5000)

10. 15 - 9 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio Raising the Reserve Ratio Banks must hold more reserves Banks decrease lending Money supply decreases Lowering the Reserve Ratio Banks may hold less reserves Banks increase lending Money supply increases

11. 15 - 10 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Buy Securities Decrease Reserve Ratio Lower Discount Rate

12. 15 - 11 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate

13. 15 - 12 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show TOOLS OF MONETARY POLICY Open Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate Discuss relative importance of each control

14. 15 - 13 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show MONETARY POLICY, REAL GDP AND THE PRICE LEVEL Cause-Effect Chain Money supply impacts interest rates Interest rates affect investment Investment is a component of AD Equilibrium GDP is changed

15. 15 - 14 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show Real domestic output, GDP DmDm Investment Demand Real rate of interest, i 10 8 6 0 Quantity of money demanded and supplied Amount of investment, i MONETARY POLICY AND EQUILIBRIUM GDP S m1 AS AD 1 P1P1 10 8 6 0 S m2 AD 2 P2P2 Money Supply Increases Interest Rate Decreases Investment Increases AD & GDP Increases with slight inflation If the money supply increases to stimulate the economy... Price level

16. 15 - 15 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show AD 3 Price level Real domestic output, GDP DmDm Investment Demand Real rate of interest, i 10 8 6 0 Quantity of money demanded and supplied Amount of investment, i MONETARY POLICY AND EQUILIBRIUM GDP S m1 AS AD 1 P1P1 10 8 6 0 S m2 AD 2 P2P2 More Money Supply Lower Interest Rates More Investment Still higher AD & GDP with significant inflation S m3 P3P3 If the money supply increases again…

17. 15 - 16 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show MONETARY POLICY, REAL GDP AND THE PRICE LEVEL Effects of an easy money policy Effects of a tight money policy Monetary policy & aggregate supply

18. 15 - 17 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show EFFECTIVENESS OF MONETARY POLICY Strengths of monetary policy Speed and flexibility Isolation from political pressure Successes in the 1980s & 1990s Shortcomings and problems Less control? Changes in velocity Cyclical asymmetry

19. 15 - 18 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show TARGETING THE FEDERAL FUNDS RATE Generalized Interest Rate Changes Money Supply Impact The Federal Funds Rate The Prime Interest Rate

20. 15 - 19 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show MONETARY POLICY AND THE INTERNATIONAL ECONOMY Net export effect Macro stability and the trade balance The “Big Picture” Chapter Conclusions

21. 15 - 20 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show Net Export Effect FED Contractionary: Raise interest rate: –Dollar goes up –Exports fall –Imports rise –Therefore: Negative Net Export Effect FED Expansionary: Lower interest rate: –Dollar goes down –Exports rise –Imports fall –GDP increases –Positive net export effect

22. ENDBACK monetary policy open-market committee reserve ratio discount rate easy money policy tight money policy velocity of money cyclical asymmetry Federal funds rate prime interest rate Copyright McGraw-Hill/Irwin, 2002

23. 15 - 22 Copyright McGraw-Hill/Irwin, 2002 Goals of Monetary Policy Consolidated Balance Sheet of the Federal Reserve Banks Tools of Monetary Policy Federal Reserve Purchase of Bonds Monetary Policy, Real GDP, and the Price Level Monetary Policy and Equilibrium GDP Effectiveness of Monetary Policy Targeting the Federal Funds Rate Monetary Policy and the International Economy Key Terms Previous Slide Next Slide End Show Next Chapter 16 Extending the Analysis of Aggregate Supply