1. Introduction to Monetary Policy Mr. Way, 2/16/12 CA Standard 12.3.4 Understand the aims and tools of monetary policy and their influence on economic activity (e.g., the Federal Reserve).

2. What is monetary policy? Actions taken by the “monetary authority” (in our case the Federal Reserve) of a country to control the money supply. Their stated goals are usually to keep prices steady or to lower unemployment. Monetary policy is largely described as “expansionary” (raising money supply) or “contractionary” (lowering money supply)

3. How does the money supply affect the economy? The money supply refers to the availability of money. The more money there is in the supply, the cheaper it is to borrow (low interest rates) The less money there is, the more expensive it is to borrow (high interest)

4. What does the interest rate have to do with the economy? When interest rates are low: –Businesses are more likely to take out loans to start- up or expand operations (hire people) –People are more likely to buy things on credit (therefore encouraging business to expand/hire more people). –People are less likely to save money in the bank, since it pays a low interest rate. Less savings = more spending = businesses expand = more jobs. The opposites are all true when interest rates are high.

5. What can the Fed do to affect the money supply? “Open market operations,” i.e. buy and sell treasury bonds. Change the “discount rate” Change federal reserve requirements.

6. Open Market Operations The simplest of the three is buying and selling bonds on the open market. When the government buys bonds, it is adding money into the supply. Buy bonds = Boom When the government sells bonds, it is taking money out of the supply. Sell bonds = Shrink

7. Federal Reserve Requirements Are laws made by the Fed stating what percentage of peoples’ saving banks must store in their vaults instead of lending out. For example, suppose that the reserve requirement is 50%. This means that if I put $100 in the bank, they must hold on to $50 and are free to loan out $50 to somebody else. If the requirement is 20%, they would hold onto $20 and loan out $80.

8. Reserve Requirements and the Money Multiplier Banks are able to multiply the money supply based on the reserve requirement: Assume the rate is 50%, and I bank $100 The bank reserves $50 and loans out $50. The $50 they loaned out will make its way to another bank, which will reserve $25 and loan out $25. That $25 loan will make its way to yet another bank, which will reserve $12.5 and loan out $12.5. This cycle will continue until $0.01

9. Calculating the Reserve Requirements Money Multiplier To calculate the change in the money supply from money a bank receives: Divide the amount the bank received by the percentage the bank must reserve Ex. 50% reserve requirement on $100: ($100 /.5) = $200 Ex. 20% reserve requirement on $100: ($100 /.2) = $500

10. Effects of changes in Reserve Requirement Ratio As you can see, lowering the reserve requirement from 50% to 20% has the potential to more than double the size of the money supply! Given that there are about $829 billion dollars in circulation, even a tiny decrease in the reserve requirement would mean the “creation” of billions of new dollars.

11. The “Discount Rate” This refers to the special, low interest rate that special “member banks” get to use when borrowing from the Fed. By lowering the discount rate, the Fed encourages banks to borrow more money from it When banks have borrowed more money, they are more likely to lend out more money as well, increasing the supply.

12. The Federal Reserve Pyramid Scam (wake up, people!) Discount Rate 2% Rate big banks charge small banks 3.5% Interest rate your local branch pays To its corporate headquarters 6% Interest Rate Average Americans End Up Paying on Loans 8% Discount Rate is what the Fed charges to big banks Big banks charge smaller banks a higher rate Smaller banks loan money to individuals at an even higher rate (Why can’t we borrow directly from our government? Why do we have to pay interest to 2-3 middle men?)

13. Conclusion Monetary policy can radically alter the money supply, with serious impacts on the economy. For small changes in money supply, adding and subtracting with open market operations are favored. For large changes in the money supply, multiplying and dividing it by changing the reserve requirement may be necessary. When banks are not loaning money even when they are legally allowed to, the fed will the lower the discount rate (increasing banks’ profit margins, and encouraging them to loan more)