PRINCIPLES OF ECONOMICS Chapter 28 Monetary Policy and Bank Regulation PowerPoint Image Slideshow

Some of the most influential decisions regarding monetary policy are made at the FED behind these doors. FEDERAL RESERVE SYSTEM (FED)

The FED is the central bank of the United States established in 1913 to regulate the private banking system and the supply of money Unique Features of the FED Decentralization: 12 districts across countryDecentralization: 12 districts across country Independent of the US governmentIndependent of the US government Decision-maker about amount of money in circulation and short-term interest ratesDecision-maker about amount of money in circulation and short-term interest rates Semi-public institutionSemi-public institution Policy goal: to sustain economic growth with zero inflationPolicy goal: to sustain economic growth with zero inflation

THE FEDERAL RESERVE SYSTEM

Janet Yellen, Chair UC, Berkeley Professor ofEconomics Stanley Fischer, Vice Chair Economics MIT, Professor of Economics

FUNCTIONS OF THE FED Clearing interbank payments Regulating the banking system Assisting banks in difficult financial times Managing the nation’s foreign exchange rates and foreign exchange reserves

FUNCTIONS OF THE FED Control of mergers between banks Examination of banks to ensure that they are financially sound Setting the short-term interest rate Lender of last resort

MONETARY POLICY Monetary Policy: FED’s action of managing the money supply and the interest rate Expansionary or Easy Monetary Policy: Drop the interest rate to boost planned investment and consumption, thus increasing the GDP Contractionary or Tight Monetary Policy: Raise the interest rate to reduce planned investment and consumption, thus curbing inflation

MONETARY POLICY The FED uses three instruments to manage the money supply and interest rates: Reserve Requirement Discount Window Open Market Operations

RESERVE REQUIREMENT Reserve Requirement is the percentage of deposits that banks must hold at their accounts in the FED. If the FED wants to increase the money supply, it lowers the Reserve Requirement. As a result, banks would hold less Required Reserve and keep more Excess Reserve. To lend the additional Excess Reserve, banks will drop the rate of interest on business and consumer loans.

DISCOUNT WINDOW Banks can borrow from the FED. The interest rate they pay on loans from the FED is the Discount Rate. If the FED wants to increase the money supply, it would lower the discount rate, which encourages banks to borrow more from the FED. To lend these additional reserves, banks will drop the interest rate on business and consumer loans.

OPEN MARKET OPERATIONS Open Market Operations: The FED’s purchase and sale of government bonds to member banks. The FED held over $2.4 trillion of US government bonds as of February 4, To increase the money supply, the FED buys more government bonds from member banks. Banks receiving additional reserves from the FED will lower the interest rate to lend them to households and business.

EXPANSIONARY MONETARY POLICY To increase the money supply and reduce the interest rate, the FED could Lower the Reserve RequirementLower the Reserve Requirement Lower the Discount RateLower the Discount Rate Buy government securities from member banksBuy government securities from member banks

CONTRACTIONARY MONETARY POLICY To decrease the money supply and increase the interest rate, the FED could Raise the Reserve Requirement Raise the Discount Rate Sell government securities from member banks

MONETARY POLICY The original equilibrium occurs at E 0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S 0 ) to the new supply curve (S 1 ) and to a new equilibrium of E 1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S 0 ) to the new supply (S 2 ), and raise the interest rate from 8% to 10%.

MONETARY POLICY

a.The economy is in recession. An expansionary monetary policy will reduce interest rate and increase investment and AD, moving the economy toward the potential GDP with a relatively small rise in the price level. a.The economy is producing above the potential GDP, experiencing rapid inflation. A contractionary monetary policy will increase the rate of interest, depressing investment and dropping AD. The economy will move to an new equilibrium with smaller GDP and lower price level.

MONETARY POLICY

In expansionary monetary policy the central bank causes the supply of money to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and raising the AD. The result is a higher price level and and a larger GDP. In contractionary monetary policy, the central bank causes the supply of money and credit to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and dropping the AD. The result is a lower price level and a smaller GDP.

MONETARY POLICY

Through the episodes shown here, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate.

VELOCITY OF MONEY Velocity is the nominal GDP divided by the money supply for a given year. Different measures of velocity can be calculated by using different measures of the money supply. Velocity, as calculated by using M1, has lacked a steady trend since the 1980s, instead bouncing up and down.

MONETARY POLICY: LONG-RUN EFFECT With a vertical AS, monetary policy is ineffective in the long-run. An expansionary policy shifting the AD will have no effect of GDP, but causes the price level to rise.