16.2 Monetary Policy

Fractional Reserves and Deposit Expansion Main Ideas Under a fractional reserve system, banks are required to keep a portion of their total deposits in the form of legal reserves. Banking with fractional reserves results in a monetary expansion process that increases the total money supply available to the public. Monetary expansion continues as long as the bank has excess reserves to lend and as long as lenders deposit part or all of that money.

Fractional Reserves and Deposit Expansion Fractional Reserve System: System requiring financial institutions to set aside a fraction of their deposits in the form of reserves or vault cash Legal Reserves: Currency and deposits used to meet the reserve requirements. Reserve Requirement: Formula used to compute the amount of depository institution’s required reserves. Member Bank Reserve (MBR) Reserve kept by member banks at the Fed to satisfy reserve requirements. Excess Reserves: Financial institution’s cash, currency and reserves in excess of required reserves; potential source of loans.

Fractional Reserves and Deposit Expansion ???? What happens to the monetary expansion if people decide to hold cash in their pockets? The expansion is limited when people hold more cash. How can the Fed’s policy of fractional reserve banking (set at 20 percent) increase the amount of money in the economy by 500 percent? banks must keep 20 percent of each deposit and then can lend out the rest. As borrowers pay back loans, or banks get additional deposits, banks can continue to lend out money.

Conducting Monetary Policy Main Ideas The Fed conducts monetary policy to expand or contract the money supply to affect the cost and availability of credit. The Fed changes interest rates by changing the size of the money supply. The three tools the Fed uses to conduct monetary policy are the reserve requirement, open market operations, and the discount rate. The Fed can raise or lower the reserve requirement, but it rarely uses this tool because other tools work better. The Fed’s most popular tool of monetary policy is the buying and selling of government securities in financial markets (open market operations). The discount rate is the interest the Fed charges on loans to financial institutions; although the Fed directly sets only the discount rate, this rate influences other interest rates, including the prime rate.

Conducting Monetary Policy Actions by the Federal Reserve System to expand or contract the money supply to affect the cost and availability of credit. Interest Rate: The price of credit to the borrower. Easy Money Policy Monetary Policy resulting in lower interest rates and greater access to credit; associated with an expansion of the money supply. Tight Money Supply Monetary Policy resulting in higher interest rates and restricted access to credit; associated with a contraction of the money supply.

Conducting Monetary Policy Open Market Operations: Monetary policy in the form of U.S. Treasury bill, or notes, or bond sales and purchased by the Fed. Discount Rate: Interest rate that the Federal Reserve System charges on the loans to the nation’s financial institution. Prime Rate: Best or lowest rate commercial banks charge their customers. How is the prime rate related to the discount rate? The prime rate is the lowest rate of interest that commercial banks charge their best customers. When the Fed adjusts the discount rate for banks, the banks in turn adjust the interest rates for their customers

Conducting Monetary Policy Under what conditions might the Fed want to institute an easy money policy? Why? The Fed might ease money policy if economic growth is slow; expanding the money supply increases business activity. Under what conditions might the Fed want to institute a tight money policy? Why? The Fed might tighten money policy if inflation is rising; it restricts the money supply to slow economic growth Can corporations or private individuals borrow money from the Fed? No Who is permitted to borrow from the Fed? Only financial institutions can borrow from the Fed. What happens to economic growth when the Fed raises the discount rate? Raising the discount rate—or the interest rate that the Fed charges on loans to financial institutions—results in banks wanting to borrow fewer funds from the Fed, which results in fewer excess reserves to loan to the public. Less borrowing results in slower economic growth.

Monetary Policy Dilemmas Main Ideas Leads and lags in the time it takes a policy to take effect make it difficult for the Fed to know exactly when to pursue or abandon a policy. Monetarism is a philosophy that allows the money supply to grow at a steady rate, at levels low enough to control inflation. Monetary policy can change interest rates, but the economy is not always responsive; changes in interest rates can only do so much. The quantity theory of money is a hypothesis that the supply of money directly affects the price level over the long term. The wage-price controls imposed by President Nixon in the early 1970s did not work; prices rose even though wage and price controls were in place.

Monetary Policy Dilemmas Monetarism: School of thought stressing the importance of the stable monetary growth to control inflation and stimulate long term growth. Quantity theory of money: Hypothesis that the supply of money directly affects the price level over the long run. Wage-Price Controls: Policies and regulations making it illegal for firms to give raises or raise prices without government approval.

Monetary Policy Dilemmas Why does the Fed use monetary policy? to promote price stability, full employment, and economic growth What are the biggest problems with using monetary policy? Monetary policy is a complex tool, and the Fed never knows how long it may take for a policy change to have an effect. Long term use of monetary policy can affect inflation