The Fed’s tools to manipulate the economy Monetary Policy The Fed’s tools to manipulate the economy

Inflationary Gap or Inflation Price Level LRAS SRAS E AD Real GDP If our economy is operating at point E what economic problem do we have? Inflationary Gap or Inflation

Recessionary gap or recession Price Level LRAS SRAS E AD Real GDP If our economy is operating at point E what economic problem do we have? Recessionary gap or recession

Copy this slide in your notes! Inflationary Gap Recessionary Gap Price Level LRAS LRAS Price Level SRAS SRAS E E AD AD Real GDP Real GDP To help remedy these problems we should. . . Money supply Money supply Copy this slide in your notes!

Let’s see how we can adjust reserve requirements.

Reserve Requirements Assume Reserve requirement of 10% $90 Reserves $100 Reserves $90 Deposit $1,000 Deposit $900 Depositor 1 Barrower 1 Barrower 2 Loan $900 Loan $810 What is the multiplier? 1/rr = 1/.1 = 10 How much has the money supply increased ? $900 x 10 = $ 9,000

NO Reserve Requirements Money supply increase $9,000 Assume Reserve requirement of 10% Reserves $100 Reserves $90 Deposit $1,000 Deposit $900 Depositor 1 Barrower 1 Barrower 2 Loan $900 Loan $810 Money supply increase $9,000 If the economy is experiencing inflation do we want to put $9,000 more into the money supply? NO

What happens if we raise reserve requirements? Assume Reserve requirement of 20% Reserves $200 Reserves $160 Deposit $1,000 Deposit $800 Depositor 1 Barrower 1 Barrower 2 Loan $800 Loan $640 What is the multiplier? 1/rr = 1/.2 = 5 How much has the money supply increased ? $800 x 5 = $ 4,000

What happens if we lower reserve requirements? Assume Reserve requirement of 5% Reserves $50 Reserves $48 Deposit $1,000 Deposit $950 Depositor 1 Barrower 1 Barrower 2 Loan $950 Loan $902 What is the multiplier? 1/rr = 1/.05 = 20 How much has the money supply increased ? $950 x 20 = $ 19,000

To help remedy these problems we should. . . Inflationary Gap Recessionary Gap Price Level LRAS LRAS Price Level SRAS SRAS E E AD AD Real GDP Real GDP To help remedy these problems we should. . . Money supply Reserve Requirements Money supply Reserve Requirements

The Fed also controls the discount rate

Hi, I’m FED chairman Janet Yellen Hi, I’m FED chairman Janet Yellen. I’ll lend you money but you have to pay me back the amount of the loan PLUS the discount rate.

The Discount rate is low! A low discount rate encourages spending When the discount rate is low borrowing money is cheap

The Discount rate is high! NOBODY will borrow money now, it is too expensive. I’m a penny pincher! A high discount rate discourages spending

To help remedy these problems we should. . . Inflationary Gap Recessionary Gap Price Level LRAS LRAS Price Level SRAS SRAS E E AD AD Real GDP Real GDP To help remedy these problems we should. . . Money Supply Reserve Requirements Discount Rate Money supply Reserve Requirements Discount Rate

The FED controls open market operations https://www.youtube.com/watch?v=zEP2vkK-LIk That means they buy and sell bonds

. . . the money supply will _____. shrink If the Fed sells bonds . . . Money the FED has is not part of the money supply, Money that people have is part of the money supply. BONDS . . . the money supply will _____. shrink

. . . the money supply will _____. grow If the Fed buys bonds . . . Money the FED has is not part of the money supply, Money that people have is part of the money supply. BONDS . . . the money supply will _____. grow

To help remedy these problems we should. . . Inflationary Gap Recessionary Gap Price Level LRAS LRAS Price Level SRAS SRAS E E AD AD Real GDP Real GDP To help remedy these problems we should. . . Money supply Reserve Requirements Discount Rate _______ bonds Money Supply Reserve Requirements Discount Rate ________ bonds buy sell