Monetarism Milton Friedman and his monetarist ideas remain influential today.

[ 9.4 ] Monetary Policy Options Learning Objectives Analyze how the Federal Reserve uses reserve requirements to implement U.S. monetary policy. Analyze the three primary tools the Federal Reserve uses to implement monetary policy, including open market operations. Explain why the Federal Reserve prefers open market operations as a means to implementing monetary policy.

[ 9.5 ] The Effects of Monetary Policy Learning Objectives Explain how monetary policy works. Describe how the timing of monetary policy can impact business cycles and key economic indicators. Analyze the costs and benefits of monetary policy in terms of economic growth.

The Basics of Monetary Policy

Monetary Tool #1: Reserve Requirements The simplest way for the Fed to adjust the amount of reserves in the banking system is to change the required reserve ratio. The Fed’s Board of Governors has sole responsibility over changes in reserve requirements. However, changing the reserve requirement is not the Fed’s preferred tool.

Monetary Tool #1: Reserve Requirements The Fed uses reserve requirements to influence the money supply.

Monetary Tool #2: The Discount Rate In the past, the Fed lowered or raised the discount rate to increase or decrease the money supply. The discount rate is the interest rate the Federal Reserve charges on loans to financial institutions. Today, the discount rate is primarily used to ensure that sufficient funds are available in the economy. For example, during a financial crisis, there may not be enough funds in the banking system to provide the necessary loans to businesses and individuals. In that case, the ability of banks to borrow from the Federal Reserve at the discount rate provides a key safety net.

Monetary Tool #2: The Discount Rate Interest rates determine the return bank customers earn on money they deposit and the cost they pay for money they borrow.

Monetary Tool #3: Open Market Operations Open market operations are the buying and selling of government securities in order to alter the supply of money. (See Figure 9.26.) A security is a financial document, such as a stock certificate or bond, that represents ownership of corporate shares or the promise of repayment by a company or government. Today open market operations are by far the most important—and most often used—tool employed by the Fed to implement U.S. monetary policy.

Monetary Tool #3: Open Market Operations

The Basics of Monetary Policy Have you ever asked a parent for money—a raise in your allowance, perhaps, or cash to buy concert tickets? If so, you know that timing is everything. If, for example, your parent has just paid a huge bill for home or car repairs, you know that’s the wrong time to ask for spending money. Timing is also critical to the Fed. Proper timing can support the Fed’s effort to achieve economic growth and stability. Bad timing can impede it.

Timing Monetary Policy Poorly timed policy can create more instability than the normal business cycle. Which scenario shown in these graphs represents the least stable economy?

Quiz: Creating Money How do banks create money by going about their ordinary business? A. by printing new money in order to make loans B. by raising the interest rates charged on loans C. by refusing to make loans with customers’ deposits D. by making loans from a portion of customers’ deposits

Quiz: Monetary Tool #1: Reserve Requirements What effect would a reduction in the required reserve rate (RRR) have on banks? A. They could raise interest rates on loans. B. They would have to call in more loans. C. They could lend and create more money. D. They would have to return money to the Fed.

Quiz: Using Monetary Policy Tools Which of the following is today the Fed’s preferred monetary policy tool? A. using the money multiplier B. changing the reserve requirement C. changing the discount rate D. using open market operations

Quiz: The Basics of Monetary Policy What would likely happen to interest rates if the supply of money were increased? A. Interest rates would go up. B. Interest rates would stay the same. C. Interest rates would go down. D. Interest rates are not affected by money supply.

Quiz: Timing Monetary Policy What problem can result from expansionary monetary policy that takes effect after the economy has already begun to expand following a period of contraction? A. deflation B. inflation C. stabilization D. fluctuation

Quiz: Anticipating Business Cycles What would be the appropriate course of action for the Fed if it predicted that a recession would quickly turn into an expansion? A. increase the money supply to lower interest rates B. decrease the money supply to raise interest rates C. lobby Congress for more federal spending D. do nothing