(& The Federal Reserve) $ Monetary Policy $ (& The Federal Reserve)

Money Supply: Narrowly defined by economists as currency (coins and paper money) in the hands of the public, plus checking-type accounts. Currency makes up about 48% of the total, and checking-type accounts about 52%. The supply of money in the economy is important for price stability and economic growth. Too much money in the economy can cause inflation. An extreme example of this occurred in Germany after WWI, when the German government printed so much money that prices increased 5,470% in 1923. Too little money in the economy can lead to falling prices and falling production. An example of this occurred in the U.S. between 1929 and 1933. The money supply fell by 30%, and most economists agree that this was a major cause of the Great Depression. The Federal Reserve controls the money supply through monetary policy. Monetary policy works through encouraging or discouraging banks from making loans. 2/21/2019

How Banks Create $$$: Banks create money by using the deposits in checking accounts to make loans. This illustration shows how the money-creation process works, starting with a $1,000 deposit. Assume banks have a 10% reserve requirement. This means that each time a bank receives a deposit, it must keep 10% in reserve and can loan out the rest. Remember that the money supply includes both currency in circulation and deposits in checking accounts.

Expanding the $$$ Supply: Bank Deposit Reserves Required Reserves Excess Reserves Loan Elm Bank $1,000 $100 $900 $900 loan to Maria Oak Bank $90 $810 $810 loan to Cody Ash Bank $81 $729 $729 loan to Rasheed

How Banks Destroy $$$: Money is “destroyed” when consumers pay back their loans, as this money is then taken out of circulation (the borrower’s checking account) and put back into bank reserves. Banks can also “destroy” money by making it more difficult for banks to make loans to consumers.

Monetary Policy: Changes in the money supply, intended to maintain stable prices, full employment, and economic growth. If the Fed is fighting unemployment and declining GDP, it wants to increase the money supply. If the Fed is fighting inflation, it wants to decrease the money supply. There are 3 tools the Fed can use to take action to influence the money supply.

Organization of the Federal Reserve:

Federal Reserve Districts:

Easy-Money vs. Tight-Money Policy The Federal Reserve follows an easy-money policy to encourage economic growth and thus lower the unemployment rate. The Fed adopts a tight-money policy in an effort to slow economic growth and thus decrease the inflation rate.

Tool #1: Open Market Operations: *Most Used!* The Fed buys or sells U.S. government securities in the bond market from banks. When the Fed buys securities from banks: Bank deposits increase Banks have more money to loan to customers The money supply increases When the Fed sells securities to banks: Bank deposits decrease Banks have less money to loan to customers The money supply decreases

Open Market Operations

Tool #2: Changing the Reserve Requirement *HARDLY ever used!* The reserve requirement is the minimum percentage of deposits that banks must keep on reserve to back up checking-type accounts. When the reserve requirement is lowered: Banks have more $ to lend out The money supply increases When the reserve requirement is raised: Banks have less $ to lend out The money supply decreases

Tool #3: Adjusting the Discount Rate The discount rate is the interest rate that the Fed charges on loans to banks. When the discount rate is decreased: Banks are encouraged to make more loans The money supply is increased When the discount rate is increased: Banks are discouraged from making loans The money supply decreases

Easy-Money Monetary Policy: What does the Fed do to expand the money supply? Buy gov’t securities from banks Lower the discount rate Lower the reserve requirement

Tight-Money Monetary Policy: What does the Fed do to contract the money supply? Sell gov’t securities to banks Raise the discount rate Increase the reserve requirement

Actions the Fed can take to… Open Market Operations ∆ the Discount Rate ∆ the Reserve Requirement INCREASE the money supply: Fed buys government securities from banks, increasing reserves for loans Decrease the discount rate, encouraging banks to borrow from the Fed, increasing reserves for loans Reduce the reserve requirement, freeing up reserves for banks, allowing them to make more loans DECREASE the money supply: Fed sells government securities to banks, decreasing reserves for loans Increase the discount rate, discouraging banks from borrowing from the Fed, decreasing reserves for loans Increase the reserve requirement, reducing reserves for banks, making less $ available for loans 2/21/2019