Entering Bernanke’s Domain

 Fundamental Questions ◦ What is money? ◦ Where does money come from? ◦ What role do banks play in the macro economy?  Important Vocab ◦ Transactions Account ◦ Bank Reserves ◦ Required Reserve Ratio ◦ Excess Reserves  Key Ideas ◦ Bank Failure ◦ Creation of the Federal Reserve ◦ Deposit Creation

 How does the government control the amount of money in the economy?  How does the money supply affect macroeconomic outcomes?  Monetary policy: the use of money and credit controls to influence macroeconomic activity

 Federal Reserve Banks ◦ 12 banks in various regions ◦ Each acts as central banker for private banks in region  Main Functions of Reserve Banks ◦ Clearing checks between private banks ◦ Holding bank reserves ◦ Providing currency ◦ Providing loans

 Board of Governors ◦ 7 members ◦ 14-year terms ◦ Not accountable to any specific elected official  The Fed Chairman ◦ Appointed by president ◦ Generally non-political appointee ◦ Generally reappointed by subsequent presidents

 Three Basic Tools of Monetary Policy ◦ Reserve Requirements ◦ Discount Rates ◦ Open-market Operations

 Basics ◦ Available Lending of Banking System = excess reserves X money multiplier ◦ Money multiplier = 1/required reserve ratio ◦ By changing the reserve requirement, the Fed can directly alter the lending capacity of the banking system  Changes in Required Reserves ◦ A change in the reserve requirement causes:  A change in the amount of excess reserves  A change in the money multiplier

 Definition:  In order to maximize lending power, banks need to have a quick source of reserves  Three Sources of Last-Minute Reserves ◦ Federal Funds Market  Borrowing money from another bank with large reserves ◦ Securities Sales  Selling off government bonds ◦ Discounting  Borrowing directly from Fed  Discount rate:

 Most immediate method of affecting reserves ◦ Principal mechanism for day-to-day alterations of reserve amounts  Portfolio Decisions ◦ Money vs. Bonds  Definition of O-M O:  Buying vs. Selling Bonds

 Expansionary Policy ◦ Shifting AD curve to the right to increase output in order to reach full employment potential  Restrictive Policy ◦ Shifting AD curve to the left to reduce excessive demand ◦ Raising Reserve Requirements ◦ Increasing Discount Rate ◦ Increasing Interest Rates  Interest-Rate Targets ◦ Interest rates link changes in money supply to shifts in Aggregate Demand

 Successful monetary policy depends on: ◦ Aggregate Demand Shifting in response to monetary policy ◦ Aggregate Supply having the correct shape  Aggregate Demand ◦ Only rarely do consumers fail to respond to changes in the money supply  Ex. Great Depression  Aggregate Supply ◦ The effects of the AD shift caused by monetary policy depend on the shape of the AS curve  Horizontal AS  Vertical AS  Sloped AS  Using Sloped AS, expansionary policy causes some inflation and restrictive policy causes some unemployment

 Discretionary Policy vs. Fixed Rules ◦ Discretionary policy  Positive and Negative shocks are frequent occurences  Counter-cyclical Policy = Stability ◦ Fixed Rules  The Fed’s discretion is dangerous because it is likely to project the AS curve incorrectly  Fixed Rules = Stability ◦ Eclecticism  Combination of two approaches:  Flexible rules + Limited Discretion = Stability  Ex. Paul Volcker and Congress