Monetary Policy © 2010, TESCCC

Monetary Policy Federal Reserve policy of regulating the availability of money and credit in the economy to deal with economic instability. © 2010, TESCCC

Major Tools of the Fed 1.Reserve Requirement- the percentage of total deposits that the Fed requires banks to hold back and not loan out 2.Discount Rate- Interest rate the Fed charges member banks 3.Open Market Operations-FOMC or Federal Open Market Committee buys and sells government bonds and securities. © 2010, TESCCC

Minor Tools 1.Moral suasion- unofficial pressure by the federal Reserve to try and change economy. This could be through press releases or speeches to Congress. 2.Margin Requirements- SEC oversees buying of stocks and securities to prevent another stock market crash. © 2010, TESCCC

Easy Money Policy Recession phase of business cycle Unemployment is the problem Goal is to increase the money supply Fed’s Major Tools 1.Reserve Requirement- Decrease reserve requirement. More money available for banks to loan out. More loans will create more money in the economy. © 2010, TESCCC

2.Discount Rate – Decrease discount rate. Makes it cheaper for banks to get a loan from the Fed, so banks will charge lower interest rate to you. This makes getting a loan more attractive so more people will get loans. 3.Open market – The Fed will buy on the open market. The Fed will purchase government securities with money. This is money that had not been out in the economy so this will increase the money available in the economy. © 2010, TESCCC

Rate of interest, i (percent) Amount of money demanded (billions of dollars) 0 DmDm ieie SmSm The Money Market © 2010, TESCCC

Rate of interest, i (percent) Amount of money demanded 0 DmDm SmSm Easy Money Policy S m2 i1i1 i2i2 © 2010, TESCCC

Tight Money Policy Expansion phase of business cycle Inflation is the problem Goal is to decrease the money supply 1.Raise Reserve Requirement- This will cause banks to have less money available for loans. Less loans will mean that less money is created in the economy so this will decrease the money supply. © 2010, TESCCC

2.Raise Discount Rate- This will make it more expensive for a bank to get a loan from the Fed so banks will increase the interest rates that they charge individuals. Higher interest rates will make getting a loan less attractive so fewer people will get loans. 3. Sell on open market- FOMC will sell government securities on the open market. The Fed takes this money and locks it up in the vault at the Fed so this decreases the available money in the economy. © 2010, TESCCC

Rate of interest, i (percent) Amount of money demanded 0 DmDm ieie SmSm The Money Market © 2010, TESCCC

Rate of interest, i (percent) Amount of money demanded 0 DmDm ieie SmSm Tight Money Policy S m2 © 2010, TESCCC

Limitations of Monetary Policy 1.Economic forecasting is not exact; human behavior is not always predictable. 2.Time lag – It takes the government time to gather financial information, analyze it and formulate a policy, and then implement 3.Can’t fight stagflation- 4.Lack of coordination with government policies (conflicting priorities between actors in the economy including the President/Congress and the budget, Treasury, Fed Policies, the markets) © 2010, TESCCC