Monetary Policy Chapter 15

GOALS OF MONETARY POLICY … to assist the economy in achieving a full- employment, noninflationary level of total output

CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANKS ASSETS Securities Loans to Commercial Banks LIABILITIES Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes

TOOLS OF MONETARY POLICY Open-Market Operations Buying Securities From commercial banks... Bank gives up securities FED pays bank Banks have increased reserves From the public... Public gives up securities Public deposits check in bank Banks have increased reserves

TOOLS OF MONETARY POLICY Open-Market Operations Selling Securities To commercial banks... FED gives up securities Bank pays for securities Banks have decreased reserves To the public... FED gives up securities Public pays by check from bank Banks have decreased reserves

New reserves $800 Excess Reserves $4000 Bank System Lending FEDERAL RESERVE PURCHASE OF BONDS Purchase of a $1000 bond from a bank... $200 Required reserves $1000 Initial Deposit Total Increase in Money Supply ($5000)

TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio Raising the Reserve Ratio Banks must hold more reserves Banks decrease lending Money supply decreases Lowering the Reserve Ratio Banks may hold less reserves Banks increase lending Money supply increases

TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate-Interest rate Charged to member banks for loans Easy Money Policy Buy Securities Decrease Reserve Ratio Lower Discount Rate

TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate

Federal Funds Rate Interest rate banks charge each other for overnite loans Prime interest rate-interest rate charged by Fed Fed. Funds rate is prime + 1 or 2 % points If Fed wants to decrease FFR, then it buys bonds Increases S of reserves----FFR drops

Monetary Policy & International trade Net Export effect Easy $ policy---decreases interest rate ___securities, ___ RR, ____DR What happens to imports? Exports? AD? GDP? Balance of trade-- Tight $ policy ___securities, ___RR, ___DR Imports? Exports? AD? GDP? Balance of trade

Real domestic output, GDP DmDm Investment Demand Real rate of interest, i Quantity of money demanded and supplied Amount of investment, i MONETARY POLICY AND EQUILIBRIUM GDP S m1 AS AD 1 (I=$15) P1P S m2 AD 3 (I=$25) P2P2 If the Money Supply Increases to Stimulate the Economy…  Interest Rate Decreases  Investment Increases  AD & GDP Increases with slight inflation Price level AD 2 (I=$20) P3P3 S m3  Increasing money supply continues the growth – but, watch Price Level.

Effectiveness of MP Strengths Isolated from politics Quickly “fix” econ 1980’s/1990’s budget deficit meant FP was not used Weaknesses Increasing globalization makes MP harder No guarantee that banks will loan excess—leakage MP can’t totally move US out of recession Change in velocity

DIFFERENT VIEWS OF MP Artful Management Alan Greenspan Manage Supply of Money based on data Inflation Targets Goal 1-2% inflation for 2 years Increased accountability instead of just based on personality

EFFECTIVENESS OF POLICIES Depends on demand for money The steeper the demand for money— more interest rates will have impact Most direct policy—Open Market Operations Others—more time; depends on banks