Chapter 15: Monetary Policy Federal Reserve Board Chairperson Federal Reserve Board (7) Federal Open Market Committee (12) Deliberate changes in money supply to influence interest rates, total level of spending in economy Goal is to achieve & maintain price-level stability, full-employment, & economic growth

Tools of Monetary Policy Open-market operations Reserve ratio Discount rate

Open-Market Operations Bond markets are open to buyers & sellers of corporate & government bonds (securities) Fed’s Open-market operations consist of buying bonds from or selling bonds to commercial banks & general public The most important instrument for influencing the money supply

Reserve Ratio Raising the reserve ratio increases amount of required reserves banks must keep  reduces money supply Forces banks to reduce amount of checkable deposits Lowering reserve ratio decreases amount of required reserves banks must keep  increases money supply Transforms required reserves into excess reserves, enhancing ability of banks to create new money by lending

Discount Rate Fed is “lender of last resort” Short-term loans to commercial banks in need in its district (12) Discount Rate: Interest rate Fed charges to commercial banks Borrowing from Federal Reserve Banks by commercial banks increases reserves of commercial banks & enhances their ability to extend credit Lowering discount rate increases money supply Increasing discount rate decreases money supply

Easy Money Policy Aka Expansionary Monetary Policy To combat recession & unemployment, Fed decides to increase money supply. How: Buy securities Lower reserve ratio Lower discount rate

Tight Money Policy Aka Restrictive Monetary Policy To reduce spending & control inflation, Fed wants to reduce aggregate demand by contracting supply of money How: Sell securities Increase reserve ratio Raise discount rate

Effectiveness of Monetary Policy Strengths: Speed & Flexibility (v. Fiscal Policy) Isolation from Political Pressure (14 year terms) Shortcomings & Problems Less control due to changes banking practices (bank reform & electronic transactions) Changes in velocity  Velocity of money: number of times per year average dollar is spent on goods & services Cyclical asymmetry: less reliable in pushing economy from recession

Targeting the Federal Funds Rate Focus of Fed’s monetary policy to stabilize the economy Interest rates in general rise & fall w/ Federal Funds rate Prime interest rate: rate banks charge their most creditworthy customers, parallels FFR By changing the FFR, Fed is changing economy’s overall interest rates Fed announces changes in monetary policy by announcing changes for target FFR

Monetary Policy & International Economy Net Export Effect Expansionary monetary policy (lower FFR) decreases foreign demand for dollars, increases net exports & dollar depreciates Restrictive monetary policy (higher FFR) increases foreign demand for dollars, decreases net exports & dollar appreciates