Monetary Policy: Regulating Money Supply

Trade Quiz #1: What are the two conflicting responsibilities of the Federal Reserve? Maximizing GDP & Employment while at the same time keeping inflation low Review Quiz

#2: What are two ways the Fed has some political independence when it comes to making their decisions? 14-year term of office Don’t rely on money from Congress to keep running Review Quiz

#e: How many members of the Fed Board of Governors are there? 7 Review Quiz

#4: How many District Branches of the Federal Reserve system are there? Review Quiz 12

Trade Quiz #5: What is the “discount rate?” The interest rate that the Federal Reserve charges on direct loans to the 12 District Banks Review Quiz

Trade Quiz #6: Who is on the Federal Open Market Committee (FOMC? The 7 members of the Board of Governors and 5 of the presidents of the District Banks Review Quiz

Trade Quiz #7: What important decisions does the FOMC make? What the FFR should be and how much money there should be in the economy? Review Quiz

Federal Reserve Structure Meets 8 times a year to vote on Monetary Policy Federal Reserve Board of Governors (7 members) Ben Bernanke Chairman Federal Open Market Committee= 7 Governors + 5 District Bank Presidents—meets 8 times per year 12 District Federal Reserve Banks Boston San Francisco New York Atlanta Chicago Dallas, etc. Member Banks All national banks Some state banks Federal Funds Rate = Interest rate that the 12 District banks charge Each other on overnight loans Discount Rate=Interest rate that the Fed lends money directly to District Banks (rarely used) SF Fed Building—Market Street

T he Money Market S-Money D-Money Interest Rate (FFR) Qty $ The Money Market Demand for money is downward sloping as interest rates ↓ more $ is demanded Supply of Money is fixed by the Fed Fed “controls” money supply through monetary policy Modern-day economies are almost entirely run on CREDIT—it’s all about borrowing CONSTANTLY

2 Types of Monetary Policy LOOSE Monetary Policy (increasing the money supply) TIGHT Monetary policy (decreasing the money supply)

1.Discount Rate Changes Changing the interest rate at which District Banks borrow directly from the Fed Two Tools of Monetary Policy

2. Open Market Operations –Federal Reserve action to buy or sell Treasury bonds --This changes the money supply, which shifts the Federal Funds Rate *Demonstration

MD MS 2 Interest Rate (FFR) Qty of $ MS FFR FFR 2 Price Level Real GDP AS 1 AD 2 AD1 Affects AD- people borrow & spend more First, the Fed lowers the discount rate (i.e. 3% to 2%) Next, the Fed uses Open Market Operations to increase money supply --the Fed Buys government bonds from anyone selling them Loose (aka Expansionary) Monetary Policy

Important Fact: Time Lag FYI: Both Fiscal Policy (6-12 months) and Monetary Policy (12-24 months) have a time lag Translation: they do not have immediate effect

MS 1 MD Interest Rate (FFR) Qty of $ MS FFR FFR 2 AS 1 Price Level Real GDP AD1 AD2 Affects AD- people borrow & spend less Tight (aka Contractionary)Monetary Policy First, the Fed raises the discount rate (i.e. 4.5% to 5.0%) Next, the Fed uses Open Market Operations to decrease money supply --the Fed Sells government bonds to willing investors

Economic Issue Policy Type (Moderately Loose, Aggressively Loose, Moderately Tight, Aggressively Tight, or Take No Action) What action would the Fed take regarding Discount Rate (increase or decrease) What would the Fed want to happed to the Federal Funds Rate (increase or decrease) What change in the Money Supply would be needed to bring about the desired change in FFR (increase or decrease ) What action in Open Market Operations would be needed to bring about the desired change in Money Supply (Buy or Sell Treasury Bills) 1. Inflation rises to 10% 2. GDP growth is at 0.9%; the inflation rate is 1.8% 3. GDP growth rate is 2.1% and the inflation rate is 3.5% 4. Consumer confidence is falling; retail sales very weak; unemployment at 8.1% 5. GDP growth is at 4.2%; inflation is at 3.6% Aggressively Tight Increase FFR Decrease FFR None OR Increase FFR Decrease Discount Rate Increase Discount Rate Moderately Tight None OR Moderately Tight Moderately Loose Aggressively Loose Decrease Money Supply Sell T-Bills Increase Money Supply Buy T-Bills None OR Increase Discount Rate None OR Decrease Money Supply None OR Sell T-Bills Increase Money Supply Decrease Discount Rate Decrease FFR Buy T-Bills Increase Discount Rate Increase FFR Decrease Money Supply Sell T-Bills

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News Clips ***(first 45 seconds of 2 minute clip) %20suze%20orman&rls=com.microsoft:*&oe=UTF-8&startIndex=&start Page=1&um=1&ie=UTF-8&sa=N&hl=en&tab=wv# (Suze Orman on FFR) (4:32) c31db8966b68 ***(4:29) good clip when Fed was considered cutting FFR from 1.5% (roundtable on FFR increase to 4.75%) (7:40)

Economic Issue 1.Inflation rises to 10% 2. GDP growth is at 4.2%; inflation is at 3.6% 3. GDP growth is 2.1% and the inflation rate is 3.5% 4. Consumer confidence is falling; retail sales very weak; unemployment at 8.1% 5. GDP growth is at 0.9%; inflation rate is 1.8% Policy Type (Moderately Loose, Aggressively Loose, Moderately Tight, Aggressively Tight, or Take No Action) Action on Open Market Operations (Buy or Sell Treasury Bills Effect on the Money Supply (increase or decrease) Effect on Federal Funds Rate (increase or decrease Aggressive Contractionary Sell T-Bills Decrease Money Supply Increases FFR Moderate Contractionary Sell T-Bills None OR Sell T-bills Buy T-Bills Decrease Money Supply None OR Decrease MS Increase Money Supply Increase Money Supply Increases FFR None OR FFR Decreases FFR Decreases FFR Take no action OR Mod. Contractionary Aggressive Expansionary Moderate Expansionary

Monetary POLICY Price Level Real GDP AS 1 Monetary Policy will shift AD curve AD 1 AD 2 Economy in recession Loose monetary policy needed Buys Securities & lowers discount rate AD shifts right Money becomes cheaper; Interest rates go down

Solution: Tight Monetary Policy Affects AD Price Level Real GDP Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3% AS 1 MS 1 MD Interest Rate Qty of $ MS i1i i2i2 AD 1 End Result: Lower GDP & less inflation! AD2 Loose or Tight Monetary policy needed?

Loose Monetary Policy Affects AD Price Level Real GDP Situation: GDP growth at -2.0%, Unemployment 9% AS 1 MS 2 MD Interest Rate Qty of $ i2i2 MS i1i1 AD1 AD2 Loose or Tight Monetary policy needed?

Loose Monetary Policy Fed _________ Securities MD MS 2 Interest Rate Qty of $ MS i1i i2i2 2. Open-Market Operations BUYS 1. Fed _________ Discount Rate LOWERS Price Level Real GDP AS 1 AD 2 AD1 Affects AD

MS 1 MD Nominal Interest Rate Qty of $ MS i1i i2i2 Tight Monetary Policy 2. Open-Market Operations Fed _________ Securities 1. Fed _________ Discount Rate AS 1 Price Level Real GDP RAISES SELLS AD1 AD2 Affects AD