MONETARYPOLICY Monetary policy has two basic goals: to promote "maximum" sustainable output and employment to promote "stable" prices

Why would the Fed want to change the money supply? INFLATIONSlow INFLATION (too much money chasing too few goods)(too much money chasing too few goods) UNEMPLOYMENTLower UNEMPLOYMENT (too many people out of work)(too many people out of work) Promote Growth in the Economy Slow down an “over-heated” economy –Adjusting for the normal business cycle

Typical Business Cycle

Long Term Growth

Monetary Policy Fed is responsible for maintaining price stability and employment “Expansionary Monetary Policy” –goal is to increase money supply to reduce unemployment to avoid deflation “Contractionary Monetary Policy” –goal is to decrease the money supply to reduce inflation To prevent “bubbles”

3 Important Tools 1.Changing the Reserve Requirement 2.Changing the Discount Rate 3.Conducting “Open Market Operations” The three tools are interactive

1. Reserve Requirement currently: 3-10% Raise the reserve requirementLessRaise the reserve requirement = Less money in circulation –slows the economy eventually brings price stability (lowers inflation) Lower the reserve requirementMoreLower the reserve requirement = More money in circulation –More money to buy goods and services requiring more jobs to produce them (lowers unemployment)

2. Changing the discount rate discount rate = interest rate on fed to bank loans (set by Fed) federal funds rate = interest rate on bank to bank loans (set by fed funds market) Raising the interest rate influences how much banks will decide to borrow from the fed (who will lend them money “out of thin air”, increasing money supply) Keeping the discount rate low encourages borrowing

federal funds rate=interest rate on bank to bank loans discount rate=interest rate on fed to bank loans When the federal funds rate is lower than the discount rate, who would you borrow from? When the discount rate is lower than the federal funds rate, who would you borrow from? The Fed can encourage borrowing by keeping rates lowThe Fed can encourage borrowing by keeping rates low Another bank The fed

currently: discount rate -.75% federal funds rate % currently: discount rate -.75% federal funds rate % 2006 discount rate % federal funds rate % What is the Fed trying to do?

Federal Open Market Committee (FOMC) controls Open Market Operationscontrols Open Market Operations –Open Market Purchases buys government securities = increases money supply –Open Market Sales sells government securities = reduces the money supply 1

Important Background Information U.S. Department of the Treasury –the agency of government responsible for paying for government and its actions collects taxes borrows money if needed –It borrows from the public by offering securities »securities: promises to repay with interest at some future time

Open Market Purchases Fed offers to buy your government security.Fed offers to buy your government security. –“Thin air” money is given to you. –Money supply increases

Open Market Sales Fed offers to sell government securities it holds.Fed offers to sell government securities it holds. –You pay for it. –Your money “disappears” into the Fed –Decreases the money supply.