Regulating Money Supply Monetary Policy Regulating Money Supply

Money Supply Total amount of money in circulation Federal Reserve “controls” size of the money supply U.S. uses a fiat currency Changing the money supply directly affects short term interest rates and future inflation Rapidly ↑ Money Supply leads to high inflation

Model of short term interest rates called the federal funds rate The Money Market Model of short term interest rates called the federal funds rate Currently 0.0% Supply of Money is fixed by the Fed Fed “controls” money supply by buying or selling Gov’t Bonds Interest Rate Qty $ The Money Market MS MD Demand for money is downward sloping as interest rates ↓ more $ is demanded

2 Types of Monetary Policy Expansionary Monetary Policy (loose) Goal: to increase the money supply MS ↑ => Short Term Interest rates ↓ => AD ↑ => GDP ↑ Contractionary Monetary policy (tight) Goal: to decrease the money supply MS ↓ =>Short Term Interest rates ↑ => AD ↓ => GDP ↓ GDP

2-Tools of Monetary Policy Discount Rate Changes Interest rate at which Banks borrow directly from the Fed It is only used in an “emergency” (currently 0.75%) Fed can simply raise or lower discount rate Open Market Operations (to change MS which moves the federal funds rate) Process of buying or selling government bonds to change money supply Change in MS alters the federal funds rate (currently 0.0%) Federal Funds Rate= rate banks borrow directly from each other at GDP

Monetary Policy Worksheet Graphing both MS & AD/AS

Federal Reserve Government bonds Money supply ↑ Example: Expansionary Monetary Policy Step #1: Lower the discount rate Step #2: Use Open Market Operations to increase money supply--the Fed Buys government bonds Federal Reserve Government bonds Money supply ↑ 23

Lower interest rates => Economic Situation GDP growth = -1.0%, Unemployment = 10.0% Little to no inflation Solution: Loose Monetary Policy (also called expansionary) ↓ Discount Rate Buy Bonds => ↑ MS => ↓ Federal Funds Rate MS2 ------------------ i2 MD Interest Rate Qty of $ MS1 --------- i1 ----------- P2 E2 Affects AD Lower interest rates => More Loans taken by Consumers & Business C ↑ + I ↑ => so AD ↑

Tight Monetary Policy Federal Reserve Government bonds Money supply ↓ Step #1: Raise the discount rate Step #2: Open Market Operations– to DECREASE money supply Fed SELLS government bonds Federal Reserve Government bonds Money supply ↓ 23

Higher interest rates => Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3.0% Solution: Tight Monetary Policy ↑ Discount Rate Sell Bonds ↓MS => ↑Federal Funds Rate MS1 MD Interest Rate Qty of $ MS2 Affects AD --------- i2 Higher interest rates => Less Loans taken by Consumers & Business C ↓ + I ↓ => so AD ↓ --------------- i1 End Result: Lower GDP & less inflation!

Bernanke Interview #1 (2009) http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?tag=mncol;lst;1 60 minutes interview 1 year after financial crisis began in 2008

Stimulus Debates Economists argue over the benefits versus costs of Loose Monetary Policy Benefits Costs/Risks

Lower interest rates => US Economy GDP growth +1.7% Unemployment = 8.3% Low inflation except for gas prices Solution: Loose Monetary Policy ↓ Discount Rate Buy Bonds => ↑ MS => ↓ Federal Funds Rate MS2 ------------------ i2 MD Interest Rate Qty of $ MS1 --------- i1 Inflation Real GDP AS1 Affects AD AD2 AD1 Lower interest rates => More Loans taken by Consumers & Business C ↑ + I ↑ => so AD ↑

Federal Reserve in action 1999 - 2012 Loose Monetary Policy 2012

Bernanke Interview #1 (2009) http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?tag=mncol;lst;1 60 minutes interview 1 year after financial crisis began in 2008

GDP growth by quarter +0.4%

Bernanke’s Challenge

Quantitative Easing Fed controls only short term interest rates http://www.npr.org/blogs/money/2010/10/07/130408926/quantitative-easing-explained Fed controls only short term interest rates Which are already at ZERO percent (liquidity trap) Traditional monetary policy can’t do anymore Goal: is to solve the credit crunch Get banks to make loans again… Strategy: buy Gov’t & Mortgage bonds to lower long term interest rates Lower long term interest rates => lead to more investment Lower mortgage rates => lead to more houses sold

Bernanke Interview #2 (2010) http://www.youtube.com/watch?v=LxSv2rnBGA8 Got Quantitative Easing?

Austrian Economics Friedrich Hayek (1899 – 1992) Austrian School of Economics Against active Fed Policy Promoted “self regulation” of free market Believed low interest rates led to Malinvestment

Gov’t Bailouts FNMA & FHLMC AIG Insurance Company Government takeover Wall Street Firms Bankrupt or Bought Bear Stearns Merrill Lynch Lehman Brothers AIG Insurance Company Government Takeover http://finance.yahoo.com/tech-ticker/article/328342/Can-Regulators-%22Save-Us-From-Ourselves%22-The-Risk-of-Another-Wall-St.-Crisis?tickers=gs,ms,skf,xlf,spy,dia

Current Problem

AS1 AD2 5.25% AD1 0.0% Real GDP Discount Rate Federal Funds Rate

Fed Chief Why is this man smiling? Glen Hubbard This is so WRONG! Ben Bernanke http://youtube.com/watch?v=CHQ_4cZY2Xk

GDP growth at +5.0%, Inflation rising, Unemployment 3% Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3% Solution: Tight Monetary Policy MS1 MD Interest Rate Qty of $ MS2 Inflation Real GDP AS1 AD1 Affects AD AD2 --------- i2 --------------- i1 End Result: Lower GDP & less inflation!

Federal Reserve in action 1999 - 2009

Problem #10 Hamburger Price -------------- Price Ceiling ------------- S1 $5 -------------- E1 ------------- 1,000 Price Ceiling $3 D1 Qty

Tight Monetary Policy Fed. Sells Securities MS1 MD MS2 --------- i2 Open-Market Operations Fed. Sells Securities MS1 MD Nominal Interest Rate Qty of $ MS2 --------- i2 --------------- i1

What Now? Fiscal Policy Monetary Policy U.S. Economy

The Fed adjusts Money Supply Monetary POLICY Monetary Policy can shift AD curve right or left Inflation AS1 The Fed adjusts Money Supply AD2 AD1 1) Discount Rate 2) Open Market Operations Real GDP

Monetary POLICY Monetary Policy will shift AD curve Economy in recession Inflation AS1 AD2 Loose monetary policy needed AD1 AD shifts right End result: higher GDP, more Jobs & risk of higher inflation Real GDP

Bernanke Interview http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?tag=mncol;lst;1