1. Please listen to the audio as you work through the slides
Monetary Policy
Please listen to the audio as you work through the slides

2. Monetary Policy Learning Objectives:
Students will be able to thoroughly and completely explain:
The 3 tools used by the Federal Reserve to operate Monetary Policy.
Easy money policy and tight money policy, when to use each, the 3 tools associated to each.
How monetary policy works using the cause and effect chain approach.
The impact of the net export effect on monetary policy
The strengths and weaknesses of monetary policy.
How to use the tools of Monetary Policy to address the problems of Inflation and Recession.

3. Goals of Monetary Policy
…to assist the economy in achieving a full-employment, noninflationary level of total output

4. Review of Monetary Policy Interest Rates
Discount rate - the interest rate that the Federal Reserve Banks charge on the loans they make to commercial banks and thrift institutions. This rate is directly established by the Fed.
Federal Funds rate – the interest rate banks and other depository institutions charge one another on overnight loans made out of their excess reserves. This rate is established by the changes in the money supply (caused by the Fed).

5. Federal Reserve Tools Open Market Operations Reserve Ratio
Buy or sell used bonds
Reserve Ratio
Raise or lower
Discount Rate

6. Create a study guide for all six tools

7. Open Market Operations
Recession Fed buy bonds What happens next?
Inflation Fed sells bonds What happens next?

8. Fiscal Policy Recession Inflation
Expansionary Fiscal Policy Contractionary Fiscal Policy
Use Tool # Use Tool # 1
Then what happens? Then what happens?

9. Tools of Monetary Policy
1. Open market operations
Buying of government securities from Commercial banks and the general public (bonds)
Selling of government securities to Commercial banks and the general public
Used to influence the money supply
When the Fed sells securities to banks, commercial bank reserves are reduced
When the Fed buys securities from banks, commercial bank reserves are increased

10. Tools of Monetary Policy
2. The reserve ratio
Changes the money multiplier
3. The discount rate
The Fed as lender of last resort for banks
Short term loans

11. Federal Reserve Policies
Easy Money Policy – fight recession
Easy Money Policy – increase reserves, increase money supply, lower interest rates, Increase AD, and employment, control recession.
Tight Money Policy – fight inflation
Tight Money Policy – reduce money supply, increase interest rates, to reduce spending, control inflation.

12. From commercial banks... How it works
Tools of Monetary Policy
Open-Market Operations
1. Fed Buying Securities – easy money policy to fight recession
increase reserves (increase money supply)
From commercial banks... How it works
Bank gives up securities (sells them)
FED pays bank – by increasing their reserves
Banks have increased reserves (increased excess reserves) – can lend more (increase money supply)
From the public... How it works
Public gives up securities (sells them)
Public deposits check from FED in bank (increase check account balances)
Banks have increased reserves (increased excess reserves) - (increase money supply)

13. Open-Market Operations
Tools of Monetary Policy
Open-Market Operations
2. Fed Selling Securities – tight money policy to fight inflation
decrease reserves (decrease money supply)
To commercial banks... How it works
FED gives up securities (sells them)
Bank pays for securities (out of excess reserves)
Banks have decreased excess reserves (decrease money supply)
To the public... How it works
FED gives up securities (sells them)
Public pays by check drawn on a bank (decrease demand deposit balances)
Banks have decreased reserves (decrease money supply) – (remember the check clearing process)

14. Open-Market Operations
Tools of Monetary Policy
Open-Market Operations
The Reserve Ratio
1. Raising the Reserve Ratio – tight money policy to fight inflation
reduce money supply
Banks must hold more reserves – (lower excess reserves)
Banks decrease lending
Money supply decreases
2. Lower the Reserve Ratio – easy money policy to fight recession
Increase money supply
Banks may hold less reserves – (higher excess reserves)
Banks increase lending
Money supply increases

15. Open-Market Operations
Tools of Monetary Policy
Open-Market Operations
The Reserve Ratio
The Discount Rate – rate Fed charges
Commercial banks. Raise or lower
Easy Money Policy – fight recession
increase reserves, increase money supply, lower interest rates, Increase AD and employment
Fed Buy’s Securities (pay bond holders who sell)
Decrease Reserve Ratio (increase excess reserves)
Lower Discount Rate (encourage borrowing by banks from each other)

16. Open-Market Operations
Tools of Monetary Policy
Open-Market Operations
The Reserve Ratio
The Discount Rate
Tight Money Policy – fight inflation
Decrease reserves, reduce money supply, raise interest rates, to reduce spending, control inflation.
Fed Sells Securities (take money out of our hands)
Increase Reserve Ratio (decrease excess reserves)
Raise Discount Rate (discourage bank borrowing)

17. Monetary Policy, Real GDP
and the Price Level
Cause-Effect Chain
Money supply impacts interest rates
Interest rates affect investment
Investment is a component of AD
Equilibrium GDP is affected by AD

18. Monetary Policy and GDP
Equilibrium real
GDP and the
Price level
(a)
The market
for money
(b)
Investment
demand
Rate of Interest, i (Percent)
Amount of money
demanded and
supplied
(billions of dollars)
Sm1
Sm2
Sm3
Amount of investment
(billions of dollars)
Price Level
Real GDP
(billions of dollars) AS 10 8 6 P3
AD3
I=$25 P2
AD2
I=$20 Dm ID
AD1
I=$15
$125
$150
$175
$15
$20
$25 Q1 Qf Q3

19. Expansionary Monetary Policy
Problem: unemployment and recession
CAUSE-EFFECT CHAIN
Fed buys bonds, lowers reserve ratio, lowers the discount rate
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises

20. Restrictive Monetary Policy
Problem: inflation
CAUSE-EFFECT CHAIN
Fed sells bonds, increases reserve ratio, increases the discount rate
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines

21. Monetary Policy in Action
Strengths of monetary policy
Speed and flexibility
Isolation from political pressure
Target the Federal Funds Rate
The Federal Funds Rate – rate banks charge each
other for overnight loans of reserves. Tighter policy higher rate.
The Prime Interest Rate – a benchmark rate banks use
The Fed does not set either of these. They are equilibrium rates
that result from open market operations to change reserves.

22. Problems and Complications
Lags
Recognition lag – same as fiscal policy – for recession
Administrative lag – very short relative to fiscal policy
Operational lag :
Approximately 12 to 24 months for interest rate changes to have full impact on I, AD, Real GDP, price level.
Changes in Velocity
Number of times per year average dollar is spent on goods and services. Velocity x money supply = total spending
Cyclical Asymmetry
Monetary policy effective in slowing expansions and controlling inflation but less reliable at curing a significant recession.
“Artful Management” or “Inflation Targeting”

23. Expansionary Monetary policy versus expansionary fiscal policy
Net Export Effect
Expansionary Monetary policy versus expansionary fiscal policy
Expansionary monetary policy increases net exports and strengthens Monetary policy.
Expansionary fiscal policy decreases net exports and weakens the fiscal policy.
The steps for expansionary fiscal policy:
Expansionary fiscal policy financed by borrowing (deficit financing)
Selling bonds (increasing the supply of bonds – bond prices dropping and interest rates rising)
Dollar appreciates – higher demand for dollars
Imports rise and exports fall – net exports fall
AD falls and dampens the expansionary fiscal policy

24. Monetary policy and the Net Export Effect
Easy money policy
Problem – recession
Easy money policy to lower interest rate
Decreased foreign demand for dollars
Dollar depreciates (takes more dollars to buy a foreign currency)
Net exports increase
(aggregate demand increases, equilibrium GDP expands, strengthening the easy money policy.)

25. Monetary policy and the net Export effect
Easy money policy
Problem – recession
Easy money policy to lower interest rate
Decreased foreign demand for dollars
Dollar depreciates (takes more dollars to buy a foreign currency)
Net exports increase
(aggregate demand increases, equilibrium GDP expands, strengthening the easy money policy.)
Tight money policy
Problem – inflation
Tight money policy (higher interest rates)
Increased foreign demand for dollars
Dollar appreciates (takes fewer dollars to buy a foreign currency)
Net exports decrease
(aggregate demand decreases, equilibrium GDP contracts, strengthening the tight money policy.)

26. Monetary policy and the net Export effect
Easy money policy
Problem – recession
Easy money policy to lower interest rate
Decreased foreign demand for dollars
Dollar depreciates (takes more dollars to buy a foreign currency)
Net exports increase
(aggregate demand increases, equilibrium GDP expands, strengthening the easy money policy.)
Tight money policy
Problem – inflation
Tight money policy (higher interest rates)
Increased foreign demand for dollars
Dollar appreciates (takes fewer dollars to buy a foreign currency)
Net exports decrease
(aggregate demand decreases, equilibrium GDP contracts, strengthening the tight money policy.)
Expansionary monetary policy increases net exports and strengthens
Monetary policy. Expansionary fiscal policy decreases net exports and
Weakens The fiscal policy.

27. monetary policy
open-market operations
reserve ratio
discount rate
easy money policy
tight money policy
Federal funds rate
prime interest rate
velocity of money
cyclical asymmetry
inflation targeting
KEY TERMS

28. Tools Exercise Recession
Explain how the problem of recession will be solved by lowering taxes and having the Fed lower the reserve ratio.

29. Tools Exercise Recession
Explain how the problem of recession will be solved by lowering taxes and lowering the discount rate.

30. Tools Exercise Recession
Explain how the problem of recession will be solved by increasing government spending and by having the Fed buy bonds from Commercial Banks or the public.

31. Tools Exercise Inflation
Explain how the problem of Inflation will be solved by lowering government spending and by having the FED sell bonds.

32. Tools Exercise Inflation
Explain how the problem of inflation will be solved by raising taxes and the Fed raising the discount rate.

33. Tools Exercise Inflation
Explain how the problem of inflation will be solved by raising taxes and the Fed raising the Reserve ratio.

34. Tools Exercise Inflation
Explain how the problem of inflation will be solved by raising taxes and the Fed selling bonds.