1. Functions of the Fed Controlling the Money Supply! –Vary money supply to meet seasonal fluctuations in the demand for money. Helps keep interest rates steady. Promote stabilizing expectations! –Adjust federal funds rate to meet policy goals of the FOMC.

2. The Fed’s Policy Tools 1) Reserve Requirements 2) Discount rate “primary lending rate” 3) Open market operations Manage the public’s expectations Inflation Targeting?

3. Reserve Requirement Legal reserves: the cash a bank holds in its vault plus its deposits at the Fed. Fed lowers reserve requirements  banks suddenly have excess reserves  increased bank lending deposit expansion multiplier  money supply increases. Similarly, the Fed may decrease the money supply by raising reserve requirements.

4. Discount Rate (Primary Lending Rate) The rate of interest a Fed District Bank charges when a bank borrows from it. When the Fed raises the discount rate, it raises the cost of borrowing reserves, reducing the amount of reserves borrowed. Lower levels of reserves result in reduced lending, and reduced money supply.

5. Open Market Operations Open Market Operations: buying and selling of government bonds by the Fed to control bank reserves, the fed funds rate, and the money supply. Buy Ease Sell Tighten The Fed buys your bond  you deposit the Fed’s check in your bank account  your bank now has more reserves  increase in reserves results  increase in money supply and reduction in the fed funds rate, the interest rate on reserves.

6. Money Supply Money supply is controlled by the Fed, and therefore is not a function of interest rates. As a result the money supply function is vertical.

7. Now to combine money supply with money demand: –Transactions demand: hold money to buy goods and services. Trade off interest you could earn on bonds against costs of managing your money “inventory” in deciding on best amount of money to hold for transactions Financial innovations reduce costs of managing money balances  reduced demand for money over time –Speculative demand: deal with uncertainty about the value of other assets … fear decline in the value of other assets, so hold money as a safeguard.

8. Money Demand Interest rate is opportunity cost of holding money. The higher the interest rate the lower the quantity of money demanded.

9. MoneyDemand High r  bond prices low  want to exchange money for bonds: speculate bond price will rise (r will fall) Low r  bond price is high  don’t want to hold bonds whose prices may fall  hold money instead

10. Effect of a change in income on money demand Transactions demand increases with income. As nominal income increases, the volume of transactions increase, requiring more money.

11. Money Market Equilibrium

12. Money Supply and Interest Rates Money Interest Rates Fed Increases Money Supply M2M2 M1M1 r2r2 r1r1 Interest Rates Fall MdMd

13. How Money Supply Changes affect GDP