2. Monetary Policy 15 C H A P T E R

3. GOALS OF MONETARY POLICY …to assist the economy in achieving a full-employment, noninflationary level of total output

5. CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANKS ASSETS Securities Loans to Commercial Banks LIABILITIES Reserves of Commercial Banks Treasury Deposits Federal Reserve Notes

6. TOOLS OF MONETARY POLICY Open-Market Operations Buying Securities From commercial banks... Bank gives up securities FED pays bank Banks have increased reserves From the public... Public gives up securities Public deposits check in bank Banks have increased reserves

7. TOOLS OF MONETARY POLICY Open-Market Operations Selling Securities To commercial banks... FED gives up securities Bank pays for securities Banks have decreased reserves To the public... FED gives up securities Public pays by check from bank Banks have decreased reserves

8. New reserves $800 Excess Reserves $4000 Bank System Lending FEDERAL RESERVE PURCHASE OF BONDS Purchase of a $1000 bond from a bank... $200 Required reserves $1000 Initial Deposit Total Increase in Money Supply ($5000)

9. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio Raising the Reserve Ratio Banks must hold more reserves Banks decrease lending Money supply decreases Lowering the Reserve Ratio Banks may hold less reserves Banks increase lending Money supply increases

10. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Buy Securities Decrease Reserve Ratio Lower Discount Rate

11. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate

12. TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate Easy Money Policy Tight Money Policy Sell Securities Increase Reserve Ratio Raise Discount Rate Discuss relative importance of each control

18. 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 changed

19. Real domestic output, GDP DmDm Investment Demand Real rate of interest, i 10 8 6 0 Quantity of money demanded and supplied Amount of investment, i MONETARY POLICY AND EQUILIBRIUM GDP S m1 AS AD 1 (I=$15) P1P1 10 8 6 0 S m2 AD 3 (I=$25) P2P2 If the Money Supply Increases to Stimulate the Economy…   Interest Rate Decreases   Investment Increases   AD & GDP Increases with slight inflation Price level AD 2 (I=$20) P3P3 S m3   Increasing money supply continues the growth – but, watch Price Level.

20. Money Market Investment Equilibrium GDP Effects of an easy money policy Effects of a tight money policy MONETARY POLICY AND EQUILIBRIUM GDP

21. MONETARY POLICY IN ACTION Strengths of monetary policy Speed and flexibility Isolation from political pressure Focus on the Federal Funds Rate The Federal Funds Rate The Prime Interest Rate Recent Monetary Policy

22. Problems and Complications Lags Changes in Velocity Cyclical Asymmetry “Artful Management” or “Inflation Targeting”

23. MONETARY POLICY AND THE INTERNATIONAL ECONOMY Net export effect Macro stability and the trade balance The “Big Picture”

24. ENDBACK 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 Copyright McGraw-Hill/Irwin, 2005