1. Regulating Money Supply
Monetary Policy
Regulating Money Supply

2. 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

3. 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

4. 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

5. 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

6. Monetary Policy Worksheet
Graphing both MS & AD/AS

7. 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

8. 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 ↑

9. 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

10. 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!

11. Bernanke Interview #1 (2009)
60 minutes interview 1 year after financial crisis began in 2008

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

15. 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 ↑

16. Federal Reserve in action 1999 - 2012
Loose
Monetary Policy
2012

17. Bernanke Interview #1 (2009)
60 minutes interview 1 year after financial crisis began in 2008

18. GDP growth by quarter
+0.4%

19. Bernanke’s Challenge

20. Quantitative Easing Fed controls only short term interest rates
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

21. Bernanke Interview #2 (2010)
Got Quantitative Easing?

22. 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

23. 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

24. Current Problem

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

26. Fed Chief
Why is this
man smiling?
Glen Hubbard
This is so
WRONG!
Ben Bernanke

27. 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!

28. Federal Reserve in action 1999 - 2009

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

30. 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

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

32. 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

33. 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

34. Bernanke Interview