Chapter 12Chapter 12

Monetary PolicyMonetary Policy

IntroductionIntroduction Monetary Policy – Federal Reserve Monetary Policy – Federal Reserve

using the money supply and interest using the money supply and interest rates to stabilize the economyrates to stabilize the economy

IntroductionIntroduction Board of Governors formulate policyBoard of Governors formulate policy 12 Districts implement the policy12 Districts implement the policy

Types of Monetary PolicyTypes of Monetary Policy Easy (loose) PolicyEasy (loose) Policy

Increase the money supplyIncrease the money supply Decrease interest ratesDecrease interest rates Increase borrowingIncrease borrowing Increase spending (C+I)Increase spending (C+I) Increase aggregate demandIncrease aggregate demand Increase GDPIncrease GDP

Tight PolicyTight Policy Decrease the money supplyDecrease the money supply Increase interest ratesIncrease interest rates Decrease borrowingDecrease borrowing Decrease spending (C+I)Decrease spending (C+I) Decrease aggregate demandDecrease aggregate demand Decrease GDPDecrease GDP

ToolsTools Open market operations - buying and Open market operations - buying and

selling govt. bonds (most important)selling govt. bonds (most important) Reserve Ratio (requirement) - % of Reserve Ratio (requirement) - % of

reserves held in the FED (least used)reserves held in the FED (least used) 1937 – 20%1937 – 20% 1958 – 13%1958 – 13% 1980 – 12%1980 – 12% 1992 – 10%1992 – 10%

Discount Rate - rate at which banks borrow Discount Rate - rate at which banks borrow from the FED (Used in emergencies)from the FED (Used in emergencies)

Policy in the GapsPolicy in the Gaps Contractionary Gap (recession): Easy Money Policy Contractionary Gap (recession): Easy Money Policy

to Inc MS, dec ir, inc borrowing and spending (C & to Inc MS, dec ir, inc borrowing and spending (C & I), inc AE & AD and inc GDPI), inc AE & AD and inc GDP Buy BondsBuy Bonds Lower RRLower RR Lower DRLower DR

Expansionary Gap (potential inflation): Tight Money Expansionary Gap (potential inflation): Tight Money Policy to dec MS, inc ir, dec borrowing and spending Policy to dec MS, inc ir, dec borrowing and spending (C & I), dec AE & AD and dec GDP(C & I), dec AE & AD and dec GDP Sell BondsSell Bonds Raise RRRaise RR Raise DRRaise DR

EffectivenessEffectiveness Faster and more flexible than Fiscal Faster and more flexible than Fiscal

PolicyPolicy Can be reversedCan be reversed

Less politicalLess political FED targets the Federal Funds Rate FED targets the Federal Funds Rate

through Open Market Operationsthrough Open Market Operations

DisadvantagesDisadvantages Can’t force banks to borrow or not borrowCan’t force banks to borrow or not borrow