Monetary PolicyChapter 15

GOALS OF MONETARY POLICY

…to assist the economy in achieving a full-employment, noninflationary level of total output

CONSOLIDATED BALANCE SHEET OF

THE FEDERAL RESERVE BANKS

ASSETS•Securities•Loans to Commercial Banks

LIABILITIES•Reserves of Commercial

Banks•Treasury Deposits•Federal Reserve Notes

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

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

New reserves$800

ExcessReserves

$4000Bank System Lending

FEDERAL RESERVEPURCHASE OF BONDS

Purchase of a$1000 bondfrom a bank...

$200Requiredreserves

$1000Initial

Deposit

Total Increase in Money Supply ($5000)

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

TOOLS OF MONETARY POLICY

Open-Market Operations

The Reserve Ratio

The Discount Rate-Interest rateCharged to member banks for loans

Easy Money Policy• Buy Securities• Decrease Reserve Ratio• Lower Discount Rate

TOOLS OF MONETARY POLICY

Open-Market Operations

The Reserve Ratio

The Discount Rate

Tight Money Policy• Sell Securities• Increase Reserve Ratio• Raise Discount Rate

Federal Funds Rate

Interest rate banks charge each other for overnite loans

Prime interest rate-interest rate charged by Fed

Fed. Funds rate is prime + 1 or 2 % points

If Fed wants to decrease FFR, then it buys bondsIncreases S of reserves----FFR drops

Monetary Policy & International trade

Net Export effect Easy $ policy---decreases interest rate

___securities, ___ RR, ____DR What happens to imports? Exports? AD? GDP? Balance of trade--

Tight $ policy ___securities, ___RR, ___DR Imports? Exports? AD? GDP? Balance of trade

Real domestic output, GDP

Dm

InvestmentDemand

Rea

l rat

e of

inte

rest

, i

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

MONETARY POLICY AND EQUILIBRIUM GDPSm1

AS

AD1(I=$15)

P1

10

8

6

0

Sm2

AD3(I=$25)

P2

If the Money SupplyIncreases to Stimulatethe Economy…Interest Rate DecreasesInvestment IncreasesAD & GDP Increases with slight inflation

Pri

ce le

vel

AD2(I=$20)

P3

Sm3

Increasing money supply continues the growth – but, watch Price Level.

Effectiveness of MP

Strengths Isolated from

politics Quickly “fix” econ 1980’s/1990’s

budget deficit meant FP was not used

Weaknesses Increasing

globalization makes MP harder

No guarantee that banks will loan excess—leakage

MP can’t totally move US out of recession

Change in velocity

DIFFERENT VIEWS OF MP

Artful Management

Alan Greenspan Manage Supply

of Money based on data

Inflation Targets Goal 1-2%

inflation for 2 years

Increased accountability instead of just based on personality

EFFECTIVENESS OF POLICIES

Depends on demand for moneyThe steeper the demand for

money—more interest rates will have impact

Most direct policy—Open Market Operations

Others—more time; depends on banks