Monetary Policy:

Regulating Money Supply

Trade Quiz

#1: What are the two conflicting responsibilities of the Federal Reserve?

Maximizing GDP & Employment while at the same time keeping inflation low

Review Quiz

#2: What are two ways the Fed has some political independence when it comes to making their decisions?

14-year term of officeDon’t rely on money from Congress to keep running

Review Quiz

#e: How many members of the Fed Board of Governors are there?

7

Review Quiz

#4: How many District Branches of the Federal Reserve system are there?

Review Quiz

12

Trade Quiz

#5: What is the “discount rate?”

The interest rate that the Federal Reserve charges on direct loans to the 12 District Banks

Review Quiz

Trade Quiz

#6: Who is on the Federal Open Market Committee (FOMC?

The 7 members of the Board of Governors and 5 of the presidents of the District Banks

Review Quiz

Trade Quiz

#7: What important decisions does the FOMC make?

What the FFR should be and how much money there should be in the economy?

Review Quiz

Federal Reserve Structure

Meets 8 times a year to vote on Monetary Policy

Federal Reserve

Board of Governors

(7 members)

Ben BernankeChairman

Federal Open Market Committee= 7 Governors + 5 District Bank Presidents—meets 8 timesper year

12 District FederalReserve Banks

BostonSan FranciscoNew YorkAtlantaChicagoDallas, etc.

Member Banks

All national banks

Some state banks

Federal Funds Rate = Interest ratethat the 12 District banks charge Each other on overnight loans

Discount Rate=Interest rate that the Fed lends money directly to District Banks

(rarely used) SF Fed Building—Market Street

The Money Market

S-Money

D-Money

InterestRate (FFR)

Qty $

The Money Market

Demand for money is downward sloping as interest rates ↓ more $ is demanded

Supply of Money is fixed by the Fed

Fed “controls” money supply throughmonetary policy

Modern-day economies are almost entirelyrun on CREDIT—it’s all about borrowingCONSTANTLY

2 Types of Monetary Policy

• LOOSE Monetary Policy (increasing the money supply)

• TIGHT Monetary policy (decreasing the money supply)

1. Discount Rate Changes• Changing the interest rate at which District

Banks borrow directly from the Fed

Two Tools of Monetary Policy

Two Tools of Monetary Policy

2. Open Market Operations– Federal Reserve action to buy or sell Treasury bonds

-- This changes the money supply, which shifts the Federal Funds Rate

*Demonstration

MD

MS2InterestRate (FFR)

Qty of $

MS1

---------FFR1

-------------------FFR2

PriceLevel

RealGDP

AS1

AD2

AD1

Affects AD-people borrow& spend more

• First, the Fed lowers the discount rate (i.e. 3% to 2%)

• Next, the Fed uses Open Market Operations to increase money supply

--the Fed Buys government bonds from anyone selling them

Loose (aka Expansionary) Monetary Policy

Important Fact: Time Lag

FYI: Both Fiscal Policy (6-12 months) and Monetary Policy (12-24 months) have a time lag

Translation: they do not have immediate effect

MS1

MD

InterestRate (FFR)

Qty of $

MS2

---------------FFR1

-------------FFR2

AS1

PriceLevel

RealGDP

AD1

AD2

Affects AD-people borrow & spend less

Tight (aka Contractionary)Monetary Policy• First, the Fed raises the discount rate (i.e. 4.5% to 5.0%)

• Next, the Fed uses Open Market Operations to decrease money supply

--the Fed Sells government bonds to willing investors

 Economic Issue

Policy Type(Moderately Loose,

Aggressively Loose,Moderately Tight,

Aggressively Tight, orTake No Action)

What action would the Fed take

regarding Discount

Rate (increase or decrease)

What would the Fed want to

happed to the Federal Funds Rate (increase or decrease)

What change in the Money Supply would be needed to bring about the desired

change in FFR (increase or decrease)

What action in Open Market Operations would be needed to

bring about the desired change in

Money Supply (Buy or Sell

Treasury Bills)1. Inflation rises to 10% 

         

2. GDP growth is at 0.9%; the inflation rate is 1.8%

   

       

3. GDP growth rate is 2.1% and the inflation rate is 3.5%

   

   

4. Consumer confidence is falling; retail sales very weak; unemployment at 8.1%

   

       

5. GDP growth is at 4.2%; inflation is at 3.6%

   

    

AggressivelyTight

IncreaseFFR

DecreaseFFR

None OR

IncreaseFFR

DecreaseDiscount Rate

IncreaseDiscount Rate

ModeratelyTight

NoneOR

ModeratelyTight

ModeratelyLoose

AggressivelyLoose

DecreaseMoneySupply

Sell T-Bills

IncreaseMoneySupply

Buy T-Bills

None OR IncreaseDiscount Rate

None OR DecreaseMoneySupply

NoneORSell T-Bills

IncreaseMoneySupply

DecreaseDiscount Rate

DecreaseFFR

Buy T-Bills

 IncreaseDiscount Rate

IncreaseFFR

DecreaseMoneySupply

Sell T-Bills

18

News Clips

http://www.asterpix.com/v/8654211/fed-cuts-interest-rates/***(first 45 seconds of 2 minute clip)

http://video.google.com/videosearch?q=federal%20funds%20rate%20suze%20orman&rls=com.microsoft:*&oe=UTF-8&startIndex=&startPage=1&um=1&ie=UTF-8&sa=N&hl=en&tab=wv#(Suze Orman on FFR) (4:32)

http://video.msn.com/video.aspx?mkt=en-us&vid=2d392a8b-ac77-4e73-8999-c31db8966b68***(4:29) good clip when Fed was considered cutting FFR from 1.5%

http://video.msn.com/video.aspx?mkt=en-us&vid=5dc4a263-0085-4db0-aecb-81f39870a948(roundtable on FFR increase to 4.75%) (7:40)

Economic Issue

1. Inflation rises to

10%

2. GDP growth is at 4.2%; inflation is at 3.6%

3. GDP growth is 2.1% and the inflation rate is 3.5%

4. Consumer confidence

is falling; retail sales very

weak; unemployment at

8.1%

5. GDP growth is at 0.9%; inflation rate is 1.8%

Policy Type(Moderately Loose, Aggressively Loose,Moderately Tight,

Aggressively Tight, orTake No Action)

Action on Open Market Operations (Buy or Sell

Treasury Bills

Effect on the Money Supply (increase or decrease)

Effect on

Federal

Funds Rate

(increase or

decrease

AggressiveContractionary

Sell T-BillsDecrease

MoneySupply

IncreasesFFR

ModerateContractionary

Sell T-Bills

NoneOR

Sell T-bills

Buy T-Bills

Buy T-Bills

DecreaseMoneySupply

NoneOR

Decrease MS

IncreaseMoneySupply

IncreaseMoneySupply

IncreasesFFR

NoneOR

FFR

Decreases FFR

DecreasesFFR

Take no actionOR

Mod. Contractionary

Aggressive Expansionary

Moderate Expansionary

Monetary POLICY

PriceLevel

RealGDP

AS1

Monetary Policy will shift AD curve

AD1 AD2

Economy in recession

Loose monetary policy needed

Buys Securities & lowers discount rate

AD shifts right

Money becomes cheaper; Interest rates go down

Solution: Tight Monetary Policy

Affects AD

PriceLevel

RealGDP

Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3%

AS1MS1

MD

InterestRate

Qty of $

MS2

---------------i1---------i2 AD1

End Result: Lower GDP & less inflation!

AD2

Loose or Tight Monetary policy needed?

Loose Monetary Policy

Affects AD

PriceLevel

RealGDP

Situation: GDP growth at -2.0%, Unemployment 9%

AS1MS2

MD

InterestRate

Qty of $

---------------i2

MS1

---------i1

AD1 AD2

Loose or Tight Monetary policy needed?

Loose Monetary Policy

Fed _________ Securities

MD

MS2InterestRate

Qty of $

MS1

---------i1

---------------i2

2. Open-Market Operations

BUYS

1. Fed _________ Discount RateLOWERS

PriceLevel

RealGDP

AS1

AD2

AD1

Affects AD

MS1

MD

NominalInterestRate

Qty of $

MS2

---------------i1---------i2

Tight Monetary Policy

2. Open-Market Operations

Fed _________ Securities

1. Fed _________ Discount Rate

AS1

PriceLevel

RealGDP

RAISES

SELLS

AD1

AD2

Affects AD