Reading Essentials and Study Guide

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1 Lesson 2 Monetary Policy ESSENTIAL QUESTION How does the government promote the economic goals of price stability, full employment, and economic growth? Reading HELPDESK Academic Vocabulary explicit openly and clearly expressed Content Vocabulary fractional reserve system system requiring financial institutions to set aside a fraction of their deposits in the form of reserves legal reserves currency and deposits used to meet the reserve requirements reserve requirement formula used to compute the amount of a depository institution s required reserves member bank reserve (MBR) reserves kept by member banks at the Fed to satisfy reserve requirements excess reserves financial institution s cash, currency, and reserves not needed for reserve requirements; potential source of new loans monetary policy actions by the Federal Reserve System to expand or contract the money supply to affect the cost and availability of credit interest rate the price of credit to a borrower easy money policy monetary policy resulting in lower interest rates and greater access to credit; associated with an expansion of the money supply tight money policy monetary policy resulting in higher interest rates and restricted access to credit; associated with a contraction of the money supply open market operations monetary policy in the form of U.S. Treasury bills, or notes, or bond sales and purchases by the Fed discount rate interest rate that the Federal Reserve System charges on loans to the nation s financial institutions prime rate best or lowest interest rate commercial banks charge their customers monetarism school of thought stressing the importance of stable monetary growth to control inflation and stimulate long-term economic growth quantity theory of money hypothesis that the supply of money directly affects the price level over the long run wage-price controls policies and regulations making it illegal for firms to give raises or raise prices without government permission 1

2 TAKING NOTES: Key Ideas and Details As you read this section, complete a graphic organizer like the one below to describe the effects of each monetary policy discussed. Monetary Policy What Is It? What Is Its Effect? reserve requirement open market operations discount rate Fractional Reserves and Deposit Expansion Guiding Question How do fractional reserves allow the money supply to grow? If we want to understand how monetary policy works, we must first understand how the fractional reserve system allows the money supply to easily grow or shrink. The fractional reserve system requires banks to keep part of their total deposits as legal reserves. Banking systems all over the world keep reserves. It is the foundation of banking in the United States. Whenever a bank accepts a deposit, it must keep some of it as legal reserves. Legal reserves are coins and currency that banks hold in their vaults, plus deposits at the Fed. The size of the reserves depends on the reserve requirement, which is the percentage of every deposit that must be set aside as legal reserves. The bank can then lend out the rest. The result is a money supply that is several times larger than the original deposit. Banking with Fractional Reserves Let s use an example from Chapter 10 to see how a fractional reserve system works. A depositor named Kim opened a demand deposit account (DDA) by depositing $1,000 in a bank. The bank must follow a 20 percent reserve requirement. If we assume that no one else has any money, the size of the entire money supply is also $1,000. Figure 16.2 shows the monetary expansion process that happens in this situation. Monday The bank must set aside $200 of Kim s deposit because of the 20 percent reserve requirement. The bank must keep the $200 as vault cash or as a member bank reserve (MBR). An MBR is a deposit a member bank keeps at the Fed to satisfy reserve requirements. 2

3 The remaining $800 is excess reserves. These are legal reserves left over after the reserve requirement. The $800 is what the bank can loan out. It represents the bank s lending power. At the end of Monday, the total money supply in the hands of the public equals Kim s $1,000 checking account. Tuesday The bank lends its $800 excess reserves to Bill. Bill decides to take the loan as a demand deposit account (DDA) so that the cash never leaves the bank. But the bank still treats Bill s DDA as a new deposit, so it has to set aside 20 percent, or $160, as a reserve. This leaves $640 of excess reserves for the bank to lend to someone else. By the end of Tuesday, the total money supply in the hands of the public amounts to $1,800. This is the sum of Kim s and Bill s DDAs. Wednesday Maria enters the bank and borrows the $640 excess reserves. If she also takes the loan as a DDA, the bank treats it as a new $640 deposit. Then the bank would have to set aside 20 percent as a required reserve. This leaves $512 of excess reserves. By the end of the day, the money supply in the hands of the public (DDAs and cash) has grown to $2,440. This is the sum of the DDAs owned by Kim, Bill, and Maria. The $2,440 result would be exactly the same if Maria had borrowed the bank s $640 excess reserves in cash. Then the money supply in the hands of the public would have been the $1,800 in Kim s and Bill s checking accounts, plus Maria s $640. Limits on Monetary Expansion The money expansion process will now stop temporarily until the $640 cash returns to the bank as a deposit. If Maria spends the money and the person who receives it opens a new deposit, the expansion process can continue. The growth in Figure 16.2 will go on as long as the bank has excess reserves to lend and as long as lenders deposit part or all of that money. As long as every dollar of DDAs is backed by 20 cents of legal reserves, the total amount of DDAs would be: $1, $5,000 People will always keep some cash, so the maximum size of the DDAs may never reach $5,000. But fractional reserve banking allows the sum of everyone s DDAs to grow several times larger than the original deposit. Reading Progress Check Describing What happens to the monetary expansion if people decide to hold cash in their pockets? 3

4 Conducting Monetary Policy Guiding Question What tools does the Fed use to expand and contract the money supply? One of the most important jobs of the Fed is to direct monetary policy. Monetary policy are actions by the Fed that cause changes in the money supply to affect the availability and cost of credit. This affects interest rates and impacts economic activity. How Monetary Policy Works Monetary policy is based on supply and demand. Figure 16.3 shows that the demand curve for money has the usual shape, which shows that people will demand more money when the interest rate is low. The interest rate is the price of credit for a borrower. But the supply curve does not have its usual shape. Instead, its vertical slope shows that the supply of money is fixed at any certain time. The Fed s monetary policy changes interest rates by changing the size of the money supply. The Fed increases the money supply under an easy money policy. This causes interest rates to fall. This kind of policy stimulates the economy because people and businesses borrow more at lower interest rates. You can see this in Panel A. The larger money supply lowers the rate from 10 to 8 percent. The Fed limits the size of the money supply under a tight money policy. You can see this in Panel B. Shrinking the money supply drives up the cost of borrowing from 10 to 12 percent. This slows borrowing and economic growth because higher interest rates normally cause people to borrow and spend less. The Fed can use three major tools to drive monetary policy. Each tool works in a different way to change the amount of excess reserves. Excess reserves are the amount of money a bank can lend to others. The The first tool of monetary policy is the reserve requirement. The Fed can change this requirement for all checking, time, and savings accounts within limits that Congress sets. For example, in Figure 16.2 we said that all the DDAs had a 20 percent reserve requirement. So the original deposit of $1,000 could grow to as much as $5,000 in total bank deposits. But the Fed could also lower the reserve requirement to 10 percent or increase it to 40 percent. A lower reserve requirement Figure 16.4 shows the results of a lower reserve requirement with the same original deposit of $1,000. In Panel A, the 10 percent reserve requirement means that the bank could lend out $900 of excess reserves on the second day. It could then lend out $810 on the third day, and so on. Excess reserves are available until the DDAs reach a maximum of: $1, $10,000 A higher reserve requirement In Panel B, the reserve requirement increases to 40 percent. The result is that $600 of excess reserves are available for the first loan, $360 of excess reserves are available for the second loan, and so on. This continues until there is $2,500 of DDAs. $1, $2,500 4

5 Historically, the Fed has avoided using the reserve requirement as a policy tool partly because other monetary policy tools work better. But the reserve requirement can be powerful if the Fed needs to use it more frequently. Open Market Operations The second tool of monetary policy is open market operations. These involve buying and selling government securities in financial markets. This is the Fed s most popular tool. Every day, the Fed buys and sells billions of dollars of government securities through dealers. The impact on the money supply is described below: Fed BUYS securities The Fed can pay for the securities by writing its own check or by paying cash to the seller. The seller is usually a securities dealer. The seller deposits the check or cash in a bank. This increases MBRs and creates excess reserves that the bank can loan to others. This means that whenever the Fed buys government securities, it creates excess reserves and the money supply expands. If the Fed buys $200 of securities, the money supply in Figure 16.2 would be $6,000: $1,000 + $ $6,000 Fed SELLS securities Suppose the Fed sells some of its government securities. When a buyer takes money out of the banking system to pay for the securities, member bank reserves go down. This forces the money supply to contract. If the Fed let the money supply reach $6,000, then it sold $400 of securities, and the size of the money supply in the equation above would be $4,000: $1,200 - $ $4,000 The 12-member Federal Open Market Committee (FOMC) is the part of the Fed that does the daily buying and selling of government securities. Normally the FOMC decides whether interest rates are too high, too low, or just right. First the committee votes to set a target interest rate, and then it buys or sells enough government securities to reach the desired interest rate. A larger money supply lowers the interest rate, as we saw in Panel A of Figure A smaller money supply raises the interest rate. The Discount Rate As a central bank, the Fed can make loans to other banks. The discount rate is the interest the Fed charges on loans to financial institutions. The discount rate is the third major tool of monetary policy. Only financial institutions can borrow from the Fed. Private individuals and companies are not allowed to borrow from the Fed. Raising the discount rate If the discount rate goes up, fewer banks will want to borrow from the Fed. Then banks will have fewer excess reserves available to loan out. A higher discount rate usually makes all borrowing more expensive. This slows down economic growth. Lowering the discount rate A bank may want to borrow from the Fed if it has an unexpected drop in its reserves. Or, a bank could also have high seasonal demands for loans. For example, a bank in an agricultural area might face heavy demand during the planting season. If enough banks acted on the lower discount rate, total MBRs would increase. This would expand the money supply. 5

6 The Fed directly sets the discount rate, but its monetary policy actions influence other interest rates. For example, changes can directly affect the prime rate. The prime rate is the lowest rate of interest that commercial banks charge their best customers. At many large banks, the prime rate is linked to other interest rates. Usually banks adjust their prime rate up or down whenever the Fed changes the discount rate. Reading Progress Check Examining Why does the Fed use open market operations? Monetary Policy Dilemmas Guiding Question Why is timing important for the use of monetary policy? The Fed uses its monetary policy tools to encourage price stability, full employment, and economic growth. This may seem like an easy task, but the impact of monetary policy is complicated. Sometimes it creates a dilemma for Fed policy makers. Leads and Lags One problem is that the Fed never knows for sure how long it will take for a particular policy to have an effect. Lower interest rates today may encourage investment spending next week, next month, next year, or even later in the future. As a result, it is often hard for the Fed to know exactly when it should follow a policy, or when it should stop. One solution is to simply let the money supply grow at a steady rate. This would avoid alternating periods of easy and tight money. This is the rule-based solution offered by monetarism, a philosophy that puts the highest importance on the role of money in the economy. Monetarists believe that changes in the money supply can cause the economy to become unstable and lead to unemployment and inflation. Monetarists want rule-based policies that lead to stable, long-term monetary growth at levels low enough to control inflation. Monetarism is an important economic philosophy. It competes with the demand-side policies and supply-side policies we learned in the last chapter. While both of these policies want to encourage production and employment, neither places much importance on the money supply and monetary policy. Monetary Policy and Public Opinion Monetary policy can change interest rates, but sometimes the economy does not respond much. For example, the Fed greatly lowered interest rates in 2001 and again in 2008 to move the economy out of the Great Recession. But it took several years for the unemployment rate to come back down. Of course, lowering unemployment would be much harder without a monetary policy that lowers interest rates. But we also have to realize that there is a limit to what interest rates can do. Politicians demand action from the Fed in a situation where it only has limited influence. 6

7 Exploring the Essential Question Monetary policy is designed to help the economy in a variety of ways. Which of the following statements is true? a. The amount of time for a policy change to affect the economy is difficult to predict. b. The Fed is able to predict exactly how and when its policies will affect the economy. Money Supply Growth and Inflation Another problem is that in the long run, the money supply also affects the general price level. If the money supply grows for a long period of time, we would have too many dollars for too few goods. Demand-pull inflation would result. The effect of the money supply on the general price level forms the basis for the long-standing quantity theory of money. For example, the Spanish brought gold and silver back to Spain from the Americas in the 1500s. This increased the money supply and started an inflation that lasted for 100 years. During the Revolutionary War, the economy suffered severe inflation when the Continental Congress issued $250 million of currency. Similar results happened when the government printed nearly $500 million of greenbacks during the Civil War. These historical examples may seem extreme, but they show the inflationary dangers the Fed still faces. For example, the Fed lowered interest rates to combat the Great Recession of It did this by quickly expanding the money supply. The low interest rates gave an important boost to the economy, but quickly expanding the money supply and letting it remain at the expanded levels caused a risk of inflation later on. It is important to control inflation because it is difficult to control once it gets started. For example, in the early 1970s, President Richard Nixon tried to stop inflation by setting wage-price controls. These were rules that made it illegal for businesses to give workers raises or to raise prices without the explicit permission from the government. Most monetarists at the time said the controls would not work. Events soon proved they were correct. Prices rose even with the legislated controls. Reading Progress Check Summarizing What problems are associated with expansionist monetary policy? 7