Monetary Policy Tools?

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1 EQ: What is the Federal Reserve System? In the U.S., the Federal Reserve System was established in 1913 to discharge the function of a central bank and provide a strengthened framework of regulatory control over commercial banking. A central bank is an institution charged primarily with controlling a country s money and banking system. The Federal Reserve (a.k.a., The Fed ) is the central bank in the U.S. EQ: What is the Federal Reserve System? The Fed serves the following functions in the U.S.: Control the money supply.* The Fed has 3 main tools at its disposable. Regulate commercial banks. Lender of last resort. Hold banks reserves. Supply the economy with currency. Provide check-clearing services. *We will focus on this role. Open Market Operations are the buying and selling of government securities by the central bank as a way to control changes in the money supply. Government securities are marketable debt instruments of the U.S. Treasury, like bonds. Buying & selling government securities changes the monetary base, changing the money supply. Open Market Operations: Increasing the Supply: The Fed buys government securities from banks. The selling banks receive money from the Fed, increasing the bank s excess reserves, which is an increase in the monetary base. Excess reserves are lent out, triggering the money creation process, & increasing the money supply.

2 Open Market Operations: Decreasing the Supply: The Fed sells government securities to banks. The buying banks give money to the Fed, decreasing the bank s reserves, and decreasing the monetary base. Decreased reserves restrict lending, triggering the money destruction process, & decreasing the money supply. The Discount Rate is the interest rate the central bank charges banks that borrow reserves from it. When the discount rate is higher, banks are less likely to borrow money from the Fed. When the discount rate is lower, banks are more likely to borrow money from the Fed. Changing the Discount Rate: Increasing the Supply: The Fed lowers the discount rate. Banks borrow more reserves from the Fed, increasing the monetary base. People borrow excess reserves from banks. The borrowed money is spent and deposited, triggering the money creation process, and increasing the money supply. Changing the Discount Rate: Decreasing the Supply: The Fed raises the discount rate. Banks borrow fewer reserves from the Fed, decreasing the monetary base. People borrow less money from banks. The decrease in borrowed money leaves fewer bank deposits, triggering the money destruction process, and decreasing the money supply.

3 Changing the Reserve Requirement is when the Fed sets the required reserve ratio. Increasing the required reserve percentage decreases the potential deposit multiplier and the actual money multiplier. Decreasing the required reserve percentage increases the potential deposit multiplier and the actual money multiplier. Changing the Reserve Requirement: Increasing the Supply: The Fed decreases the reserve ratio. Banks excess reserves increase. Banks lend their excess reserves. The borrowed money is spent and deposited, triggering the money creation process, and increasing the money supply. Changing the Reserve Requirement: Decreasing the Supply: The Fed increases the reserve ratio. Banks excess reserves decrease. Banks restrict their lending to cover the higher ratio. The decrease in borrowed money leaves fewer bank deposits, triggering the money destruction process, and decreasing the money supply. At a very basic level, the money supply is positively related to Total Expenditures, which is positively related to Aggregate Demand. When the money supply increases, Total Expenditures & Aggregate Demand increase. When the money supply decreases, Total Expenditures & Aggregate Demand decrease. Changes in the money supply affect aggregate demand through the interest rate.

4 When the Fed: Buys government securities, Decreases the discount rate, or Decreases the reserve ratio the money supply increases. Banks now have more excess reserves to loan. When the supply of loanable funds is greater, there is a right shift of the supply curve in the credit market. This decreases the price of borrowed money. The price of money is called the interest rate. Supply of M Supply Interest Rate Decreases Demand for When interest rates decrease, households and businesses borrow more money and spend that money on stuff. Increase in both Consumption & Investment This increases Total Expenditures and Aggregate Demand. (CPI) Increase in the Supply Decrease in Interest Rates Negative Relationship Increase in Consumption & Investment Increase in Total Expenditures Positive Relationship Increase in Aggregate Demand Right Shift of the Curve Economic Output ( GDP)

5 When the Fed Sells government securities, Increases the discount rate, or Increases the reserve ratio the money supply decreases. Banks now have fewer reserves to loan. When the supply of loanable funds is smaller, there is a left shift of the supply curve in the credit market. This increases the price of borrowed money. The price of money is called the interest rate. M Supply Supply of Interest Rate Increases Demand for When interest rates increase, households and businesses borrow less money and buy less stuff. Decrease in both Consumption & Investment This decreases Total Expenditures and Aggregate Demand. (CPI) Decrease in the Supply Increase in Interest Rates Decrease in Consumption & Investment Decrease in Total Expenditures Decrease in Aggregate Demand Left Shift of the Curve Economic Output ( GDP)

6 EQ: What is Expansionary Monetary Policy? Expansionary monetary policy is any decision by the Fed to increase the money supply with the purpose of increasing Aggregate Demand and closing a recessionary gap. Increasing the money supply means: Buying securities in open market operations, Decreasing the discount rate, or Decreasing the reserve ratio. EQ: What is Expansionary Monetary Policy? When the economy is in a recessionary gap, GDP is less than Natural GDP and output needs to expand. An increase in either or will do this. Recessionary Gap EQ: What is Expansionary Monetary Policy? EQ: What is Expansionary Monetary Policy? To increase aggregate demand, the Fed will increase the money supply using one of its three tools of monetary policy. The increase in the money supply will cause: Decrease in interest rates Increase in Consumption & Investment Increase in Total Expenditures and Right shift of the curve Increase in GDP (closing the recessionary gap) Increase in Decrease in Unemployment PL e PL e 1. The Fed increases the Supply. 2. Interest Rates fall in the Credit Market. 3. Consumption & Investment Increase. 4. TE and both Increase. 5. The Curve shifts right. 6. GDP Increases, closing the recessionary gap. 7. Increases. 8. Unemployment Decreases. GDP

7 EQ: What is Contractionary Monetary Policy? Contractionary monetary policy is any decision by the Fed to decrease the money supply with the purpose of decreasing Aggregate Demand and closing an inflationary gap. Decreasing the money supply means: Selling securities in open market operations, Increasing the discount rate, or Increasing the reserve ratio. EQ: What is Contractionary Monetary Policy? When the economy is in an inflationary gap, GDP is greater than Natural GDP and output needs to contract. A decrease in either or will do this. Inflationary Gap EQ: What is Contractionary Monetary Policy? EQ: What is Contractionary Monetary Policy? To decrease aggregate demand, the Fed will decrease the money supply using one of its three tools of monetary policy. The decrease in the money supply will cause: Increase in interest rates Decrease in Consumption & Investment Decrease in Total Expenditures and Left shift of the curve Decrease in GDP (closing the inflationary gap) Decrease in Increase in Unemployment PL e PL e 1. The Fed decreases the Supply. 2. Interest Rates rise in the Credit Market. 3. Consumption & Investment Decrease. 4. TE and both Decrease. 5. The Curve shifts left. 6. GDP Decreases, closing the inflationary gap. 7. Decreases. 8. Unemployment Increases. GDP