16-3: Monetary Policy. Notes

Transcription

1 16-3: Monetary Policy Notes

2 I will gain an understanding of the three tools used by the Fed I will gain an understanding of when the Fed uses expansionary and contractionary monetary policy.

3 Monetary Policy Monetary policy: refers to what the Federal Reserve, the nation's central bank, does to influence the amount of money and credit in the U.S. economy What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy

4 Monetary Policy The goals of monetary policy are: To promote maximum employment Stable prices (regulate inflation) Moderate long-term interest rates

5 Monetary Policy By implementing effective monetary policy, the Fed can maintain stable prices and the conditions needed for long-term economic growth and maximum employment

6 The Fed s Monetary Tools The Fed has 3 tools that can be used to regulate monetary policy

7 The Fed s Monetary Tools Tool #1: Open Market Operations The purchase and sale of federal government securities (bonds) The term open market means that the Fed doesn t decide on its own which securities dealers it will do business with on a particular day

8 The Fed s Monetary Tools It chooses from the open market in which the various securities dealers that the Fed does business with the primary dealers compete on the basis of price

9 The Fed s Monetary Tools When the Fed wants to expand the money supply, it buys government securities It buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer s bank [Think buy big increases the money supply]

10 The Fed s Monetary Tools When the Fed wants to contract the money supply, it sells government bonds on the open market It sells securities and collects from those accounts [Think sell small decreases the money supply]

11 The Fed s Monetary Tools Federal funds rate (FFR): the interest rate at which banks charge one another to borrow money The Fed decides on a target rate and takes steps to reach this target When the rate is lowered, the Fed buys bonds

12 The Fed s Monetary Tools When the rate is raised, the Fed sells bonds The federal funds rate is sensitive to changes in the demand for, and supply of, reserves in the banking system, and thus provides a good indication of the availability of credit in the economy

13 The Fed s Monetary Tools Tool #2: Adjusting the Reserve Requirement Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve bank

14 Increasing the RRR reduces the money supply and decreasing it expands the money supply Today, the Fed really does not use this approach as it could negatively impact banks with drastic changes

15 The Fed s Monetary Tools Tool #3: Adjusting the Discount Rate The discount rate is the interest rate charged by Federal Reserve banks to depository institutions on short-term loans

16 The Fed s Monetary Tools When this rate increases, banks tend to borrow less money from the Fed When this rate decreases, banks tend to borrow more money from the Fed

17 The Fed s Monetary Tools This rate is generally higher than the federal funds rate and it is usually in line with other interest rates in the economy

18 The Fed s Monetary Tools The prime rate: the interest rate that banks charge their best customers Interest rates for other borrowers tend to be 2 or 3 points above prime

19 Approaches to Monetary Policy Policy 1: Expansionary monetary policy attempts to increase the amount of money in circulation Also referred to as the easy-money policy

20 Approaches to Monetary Policy This policy is enacted by: Buying bonds on the open market Decreasing reserve requirements Decreasing the discount rate Or a combination of these tools

21 Approaches to Monetary Policy The most common action is for the Fed to buy bonds on the open market This increases demand for bonds and raises their price As bond prices increase, interest rates decrease and this encourages more lending

22 Approaches to Monetary Policy An expansionary monetary policy is common during a recession Also when unemployment is high Having more money in the economy stimulates demand and allows businesses to borrow money to produce more and also creates jobs

23 Approaches to Monetary Policy Policy 2: Contractionary monetary policy reduces the money supply Also referred to as a tight-money policy

24 Approaches to Monetary Policy This policy is enacted by: Selling bonds on the open market Increasing reserve requirements Increasing the discount rate

25 Approaches to Monetary Policy The Fed enacts a contractionary monetary policy be selling bonds on the open market This causes bond prices to fall and interest rates to increase Higher interest rates discourage lending and less lending decreases aggregate demand

26 Approaches to Monetary Policy A contractionary monetary policy is designed to reduce inflation by cutting the money supply This is common when aggregate demand increases faster than aggregate supply Less money in circulation means fewer loans are given out

27 Policy lags the Fed needs specific information to address the economic problem in order to act In some cases it may take time for policy to be implemented through the FOMC

28 Monetary policy must also be coordinated with the business cycle to even it out One theory, monetarism, suggests that rapid changes in the money supply cause economic instability

29 They disagree with the Fed s constant regulation of the money supply Milton Friedman was a famous monetarist who favored finding ways to keep stable prices

30 John Maynard Keynes would argue that fiscal policy, government spending, should be used to smooth out a business cycle or recession as opposed to monetary policy