Unit: Monetary Policy
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Showing the Effects of Monetary Policy Graphically Three Related Graphs: Ø Money Market Ø Investment Demand Ø AD/AS
Interest Rate (i) S&D of Money S M S M1 Interest Rate (i) Investment Demand 10% 10% 5% 5% 2% D M 2% D I PL PL 1 PL e 200 250 AD/AS Quantity M AS AD AD 1 Quantity of Investment The FED increases the money supply 2 stimulate the economy 1. Interest Rates Decreases 2. Investment Increases 3. AD, GDP and PL Increases Q e Q 1 GDP R
Interest Rate (i) S&D of Money S M1 S M Interest Rate (i) Investment Demand 10% 10% 5% 5% 2% D M 2% D I PL 175 200 AD/AS Quantity M AS Quantity of Investment The FED decreases the money supply to slow down the economy PL e PL 1 AD AD 1 1. Interest Rtes increase 2. Investment decreases 3. AD, GDP and PL decrease Q 1 Q e GDP R
The role of the Fed is to take away the punch bowl just as the party gets going
The Government Stabilizing the Economy
The 3 tools of the FED
3 ways the FED can affect AD Discount Rate Lending Money to other Banks & credit unions Open Market Operations Buying and selling Bonds Reserve Requirement The FED can set the reserve requirements of banks. The FED is now chaired by Janet Yellen.
#1. The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. Example: If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it back with 3% interest. To increase the Money supply, the FED should DECREASE the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should INCREASE the Discount Rate (Tight Money Policy).
Federal Funds Rate Vs Discount Rate Federal Funds Rate Over the course of each day, as banks pay out and receive funds, they may end up with more (or fewer) funds than they need to meet their reserve requirement. Banks with excess funds lend them overnight to other banks that are short on funds. Discount Rate Banks may borrow funds directly from the discount window at their District Federal Reserve Bank to meet their reserve requirements The FED influences the Federal Funds Rate by setting a target rate and using open market operations.
Federal Funds Rate Target Federal Funds Rate 6 5 4 Percent 3 2 1 0 January February March April May June July August September October November December January February March April May June July August September October November December January February March April May June July August September October November December 2007 2008 2009.25%
#2. Open Market Operations Open Market Operations is when the FED buys or sells government bonds (securities). To increase the Money supply, the FED should BUY government securities. To decrease the Money supply, the FED should SELL government securities. How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply
Practice Don t forget the Monetary Multiplier!!!! 1. If the reserve requirement is.5 and the FED sells $10 million of bonds, what will happen to the money supply? 2. If the reserve requirement is.1 and the FED buys $10 million bonds, what will happen to the money supply? 3. If the FED decreases the reserve requirement from.50 to.20 what will happen to the money multiplier?
#3. The Reserve Requirement Fractional Reserve Banking - Only a small percent of your money is in the safe. The rest has been loaned out. Ø The Reserve Requirement is set by the FED Ø The reserve requirement is the percent of deposits that banks can NOT loan out FED Increase money supply A Banks keeps some in reserves and loans out the rest Those loans turn into deposits for other banks Other banks will take those deposits and loan out their excess reserves
The Money Multiplier Example: Assume the reserve ratio in the US is 10% You deposit $1000 in the bank The bank must hold $100 (required reserves) The bank lends $900 out to Bob (excess reserves) Bob deposits the $900 in his bank Bob s bank must hold $90. It loans out $810 to Jill Jill deposits $810 in her bank SO FAR, the initial deposit of $1000 caused the CREATION of another $1710 (Bob s $900 + Jill s $810) Money Multiplier = 1 Reserve Requirement (ratio) Example: If the reserve ratio is.20 and the money supply increases 2 Billion dollars. How much GDP increase by?
Using Reserve Requirement 1. If there is a recession, what should the FED do to the reserve requirement? (Explain the steps.) Decrease the Reserve Ratio 1. Banks hold less money and have more excess reserves 2. Banks create more money by loaning out excess 3. Money supply increases, interest rates fall, AD goes up 2. If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.) Increase the Reserve Ratio 1. Banks hold more money and have less excess reserves 2. Banks create less money 3. Money supply decreases, interest rates up, AD down
Video: Bonds and Interest Rates
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2009B Practice FRQ 21
2010 FRQ 2. A drop in credit card fees causes people to use credit cards more often for transactions and demand less money. (a) Using a correctly labeled graph of the money market, show how the nominal interest rate will be affected. (b) Given the interest rate change in part (a), what will happen to bond prices in the short run? (c) Given the interest rate change in part (a), what will happen to the price level in the short run? Explain. 22
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