Monetary PolicyMonetary Policy

Involves controlling the money Involves controlling the money supply to change the level of GDP supply to change the level of GDP or the rate of inflation. or the rate of inflation.

The Money SupplyThe Money Supply

The The money supplymoney supply is is increasedincreased when when banks make banks make loansloans..

The The more loansmore loans banks make the banks make the more more moneymoney there is in circulation. there is in circulation.

The The banking systembanking system can create loans in can create loans in multiplesmultiples of an original loan. of an original loan.

The The money supplymoney supply is is decreaseddecreased when a when a bank or the public bank or the public buys government buys government bonds.bonds.

Banking ReservesBanking Reserves ReservesReserves are the amount of deposits that a are the amount of deposits that a

bank has accepted but not loaned out.bank has accepted but not loaned out. Required reservesRequired reserves are the amount a bank are the amount a bank

must keep on hand by law. The must keep on hand by law. The required required reserve ratioreserve ratio determines this amount. determines this amount.

Excess reservesExcess reserves are whatever the bank are whatever the bank has over and above the required reserves. has over and above the required reserves. It is the amount that a bank can loan out or It is the amount that a bank can loan out or use to purchase government securities use to purchase government securities (bonds).(bonds).

Money CreationMoney Creation

Money creationMoney creation (putting new money into (putting new money into circulation) occurs when circulation) occurs when banksbanks make make loansloans to the to the publicpublic. .

Monetary Policy ToolsMonetary Policy Tools

The Federal Reserve controls the The Federal Reserve controls the amount of excess reserves and money amount of excess reserves and money creation through use of its three tools. creation through use of its three tools.

Reserve RequirementsReserve Requirements Discount RateDiscount Rate Open Market OperationsOpen Market Operations

Federal Reserve ToolsFederal Reserve Tools Required Reserve RatioRequired Reserve Ratio – the percentage of – the percentage of

demand deposits a bank must keep on hand demand deposits a bank must keep on hand for customers’ withdrawals.for customers’ withdrawals.

It determines It determines how muchhow much of a bank’s deposits of a bank’s deposits are available for are available for loansloans and the size of the and the size of the money multipliermoney multiplier. .

The money multiplier The money multiplier determines the amount of determines the amount of new money that will be created by the banking new money that will be created by the banking system (1/RR)system (1/RR)

Least used of the Fed’s tools because it is the Least used of the Fed’s tools because it is the most powerful and disruptivemost powerful and disruptive. .

Federal Reserve ToolsFederal Reserve Tools Discount RateDiscount Rate – the interest rate the – the interest rate the

Fed will charge a bank for a loan.Fed will charge a bank for a loan. If the Fed If the Fed lowerslowers the discount rate the discount rate banks banks

would be encouraged to borrow from the would be encouraged to borrow from the FedFed (the bank could loan that money out (the bank could loan that money out to the public at a higher rate and make to the public at a higher rate and make money doing so).money doing so).

The more loans a bank makes the more The more loans a bank makes the more the money supply grows and vice versa.the money supply grows and vice versa.

Least effective tool.Least effective tool.

Federal Reserve ToolsFederal Reserve Tools Open Market OperationsOpen Market Operations – the Fed purchases – the Fed purchases

or sells securitiesor sells securities (government bonds) to banks (government bonds) to banks and the public, which changes the amount of and the public, which changes the amount of money available from the public and banks for money available from the public and banks for loans.loans.

The Fed would The Fed would purchasepurchase securities to securities to pumppump in in money to increase economic growth.money to increase economic growth.

The Fed would The Fed would sellsell securities to securities to soak upsoak up money from the economy (anti-inflationary). money from the economy (anti-inflationary). Banks or the public now Banks or the public now have a bond instead have a bond instead of cash and spending is slowed downof cash and spending is slowed down..

Most used tool.Most used tool.

Macroeconomic Effects of Macroeconomic Effects of Monetary PolicyMonetary Policy

A change in the supply of money A change in the supply of money changes the changes the interest rateinterest rate..

Interest ratesInterest rates are the cost of are the cost of borrowingborrowing money.money.

A high supply of money A high supply of money lowers the lowers the interest rateinterest rate and gives businesses and gives businesses more more opportunities for investment spendingopportunities for investment spending (buying capital goods) and vice versa.(buying capital goods) and vice versa.

Macroeconomic Effects of Macroeconomic Effects of Monetary PolicyMonetary Policy

The Fed will follow an The Fed will follow an easy money policyeasy money policy ((an an increaseincrease in the money supply in the money supply) when ) when the economy is in a the economy is in a recessionrecession..

The Fed will follow a The Fed will follow a tight money policytight money policy ((a a decreasedecrease in the money supply in the money supply) when ) when the economy is experiencing the economy is experiencing inflationinflation..

The goal of monetary stabilization The goal of monetary stabilization policies are to policies are to smooth out fluctuationssmooth out fluctuations in in the the business cycles.business cycles.

Problems of TimingProblems of Timing If expansionary policies take effect while If expansionary policies take effect while

the economy is already expanding, the the economy is already expanding, the result could be result could be higher inflationhigher inflation..

Inside lagsInside lags refer to refer to the delay in the delay in implementing monetary policy.implementing monetary policy. It is difficult to It is difficult to accurately identify and accurately identify and

recognize economic problems.recognize economic problems. It takes It takes additional time to enact the additional time to enact the

appropriate policyappropriate policy. (This is more of a fiscal . (This is more of a fiscal policy problem, since policy problem, since the FOMCthe FOMC can act can act much more quickly)much more quickly)

Problems of TimingProblems of Timing Outside lagsOutside lags refer to the refer to the time it takes for time it takes for

monetary policy to have an effect.monetary policy to have an effect. The outside lag is short for The outside lag is short for fiscal policyfiscal policy but but

lengthy for monetary policy.lengthy for monetary policy. Monetary policy primarily affects Monetary policy primarily affects business business

investment plans which are made far in advance.investment plans which are made far in advance.

Monetary policy is still preferred because of the Monetary policy is still preferred because of the inside lag caused by the inside lag caused by the President and President and CongressCongress having to agree on budgetary having to agree on budgetary matters.matters.

Bank balance sheets or Bank balance sheets or T-AccountsT-Accounts

Illustrates the relationship between assets and Illustrates the relationship between assets and liabilities held by a bank. liabilities held by a bank.

They can be used to explain the money They can be used to explain the money creating potential of banks through the creating potential of banks through the fractional reserve system.fractional reserve system. AssetsAssets – the property, possessions and claims on – the property, possessions and claims on

others held by the bank (reserves, loans, securities)others held by the bank (reserves, loans, securities) LiabilitiesLiabilities – the debts and obligations of the bank – the debts and obligations of the bank

to others (demand deposits, loans from the Fed)to others (demand deposits, loans from the Fed)

Bank balance sheets or Bank balance sheets or T-AccountsT-Accounts

AssetsAssets LiabilitiesLiabilities

reserves $10,000reserves $10,000 DDA $10,000DDA $10,000

(reserve ratio 10%)(reserve ratio 10%)

AssetsAssets LiabilitiesLiabilities

RR $1,000RR $1,000 DDA 10,000DDA 10,000

ER $9,000ER $9,000

BANK 1BANK 1

AssetsAssets LiabilitiesLiabilities

RR $1,000RR $1,000 DDA 10,000DDA 10,000

ER ER

loans $9,000loans $9,000

AssetsAssets LiabilitiesLiabilities RR $900RR $900 DDA $9,000DDA $9,000ER $8,100ER $8,100

Total money supply = $10,000+9,000Total money supply = $10,000+9,000

BANK 2BANK 2

AssetsAssets LiabilitiesLiabilitiesRR $900RR $900 DDA 9,000DDA 9,000ER ER Loans $8,100Loans $8,100

Total Expansion of the money supply =Total Expansion of the money supply =$9,000 x 10 (1/.10) = $90,000$9,000 x 10 (1/.10) = $90,000