Money Supply & The Fed

How the Fed “creates” money

The Federal Reserve primary job is the manage the nation’s

MONEY SUPPLY (MS) to achieves their 2 goals

Too much money leads to INFLATION

Too little money leads to Deflation

Monetary Policy• The Fed conducts Monetary Policy by changing the nation’s money supply (MS) which then

alters short term interest rates– Federal Funds = 1.0%

Dot-Com Crash

1.0% 0.0%

HousingBubble

1.0%

Money Market

At any moment in time, Money Supply (MS) is fixed by the Fed

Using monetary policy the Fed can shift MS right or left to change short term interest rates (federal funds rate)

Money Demand (MD)= desire to “hold” money•Similar to M1

•As interest rates ↓ => cost to “hold money” ↓

Increasing Money Supply

MD

MS2NominalInterestRate

Qty of $

MS1MS1

MD

NominalInterestRate

Qty of $

MS2

---------i1

---------------i2 ---------------i1---------i2

Decreasing Money Supply

Graphing The Money Market

Represents a short term, nominal interest rateThink of it as the Federal Funds MarketDifferent than Loanable Funds Market! (don’t mix them up!)

3-Tools of Monetary Policy

• The Fed has 3-tools to change money supply:– reserve requirement (currently 10.0%)

– discount rate (currently 1.75%)

– open-market operations (currently 1.00% target)• alters the Federal Funds Rate

Discount Rate & Federal Funds Rate

• Discount rate: the interest rate the Fed charges banks for loans– Banks borrow money directly from the Fed at the discount rate (1.0%)– The Fed is the “lender of last resort” in a financial crisis (very important in 2008!)

• Federal Funds Rate: the interest rate banks charge other banks for short term loans– This is the rate graphed in the money market ( currently 0.25%)– The Fed uses open market operations to alter it

Worksheet

Open-Market Operations

• What: The primary way the Fed changes money supply

• How: A process which involves the Fed buying & selling U.S. Government bonds – Bonds are also known as gov’t securities

• Result: the “open-market” process alters the Federal Funds Rate

Open-Market Operations “in action”

• To increase money supply: – the Fed buys government bonds (securities) from public

• To decrease money supply:– the Fed sells government bonds (securities) to public

Federal Reserv

e

Gov’t bonds

Money

PublicMarket &

Banks

Expansionary Monetary Policy

MD

NominalInterestRate

Qty of $

MS1

---------i1

MS2

---------------i2

Affects AD

LRAS1PriceLevel

RealGDP

AD1

SRAS1

------------------

P1

Y1

Money Market AS/AD Model

-------------

AD2

P2

Y2

E1

E1

E2

E2

Bernanke Interview Part I