Transcript Monetary Policy

Monetary Policy
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Monetary policy is the deliberate change
instituted in the money supply to
influence interest rates and thus total
spending in the economy. The goals of
monetary policy are to achieve price level
stability, full employment, and economic
growth.
Tools of Monetary Policy
The federal reserve has three (3) tools
that it uses (depending on what is
currently seen as necessary) to influence
the money creation ability of the banking
system. These are:
 1. Open Market Operations
 2. Reserve Ratio Change
 3. Discount Rate
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Open Market Operation
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The federal reserve’s open market
operations involve the buying or selling of
government bonds to commercial banks
or to the public. This is the MOST
IMPORTANT instrument for influencing
the money supply.
Buying Bonds
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Buying Bonds is an EXPANSIONARY MONETARY policy
The Fed will do this to increase reserves in the banking
system. This is how it works:
IF the Fed buys government securities (bonds) owned by
banks the following occurs:
A. Banks sell bonds to the Fed reducing their assets by that
amount
B. The Fed will then pay the banks for their bonds increasing
banks assets as RESERVES by the same amount
C. This will increase the ability of the banks to lend,
increasing the money supply, reducing interest rates as the
supply of money increases, thus increasing C and Ig.
The fed funds rate will decline. This is the target the fed is
aiming for.
Buying bonds part II
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If the Fed buys government bonds from the
general public (you or me) the following occurs:
A. we sell the bonds to the feds and receive from
the Fed a check for that amount
B. We deposit that check into our local bank
C. As a result the checkable deposits of the bank
increase, which increases its reserves.
D. This results in an increase in lending, which
increases the supply of money, which lowers
interest rates, which increases C and Ig.
The fed funds rate will decline and this is the
target that the Fed is aiming for.
Buying bonds part III
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One note: when the Fed buys bonds from a bank,
all of the money received by the bank will go into
reserves. The bank does not have to keep a
reserve for this money as it is not a checkable
deposit. When individuals deposit Fed money for
bonds into the bank, the bank must hold a % of it
as reserves. This means that there is slightly less
monetary creation potential with the second
scenario. In practice, this doesn’t affect the
expansionary nature of the policy. Bank reserves
increase in both cases.
Selling Bonds
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Selling Bonds by the Fed is a
contractionary monetary policy. The
purpose is to reduce bank reserves and
curb the growth of the money supply.
Selling bonds to banks
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When the fed sells bonds to banks the following
occurs:
A. The fed sells the bonds and receives a check
from the bank against its cash reserves.
B. The banks reserves are reduced by that
amount.
C. This, in turn, will reduce the ability of the bank
(banking system) to make loans, reducing the
money supply, increasing interest rates, and
reducing C and Ig.
The fed funds rate will increase-this is the fed’s
target.
Selling bonds to the public
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If the fed sells bond to the public, the following
occurs:
A. individuals or companies buy the bonds and
write a check to the Fed
B. The checks reduce the checkable deposits of
the banks, reducing excess reserves in the
process.
C. This, in turn, reduces the ability of banks
(banking system) to make loans, reducing the
money supply, raising interest rates, and reducing
C and Ig.
The fed funds rate will increase which is the
purpose of the policy change.
Why should banks and people buy and sell
securities to and from the FED
The answer is the price of bonds and the
interest rate of the bonds.
 As we have seen, bond price and interest
rates are INVERSELY related
 So, when the FED buys bonds, the
demand for them increases, the price rises,
and the interest rate drops. This
encourages banks and the public to sell
the bonds to the FED.
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Why…?
On the other hand, when the Fed sells
bonds in the open market, the additional
supply of bonds reduces the price and
increases the interest rate, making them
more attractive to potential buyers.
 The MAIN AIM of the FED is not to
enrich bond buyers or sellers, but to
CHANGE the FED FUNDS RATE as a
tool for money supply change.
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Tool Two: The Reserve Ratio
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The fed can also manipulate the required
reserve ratio for banks to influence the
amount of money a bank MUST hold. This
will influence the total amount of excess
or loanable funds in the system
Raising the Reserve Ratio
Suppose the federal reserve raises the
reserve ratio from 20% to 30%.
 If the bank has deposits of $100,000 it
would keep reserves of $20,000 under
the old ratio. But under the new one, it
would need to keep $30,000 thus
reducing the amount it can loan
significantly.
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Raising the Reserve
Several things might result from this.
 A. Banks would lend less money
 B. Banks would call in old loans
 Overall, the effect would be the same as the
selling of securities. Raising the reserve would be
contractionary monetary policy. It would reduce
banks excess reserves, reduce lending, reduce the
money supply, increase interest rates and reduce
C and Ig.
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Lowering the Reserve Ratio
Suppose the Fed lowers the reserve ratio
required of banks from 20% to 10%
 If the bank has deposits of $100,000 it
would have had to keep $20,000 under
the old ratio, but only needs to keep
$10,000 under the lowered ratio. This
would increase the amount it could lend
significantly.
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How this affects money supply
It changes the amount of excess reserves
available to the banks to lend
 It changes the size of the monetary
multiplier
 Remember the Monetary Multiplier is
1/RRR (required reserve ratio)
 Because of the power of this tool and its
dramatic effects, it is infrequently used.
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The Discount Rate
The Fed is a central bank. As such, it is
what is known as a lender of the last
resort.
 This means that if a bank has an
unexpected shortfall of cash, it can
borrow these funds from the Federal
Reserve.
 The Fed will charge the bank an interest
rate. This rate is known as the
DISCOUNT rate.
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Discount Rate continued
Since this borrowed money is not required to
have a reserve all of this money would be
available to the bank for lending.
 This increases the banks reserves, decreasing
interest rates, increasing the money supply, and
thus C and Ig.
 Since the Fed sets the discount rate, it can and
does use it to encourage banks to borrow or to
discourage banks from borrowing. This will affect
the banks ability to lend. So this can be
expansionary or contractionary depending.
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Easy Money
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Easy money is an expression for expansionary
Monetary Policy
Using the 3 tools Easy Money would consist of
the following:
BUY SECURITIES (BONDS): This allows banks to
increase reserves
LOWER THE RESERVE RATIO: This allows banks
to increase excess reserves
LOWER THE DISCOUNT RATE: This allows
banks to increase reserves with $ from the Fed
PURPOSE
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The purpose of an EASY money policy is
to make bank loans less expensive by
lowering interest rates and more available
by increasing the money supply and
increase output, AD, and employment.
TIGHT MONEY
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Tight money is an expression for contractionary
Monetary Policy
Using the 3 tools Tight Money would consist of
the following:
SELL SECURITIES: This reduces banks reserves
RAISE THE RESERVE RATIO: This reduces banks
reserves
RAISE THE DISCOUNT RATE: This inhibits banks
ability to have extra funds to lend
PURPOSE
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The aim of TIGHT MONETARY POLICY
is to reduce bank reserves, reduce banks’
abilities to lend, reduce the money supply,
increase interest rates, and reduce the
price level or stabilize it, reduce output,
reduce employment, and reduce AD.
Relative Importance of the TOOLS
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Open Market Sales and Purchase of
Bonds is the MOST IMPORTANT. It is
flexible in that small or large amounts of
bonds can bought or sold. It is subtle and
less noticeable to the public etal.. The fed
also has extremely large amounts of
bonds to sell and lots of money to buy
with.
Relative Importance
Changing the Reserve Requirements
Perhaps the main reason the FED uses this
tool sparingly is because it can severely
impact bank earnings. Reserves earn no
interest, and having no money to loan or
having too much and not being able to
loan it are essentially the same to a bank,
so the FED seldom uses this approach.
Relative Importance
The Discount Rate
The discount rate is often raised or lowered by the
FED, but since banks rarely acquire more than a
few percentage points of reserves this way it has
little impact. The fact is that most bank borrowing
from the FED is the result of bank wanting to
purchase bonds in open market operations.
 The discount rate is more of an announcement of
intent about the general direction of Monetary
Policy.
Easy Money Policy: Problem and
corrective action
Problem: Unemployment and recession
 Fed buys bonds, lowers RRR, or lowers
the discount rate
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 Excess reserves increase
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 Money supply rises
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continued
Interest Rate falls
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 Investment spending increases (Ig)
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 Aggregate demand (AD) increases
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 Real GDP increases by a multiple of the increase in Ig
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Tight money policy: Problem and
corrective action
Problem: Inflation
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 Fed sells bonds, increases RRR, or increases discount
rate
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 Excess reserves decrease
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 Money supply falls
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continued
Interest rate rises
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 Investment spending (Ig) decreases
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 Aggregate demand (AD) decreases
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 Inflation declines
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Effectiveness
Effectiveness of any policy in this large
economy is problematic.
 However, monetary policy has been used
more successfully than fiscal policy in the
US for the last two generations
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Strengths:
Speed and Flexibility
 Isolation from most Political Pressure
 Successfully used for most of the last
three decades
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Shortcomings and problems:
Changes in the way banking is done may
cause loss of FED control
 Global markets and currency trading may
be beyond the control of the FED
 The Velocity of money (V) may be
changing.
 Cyclical Asymmetry
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Fed Funds Rate
This rate is used by the FED to stabilize
the economy
 It is the rate banks charge each other for
overnight loans.
 An increase in the fed fund rate signals a
tight money policy.
 A decrease would signal an easy money
policy
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Why is this important?
Most interest rates are based on this FED
FUND rate.
 If prime rates move up or down this will
affect all borrowers in the economy.
 The fed will sell bonds in the open market
to increase the fed funds rate
 The fed will buy bonds in the open
market to decrease the fed funds rate.
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Exports and Monetary policy:
Net Export Effect of monetary policy
 Easy money policy:
 Recession; slow growth
 Easy money policy = lower interest rate
 Decreased foreign demand for dollars
 Dollar depreciates
 Net Exports increase ergo AD increases
strengthening the easy money policy
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Net Export effect
Tight Money Policy
 Problem: inflation
 Tight money policy: interest rates rise
 Increased foreign demand for dollars
 Dollar appreciates
 Net exports decrease
 AD shrinks, strengthening tight money
policy
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Assume a large trade deficit:
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Easy money policy, which is appropriate for the
alleviation of unemployment and sluggish
growth, is compatible with the goal or policy of
correcting a balance of trade deficit. That is,
because expansionary policy results in lower
interest rates, foreigners will give up or not
purchase US securities. This will lower the
demand for dollars, cheapening the dollar. This
will cause demand for US goods as exports to
increase. This will then reduce any balance of
trade deficit the US has on its current account.
Assume a large trade deficit:
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A tight money policy that is used to
correct inflation conflicts with the goal of
correcting a balance of trade deficit.
Because tight money policy restrains
money and interest rates rise, foreigners
would demand US dollars for asset
purchases, the dollar would appreciate in
value, and US exports would become less
competitive.
The Big Picture
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In your textbook on pages 300 and 301 is
an elegantly structured graph of the
economy showing the AD/AS theory of
the price level, real output and how
stabilization can occur using Fiscal and
Monetary Policy. This is well worth some
time to look at if you are serious about
understanding the relationships between
all the things we have discussed from
chapter 11 through 15