Transcript Monetary Policy - Coach Wilkinson`s AP Government Class

$ Monetary Policy $
(& The Federal Reserve)
Money Supply:
• Narrowly defined by economists as currency (coins and
paper money) in the hands of the public, plus checkingtype accounts. Currency makes up about 48% of the total,
and checking-type accounts about 52%.
• The supply of money in the economy is important for price
stability and economic growth.
• Too much money in the economy can cause inflation. An
extreme example of this occurred in Germany after WWI,
when the German government printed so much money
that prices increased 5,470% in 1923.
• Too little money in the economy can lead to falling prices
and falling production. An example of this occurred in the
U.S. between 1929 and 1933. The money supply fell by
30%, and most economists agree that this was a major
cause of the Great Depression.
• The Federal Reserve controls the money supply through
monetary policy. Monetary policy works through
encouraging or discouraging banks from making loans.
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How Banks Create $$$:
• Banks create money by using the deposits in
checking accounts to make loans. This illustration
shows how the money-creation process works,
starting with a $1,000 deposit.
• Assume banks have a 10% reserve requirement.
This means that each time a bank receives a
deposit, it must keep 10% in reserve and can loan
out the rest.
• Remember that the money supply includes both
currency in circulation and deposits in checking
accounts.
Expanding the $$$ Supply:
Bank
Deposit Required Excess
Reserves Reserves Reserves
Loan
Elm Bank
$1,000
$100
$900
$900 loan to Maria
Oak Bank
$900
$90
$810
$810 loan to Cody
Ash Bank
$810
$81
$729
$729 loan to Rasheed
How Banks Destroy $$$:
• Money is “destroyed” when consumers pay back
their loans, as this money is then taken out of
circulation (the borrower’s checking account) and
put back into bank reserves.
• Banks can also “destroy” money by making it more
difficult for banks to make loans to consumers.
Monetary Policy:
• Changes in the money supply, intended to
maintain stable prices, full employment,
and economic growth.
• If the Fed is fighting unemployment and
declining GDP, it wants to increase the
money supply.
• If the Fed is fighting inflation, it wants to
decrease the money supply.
• There are 3 tools the Fed can use to take
action to influence the money supply.
Organization of the Federal Reserve:
Federal Reserve Districts:
Easy-Money vs. Tight-Money Policy
The Federal Reserve follows
an easy-money policy to
encourage economic growth
and thus lower the
unemployment rate.
The Fed adopts a tightmoney policy in an effort
to slow economic growth
and thus decrease the
inflation rate.
Tool #1: Open Market Operations:
*Most Used!*
• The Fed buys or sells U.S. government
securities in the bond market from banks.
• When the Fed buys securities from banks:
– Bank deposits increase
– Banks have more money to loan to customers
– The money supply increases
• When the Fed sells securities to banks:
– Bank deposits decrease
– Banks have less money to loan to customers
– The money supply decreases
Open Market Operations
Tool #2: Changing the Reserve Requirement
*HARDLY ever used!*
• The reserve requirement is the minimum
percentage of deposits that banks must
keep on reserve to back up checkingtype accounts.
• When the reserve requirement is
lowered:
– Banks have more $ to lend out
– The money supply increases
• When the reserve requirement is raised:
– Banks have less $ to lend out
– The money supply decreases
Tool #3: Adjusting the Discount Rate
• The discount rate is the interest rate
that the Fed charges on loans to banks.
• When the discount rate is decreased:
– Banks are encouraged to make more loans
– The money supply is increased
• When the discount rate is increased:
– Banks are discouraged from making loans
– The money supply decreases
Easy-Money
Monetary Policy:
• What does the Fed do to expand the money supply?
–Buy gov’t securities from banks
–Lower the discount rate
–Lower the reserve requirement
Tight-Money
Monetary Policy:
• What does the Fed do to contract the money supply?
–Sell gov’t securities to banks
–Raise the discount rate
–Increase the reserve requirement
Actions the
Fed can take
to…
INCREASE
the money
supply:
DECREASE
the money
supply:
4/10/2016
Open
Market
Operations
∆ the
∆ the
Discount
Reserve
Rate
Requirement
Fed buys
government
securities from
banks, increasing
reserves for loans
Decrease the
Reduce the reserve
discount rate,
requirement, freeing
encouraging
up reserves for
banks to borrow banks, allowing them
from the Fed,
to make more loans
increasing
reserves for loans
Fed sells
government
securities to banks,
decreasing reserves
for loans
Increase the
Increase the reserve
discount rate,
requirement,
discouraging
reducing reserves for
banks from
banks, making less $
borrowing from
available for loans
the Fed,
decreasing
16
reserves for loans