Transcript Monetary Policy - Diablo Valley College

Monetary Policy
 Changing reserve requirements
 altering minimum reserve
requirements
 altering the “discount” rate
 Open market operations
Reserve requirements
 By lowering minimum reserve requirements, the Fed
“signals” to banks that:
 The economy is well
 Further extension of credit to borrowers is beneficial-on the margin.
 Banks can circulate more money through the economyextend credit.
 By raising minimum reserve requirements, the Fed
“signals” to banks that:
 The economy is deteriorating
 Further extension of credit to borrowers is
detrimental—on the margin.
 Banks can circulate more (less) money through the
economy.
Reserve requirements
 More money  More Income  rightward
Shift of AD
 Less money  Less Income  leftward
Shift of AD
Reserve requirements
 Respectively, lowering or raising the
discount rate has the same effects in the
short run, as modifying reserve
requirements of banks.
 In the long run, supply (LAS) may shift
right, if the additional money circulating
through the economy generates sufficient
new/additional Investment consumption.
Open Market Operations
 When the Fed’s Open Market Committee purchases
securities in secondary financial markets, bank
reserves increase, so interest rates fall—due to the
higher supply of funds at banks.
 This increases consumption and investment
which increases AD, GDP, and CPI.
 When the Fed’s Open Market Committee sells
securities in secondary financial markets, bank
reserves decrease, so interest rates increase due to
the lower supply of funds at banks.
 This decreases consumption and investment
which decreases AD, GDP, and CPI.
Open market operations: global effects
 The dollar (Exchange rates) weakens as
interest rates fall, which improves our
nation’s net export position (trade balance)
with respect to the rest of the world. This
increases AD, GDP, and CPI.
 The dollar (Exchange rates) strengthens as
interest rates increase, which worsens our
nation’s net export position (trade balance)
with respect to the rest of the world. This
decreases AD, GDP, and CPI.
Summary
 Interest rates and exchange rates adjust faster
than prices (CPI/inflation), employment, and
output (GDP).
 Interest rates and exchange rates “signal” future
economic expectations by C, I, G, and the rest
of the world.
 Fed policy is important information
mechanism about the economy’s wellness: FRB
signals if episodes of inflation, unemployment,
or recession, may be averted.