Transcript Fundamental Questions of Monetary Policy

Entering Bernanke’s Domain
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Fundamental Questions
◦ What is money?
◦ Where does money come from?
◦ What role do banks play in the macro economy?
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Important Vocab
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Transactions Account
Bank Reserves
Required Reserve Ratio
Excess Reserves
Key Ideas
◦ Bank Failure
◦ Creation of the Federal Reserve
◦ Deposit Creation
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How does the government control the
amount of money in the economy?
How does the money supply affect
macroeconomic outcomes?
Monetary policy: the use of money and credit
controls to influence macroeconomic activity
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Federal Reserve Banks
◦ 12 banks in various regions
◦ Each acts as central banker for private banks in
region
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Main Functions of Reserve Banks
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Clearing checks between private banks
Holding bank reserves
Providing currency
Providing loans
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Board of Governors
◦ 7 members
◦ 14-year terms
◦ Not accountable to any specific elected official
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The Fed Chairman
◦ Appointed by president
◦ Generally non-political appointee
◦ Generally reappointed by subsequent presidents
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Three Basic Tools of Monetary Policy
◦ Reserve Requirements
◦ Discount Rates
◦ Open-market Operations
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Basics
◦ Available Lending of Banking System = excess
reserves X money multiplier
◦ Money multiplier = 1/required reserve ratio
◦ By changing the reserve requirement, the Fed can
directly alter the lending capacity of the banking
system
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Changes in Required Reserves
◦ A change in the reserve requirement causes:
 A change in the amount of excess reserves
 A change in the money multiplier
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Definition:
In order to maximize lending power, banks
need to have a quick source of reserves
Three Sources of Last-Minute Reserves
◦ Federal Funds Market
 Borrowing money from another bank with large
reserves
◦ Securities Sales
 Selling off government bonds
◦ Discounting
 Borrowing directly from Fed
 Discount rate:
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Most immediate method of affecting reserves
◦ Principal mechanism for day-to-day alterations of
reserve amounts
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Portfolio Decisions
◦ Money vs. Bonds
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Definition of O-M O:
Buying vs. Selling Bonds
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Expansionary Policy
◦ Shifting AD curve to the right to increase output in
order to reach full employment potential
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Restrictive Policy
◦ Shifting AD curve to the left to reduce excessive
demand
◦ Raising Reserve Requirements
◦ Increasing Discount Rate
◦ Increasing Interest Rates
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Interest-Rate Targets
◦ Interest rates link changes in money supply to
shifts in Aggregate Demand
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Successful monetary policy depends on:
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Aggregate Demand
◦ Aggregate Demand Shifting in response to monetary
policy
◦ Aggregate Supply having the correct shape
◦ Only rarely do consumers fail to respond to changes in
the money supply
 Ex. Great Depression
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Aggregate Supply
◦ The effects of the AD shift caused by monetary policy
depend on the shape of the AS curve
 Horizontal AS
 Vertical AS
 Sloped AS
 Using Sloped AS, expansionary policy causes some inflation
and restrictive policy causes some unemployment
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Discretionary Policy vs. Fixed Rules
◦ Discretionary policy
 Positive and Negative shocks are frequent occurences
 Counter-cyclical Policy = Stability
◦ Fixed Rules
 The Fed’s discretion is dangerous because it is likely to
project the AS curve incorrectly
 Fixed Rules = Stability
◦ Eclecticism
 Combination of two approaches:
 Flexible rules + Limited Discretion = Stability
 Ex. Paul Volcker and Congress