Transcript Monetary Policy - HCC Learning Web

Monetary Policy
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Monetary Policy
Learning Objectives:
Students will be able to thoroughly and completely explain:
1. The 3 tools used by the Federal Reserve to operate Monetary Policy.
2. Easy money policy and tight money policy, when to use each, the 3
tools associated to each.
3. How monetary policy works using the cause and effect chain
approach.
4. The impact of the net export effect on monetary policy
5. The strengths and weaknesses of monetary policy.
6. How to use the tools of Monetary Policy to address the problems of
Inflation and Recession.
Goals of Monetary Policy
…to assist the
economy in achieving
a full-employment,
noninflationary level
of total output
Review of Monetary Policy Interest Rates
• Discount rate - the interest rate that the Federal
Reserve Banks charge on the loans they make to
commercial banks and thrift institutions. This rate is
directly established by the Fed.
• Federal Funds rate – the interest rate banks and
other depository institutions charge one another on
overnight loans made out of their excess reserves.
This rate is established by the changes in the money
supply (caused by the Fed).
Federal Reserve Tools
1. Open Market Operations
2. Reserve Ratio
3. Discount Rate
Create a study guide
for all six tools
Open Market Operations
Recession
Fed buy bonds
What happens next?
Inflation
Fed sells bonds
What happens next?
Fiscal Policy
• Recession
Inflation
• Expansionary Fiscal Policy
Contractionary Fiscal Policy
– Use Tool # 1
– Then what happens?
- Use Tool # 1
Then what happens?
Tools of Monetary Policy
• 1. Open market operations
A. Buying of government securities from
Commercial banks and the general public
(bonds)
B. Selling of government securities to
Commercial banks and the general public
– Used to influence the money supply
• When the Fed sells securities to banks,
commercial bank reserves are reduced
• When the Fed buys securities from banks,
commercial bank reserves are increased
Tools of Monetary Policy
2. The reserve ratio
–Changes the money multiplier
3. The discount rate
–The Fed as lender of last resort for banks
–Short term loans
Federal Reserve Policies
*
• Easy Money Policy – fight recession
– Easy Money Policy – increase reserves, increase money
supply, lower interest rates, Increase AD, and
employment, control recession.
• Tight Money Policy – fight inflation
– Tight Money Policy – reduce money supply, increase
interest rates, to reduce spending, control inflation.
Tools of Monetary Policy
Open-Market Operations
1. Fed Buying Securities – easy money policy to fight recession
increase reserves (increase money supply)
From commercial banks... How it works
• Bank gives up securities (sells them)
• FED pays bank – by increasing their reserves
• Banks have increased reserves (increased excess
reserves) – can lend more (increase money supply)
From the public... How it works
• Public gives up securities (sells them)
• Public deposits check from FED in bank (increase check
account balances)
• Banks have increased reserves (increased excess
reserves) - (increase money supply)
Tools of Monetary Policy
Open-Market Operations
2. Fed Selling Securities – tight money policy to fight inflation
decrease reserves (decrease money supply)
To commercial banks... How it works
• FED gives up securities (sells them)
• Bank pays for securities (out of excess reserves)
• Banks have decreased excess reserves (decrease money
supply)
To the public... How it works
• FED gives up securities (sells them)
• Public pays by check drawn on a bank (decrease demand deposit
balances)
• Banks have decreased reserves (decrease money supply) – (remember
the check clearing process)
Tools of Monetary Policy
Open-Market Operations
The Reserve Ratio
1. Raising the Reserve Ratio – tight money policy to fight inflation
reduce money supply
• Banks must hold more reserves – (lower excess reserves)
• Banks decrease lending
• Money supply decreases
2. Lower the Reserve Ratio – easy money policy to fight recession
Increase money supply
• Banks may hold less reserves – (higher excess reserves)
• Banks increase lending
• Money supply increases
Tools of Monetary Policy
Open-Market Operations
The Reserve Ratio
The Discount Rate – rate Fed charges
Commercial banks. Raise or lower
Easy Money Policy – fight recession
increase reserves, increase money supply, lower interest
rates, Increase AD and employment
• Fed Buy’s Securities (pay bond holders who sell)
• Decrease Reserve Ratio (increase excess reserves)
• Lower Discount Rate (encourage borrowing by
banks from each other)
Tools of Monetary Policy
Open-Market Operations
The Reserve Ratio
The Discount Rate
Tight Money Policy – fight inflation
Decrease reserves, reduce money supply, raise
interest rates, to reduce spending, control inflation.
• Fed Sells Securities (take money out of our hands)
• Increase Reserve Ratio (decrease excess reserves)
• Raise Discount Rate (discourage bank borrowing)
Monetary Policy, Real GDP
and the Price Level
Cause-Effect Chain
1. Money supply impacts interest rates
2. Interest rates affect investment
3. Investment is a component of AD
4. Equilibrium GDP is affected by AD
Monetary Policy and GDP
Sm1
Sm2
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Sm3
AS
10
P3
Price Level
Rate of Interest, i (Percent)
(a)
The market
for money
8
Dm
6
0
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
ID
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
Expansionary Monetary Policy
Problem: unemployment and recession
CAUSE-EFFECT CHAIN
Fed buys bonds, lowers reserve ratio, lowers the
discount rate
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
Restrictive Monetary Policy
Problem: inflation
CAUSE-EFFECT CHAIN
Fed sells bonds, increases reserve ratio, increases the
discount rate
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
Monetary Policy in Action
Strengths of monetary policy
1.Speed and flexibility
2.Isolation from political pressure
Target the Federal Funds Rate
The Federal Funds Rate – rate banks charge each
other for overnight loans of reserves. Tighter policy higher rate.
The Prime Interest Rate – a benchmark rate banks use
The Fed does not set either of these. They are equilibrium rates
that result from open market operations to change reserves.
Problems and Complications
Lags
•Recognition lag – same as fiscal policy – for recession
•Administrative lag – very short relative to fiscal policy
•Operational lag :
Approximately 12 to 24 months for interest rate changes to have full impact on
I, AD, Real GDP, price level.
Changes in Velocity
Number of times per year average dollar is spent on goods and services.
Velocity x money supply = total spending
Cyclical Asymmetry
Monetary policy effective in slowing expansions and controlling inflation but
less reliable at curing a significant recession.
“Artful Management” or “Inflation Targeting”
Net Export Effect
Expansionary Monetary policy versus expansionary fiscal policy
•Expansionary monetary policy increases net exports and
strengthens Monetary policy.
•Expansionary fiscal policy decreases net exports and weakens
the fiscal policy.
The steps for expansionary fiscal policy:
1. Expansionary fiscal policy financed by borrowing (deficit financing)
2. Selling bonds (increasing the supply of bonds – bond prices
dropping and interest rates rising)
3. Dollar appreciates – higher demand for dollars
4. Imports rise and exports fall – net exports fall
5. AD falls and dampens the expansionary fiscal policy
Monetary policy and the Net Export Effect
Easy money policy
Problem – recession
Easy money policy to lower
interest rate
Decreased foreign demand
for dollars
Dollar depreciates (takes
more dollars to buy a
foreign currency)
Net exports increase
(aggregate demand
increases, equilibrium GDP
expands, strengthening the
easy money policy.)
Monetary policy and the net Export effect
Easy money policy
Tight money policy
Problem – recession
Problem – inflation
Easy money policy to lower
interest rate
Tight money policy (higher
interest rates)
Decreased foreign demand
for dollars
Increased foreign demand for
dollars
Dollar depreciates (takes
more dollars to buy a
foreign currency)
Dollar appreciates (takes fewer
dollars to buy a foreign
currency)
Net exports increase
Net exports decrease
(aggregate demand
increases, equilibrium GDP
expands, strengthening the
easy money policy.)
(aggregate demand decreases,
equilibrium GDP contracts,
strengthening the tight money
policy.)
Monetary policy and the net Export effect
Easy money policy
Tight money policy
Problem – recession
Problem – inflation
Easy money policy to lower
interest rate
Tight money policy (higher
interest rates)
Decreased foreign demand
for dollars
Increased foreign demand for
dollars
Dollar depreciates (takes
more dollars to buy a
foreign currency)
Dollar appreciates (takes fewer
dollars to buy a foreign
currency)
Net exports increase
Net exports decrease
(aggregate demand
increases, equilibrium GDP
expands, strengthening the
easy money policy.)
(aggregate demand decreases,
equilibrium GDP contracts,
strengthening the tight money
policy.)
Expansionary monetary policy increases net exports and strengthens
Monetary policy. Expansionary fiscal policy decreases net exports and
Weakens The fiscal policy.
monetary policy
open-market operations
reserve ratio
discount rate
easy money policy
tight money policy
Federal funds rate
prime interest rate
velocity of money
cyclical asymmetry
inflation targeting
Tools Exercise
Recession
• Explain how the problem of recession
will be solved by lowering taxes and
having the Fed lower the reserve ratio.
Tools Exercise
Recession
• Explain how the problem of recession will be
solved by lowering taxes and lowering the
discount rate.
Tools Exercise
Recession
• Explain how the problem of recession
will be solved by increasing
government spending and by having
the Fed buy bonds from Commercial
Banks or the public.
Tools Exercise
Inflation
• Explain how the problem of Inflation
will be solved by lowering government
spending and by having the FED sell
bonds.
Tools Exercise
Inflation
• Explain how the problem of inflation
will be solved by raising taxes and the
Fed raising the discount rate.
Tools Exercise
Inflation
• Explain how the problem of inflation will be
solved by raising taxes and the Fed raising the
Reserve ratio.
Tools Exercise
Inflation
• Explain how the problem of inflation
will be solved by raising taxes and the
Fed selling bonds.