Monetary Policy Tools

Todays Warm UpBased on the functions of the Fed you studied yesterday, which do you think is most important and why?Monetary Policy ToolsTodays LEQ: How do Federal Reserve decisions impact the stability of the economy?Monetary Policy ToolsUsed to combat the instability of inflation and recession, the Fed uses tools of monetary policyGoals are to promote economic growth, full employment, and price stabilityMonetary PolicyContractionary

ExpansionaryUsed to combat inflation:Decrease money supplyDecrease amount of credit available Used to combat deflation:Increase money supplyIncrease amount of credit available

Money CreationThe Fed is responsible for putting dollars into circulation This process is called Money Creation Not just printing paper currency or minting coins!Pause: Money Supply ActivityRefer to your chartUse pages 258-259 and page 422 to answer the questions on money supplyBe prepared to compare/contrast M1, M2, and M3

Three Monetary Policy ToolsReserve RequirementSetting RatesOpen Market Operations

Tool 1: Reserve RequirementThe Required Reserve Ratio (RRR) determines the fraction of deposits that must be kept on reserve & how much a bank can lendSet by the Fed to ensure banks have enough funds to supply customers withdrawal needsRRR ExampleLets say the RRR = .1 or 10%You deposit $1,000 into your checking accountThis means that of your $1,000 demand deposit balance, the bank is allowed to lend $900RRR Example

The Money MultiplierThis process continues until the loan amount, and hence the amount of new money that can be created, becomes very smallHow much can we increase the money supply? This is given by the money multiplier formulaInitial cash deposit x 1/RRR$1,000 x 1/.1 = $10,000

PAUSE: Money Creation PracticeComplete the activity on the bottom of page 426Figure 16.5: Money CreationSuppose Joshua deposited only $500 of Elaines payment into his account. How much would the money supply increase then?Excess ReservesSometimes banks hold excess reserves which are greater than required amountsAs a result, sometimes funds leak out of the money multiplier process & its impact is a bit lower in realityTool 1: Reserve RequirementsReserve requirements & the money supply have an inverse relationshipTool 1: Reserve RequirementsReserve Requirement

An increase in reserve requirements causes banks to increase reservesMoney Supply

Banks reduce lending, causing the money supply to contractTool 1: Reserve RequirementsMoney Supply

Banks increase lending, causing the money supply to expandReserve Requirement

A decrease in reserve requirements causes banks to decrease reservesTool 2: Setting RatesInterest rates can be adjusted to encourage or discourage lendingThis will expand or contract the money supply

Tool 2: Setting RatesDiscount Rate interest charged by the Fed on loans to banksFederal Funds Rate interest charged by banks on loans to other banksPrime Rate interest charged by banks on short-term loans to their best companies

Tool 2: Setting RatesWhen the Fed makes its decisions on monetary policy, it does so by setting a target for the federal funds rateThe discount rate rises and falls with the funds rate; these changes are then reflected in the prime ratePAUSE: Which rate do you think is set higher the discount rate or the federal funds rate and why?Tool 2: Setting RatesDiscount Rate > Funds RateThe Fed is the lender of last resort and wants banks to borrow from each other firstThese are short-term rates and changes have a limited impact on long-term growth of the economyTool 2: Setting RatesFederal Funds Rate

An increase in the federal funds rate makes banks less willing to borrow from other banksMoney Supply

Banks reduce lending in order to build reserves, causing money supply to contractTool 2: Setting RatesFederal Funds Rate

A decrease in the federal funds rate makes banks more willing to borrow from other banksMoney Supply

Banks increase lending, causing the money supply to expandTool 3: Open Market OperationsThe buying and selling of govt securities to alter the supply of moneyConsidered the most important and most-used tool

What is a Government Bond?IOURepresent debt the govt must repay to an investorTypically pays fixed amount of interest for a fixed amount of time Safe investment but low rate of returnBond PurchasesTo increase the money supply, the Fed will purchase govt securities on the open marketBought with a check drawn on Federal Reserve fundsBond seller then deposits the money and it becomes part of the money creation process Bond SalesTo decrease the money supply, the Fed will sell govt securities back to bond dealersBought with checks drawn on the bond dealers own banksThe Fed processes these checks & the money is out of circulationBond SalesThis operation reduces reserves & banks will lend less to keep reserves at required levelThe money multiplier process works in reverse & money supply declines more than the value of the initial securities purchaseTool 3: Open Market OperationsBond Circulating

Through bond sales, the Fed removes reserves from the banking systemMoney Supply

Banks reduce lending, causing the money supply to contractTool 3: Open Market OperationsBond Circulating

The Feds purchase of bonds increases reserves in the banking systemMoney Supply

Banks increase lending, causing the money supply to expandExtension ActivityYou will be working in groups of 2 or 3Each group will be given a set of economic statistics: inflation, GDP, and unemploymentYou must analyze these statistics then summarize the appropriate monetary policy actions that should be takenPresentationsExplain where your economy is on the business cycleRecommend a monetary policy of expansion or contractionExplain what action should be taken for each monetary policy toolSelect which tool you feel would be most effective and explain why