PSCI 1500: Introduction to

Economics

Monetary Policy

MONETARY POLICY

Monetary PolicyChanging the money supply to influence the levels of output, employment, and/or prices in the economy.

i. Easy Money Policy (expansionary)Policy by the Federal Reserve to increase excess reserves of depository institutions in an effort to increase spending and reduce unemployment.

ii. Tight Money Policy (restrictive)Policy by the Federal Reserve to reduce excess reserves of depository institutions in an effort to reduce spending and inflationary pressure.

MONETARY POLICY

MONETARY POLICY TOOLS

Federal Reserve has three major tools to change excess reserves (ER) in the financial depository institutions system:

1. Reserve Requirement2. Discount Rate (Interest Rate)3. Federal Funds Market/OMO

MONETARY POLICY

Monetary Policy Tools1. Reserve Requirementi. Easy Money Policy Decreases in the reserve requirement

would increase excess reserves and encourage borrowing; appropriate to stimulate the economy. Appropriate to fight recession or unemployment

ii. Tight Money Policy Increases in the reserve requirement

would decrease excess reserves and discourage borrowing; appropriate to fight demand-pull inflation.

2. Discount Rate• Refers to the interest rate that a Federal

Reserve Bank charges a financial institution for borrowing of reserves.

• Financial depository institutions borrow reserves to increase it’s reserve accounts, the cost of this borrowing is called Discount Rate.

Easy Money Policy• Decrease in discount rate will encourage

reserve borrowings Tight Money Policy• Increase in discount rate will discourage

reserve borrowings

MONETARY POLICY

3. Open Market Operations (OMO)• The most often used tool for changing the

excess reserve, can be achieved quickly since it’s operations is being carried on every business day

• Buying and selling of securities, primarily government securities, by the Federal Reserve.

• Open Market Committee - determines the general policy on OMO.

• Excess reserves can be altered slightly or greatly depending on whether the government securities are bought in small or large quantitiesi. Easy Money Policy - buy securities in the

OMOii. Tight Money Policy - sell securities in the

OMO

MONETARY POLICY

Tools & Policy Objectives

1. Expanding the economy requires:• Buying securities from banks and dealers on the open market, and/or• Lowering the reserve requirement, and/or• Lowering the discount rate

2. Fighting demand-pull inflation requires:• Selling securities to banks and dealers on the open market, and/or• Increasing the reserve requirement, and/or• Increasing the discount rate

MONETARY POLICY

Government Fiscal Deficits & Monetary Policy

Crowding Out

Occurs when borrowing by the government increases the interest rate and reduces households and businesses borrowings

Government borrowing to finance deficit budget give upward pressure on interest rate and causes the households and business to borrow less.

FISCAL & MONETARY POLICY

Fiscal Deficits & Monetary Policy (Cont’d)

Monetizing the Debt To offset the crowding out effect via preventing the rise of interest rate; prevent government borrowing through the increase in excess reserve (reduce reserve requirement ratio) by amount equal to increase in demand for borrowing.

Increasing the money supply to accommodate the government borrowing and reduce upward pressure on the interest rate.

FISCAL & MONETARY POLICY

Effect of Government Borrowing and Monetizing the Debt on the Interest Rate and Loan Making

CROWDING OUT & MONETIZING THE DEBT FISCAL & MONETARY POLICY

ADVANTAGES & DISADVANTAGES OF MONETARY POLICY

Advantages:• Quickly implemented as compared to fiscal

policy• Largely removed from politics

Disadvantages:• Loan-making link - Someone must be willing to

borrow and a bank must be willing to lend. The Fed cannot force the loan-making process.

• Inflation - As the money supply is tightened, interest rates increase, and businesses that borrow at high rate may raise prices on their products to compensate.

Evaluate on the use of the monetary policy tools.

Government Securities - open market operations (OMO)buying government securities in OMO from banks or the public will increase the excess reserves and expand the money supply while selling them decrease the excess reserves of the banks and shrink the money supply.

Reserve Ratio (RR)raising the RR will decrease while lowering RR will increases the excess reserves.

Interest Rate/Discount Rate (DR)raising the DR discourages banks from borrowing while lowering DR encourages the borrowing of reserves from the central bank.

TEST YOUR UNDERSTANDING

Describe how changes in the policy tool leads to expansionary and restrictive fiscal policies.

  With an expansionary fiscal policy, to expand to promote aggregate spending, borrowing and growth - lower taxes, increase government expenditure and or transfer payments - will increase the level of spending.

With a restrictive fiscal policy, the vice versa!

TEST YOUR UNDERSTANDING