Monetary Policy The fundamental objective is to assist the economy in achieving a full-employment, non-inflationary level of total output. • The FED alters the economy’s money supply to stabilize aggregate output, employment and the price level. • Monetary policy — increasing the money supply during a recession to stimulate spending — restrict money supply during inflation to constrain spending.
Balance Sheet Of The Federal Reserve Banks ASSETS • Securities • Loans to Commercial Banks LIABILITIES • Reserves of Commercial Banks • Treasury Deposits • Federal Reserve Notes
Tools Of Monetary Policy Open-Market Operations √ Buying Securities From commercial banks. . . • Bank gives up securities • FED pays bank • Banks have increased reserves From the public. . . • Public gives up securities • Public deposits check in bank • Banks have increased reserves
Tools Of Monetary Policy Open-Market Operations √ Selling Securities To commercial banks. . . • FED gives up securities • The Bank pays FED • Banks have decreased reserves To the public. . . • FED gives up securities • Public writes check to FED • Banks have decreased reserves
Bond Prices and Interest Rates Bond prices and interest rates are inversely related. When FED is buying bonds, the demand for them increases: • price of bonds rise and their interest rates fall • Lower interest rates causes banks and other bondholders to sell them to FED. When FED is selling bonds, the increase in the supply of bonds in the market, causes: • price of bonds to fall and their interest rates to rise • higher interest rates causes banks and other bondholders to buy them from the FED since bonds are now a better investment.
Federal Reserve—Buying Bonds Purchase of a $1000 bond from a bank or from the public. . . New reserves $800 Excess Reserves $4000 Bank System Lending $200 Required reserves $1000 Initial Deposit Total Increase in Money Supply ($5000)
Tools Of Monetary Policy The Reserve Ratio Raising the Reserve Ratio • Banks must hold more reserves • Banks decrease lending • Money supply decreases Lowering the Reserve Ratio • Banks may hold less reserves • Banks increase lending • Money supply increases
Tools Of Monetary Policy The Discount Rate Raising the Discount Rate • Banks borrow less from the FED • Banks decrease lending • Money supply decreases Lowering the Discount Rate • Banks may borrow more from the FED • Banks increase lending • Money supply increases
Easy Money Policy Goal: Cheap, available credit; increase the money supply
Tight Money Policy Goal: Restrict credit; decrease the money supply
Monetary Policy, Real GDP, the Price Level Transmission Mechanism • Money supply impacts interest rates • Interest rates affect investment and some consumer spending • C and In are components of AD • Equilibrium GDP and PL are changed.
Easy Monetary Policy And Equilibrium GDP Real rate of interest, i Sm 1 Sm 2 Sm 3 10 10 8 8 6 6 0 Dm Quantity of money demanded and supplied AS Price level Investment Demand PL 3 PL 2 PL 1 0 Amount of investment, i If the Money Supply Increases to Stimulate the Economy… §Interest Rate Decreases §Investment Increases §AD & GDP Increases AD 3(I=$25) with slight inflation AD 2(I=$20) §Increasing money supply AD 1(I=$15) continues the growth – Real domestic output, GDP but, watch Price Level.
Tight Monetary Policy And Equilibrium GDP Real rate of interest, i Sm 3 Sm 2 Sm 1 10 10 8 8 6 6 0 Dm Quantity of money demanded and supplied PL 1 PL 2 PL 3 0 Amount of investment, i If the Money Supply Decreases to “cool” the Economy… §Interest Rate Increases §Investment Decreases §AD & GDP Decreases AD 1(I=$25) with lower PL AD 2(I=$20) §Decreasing money supply AD 3(I=$15) continues the “cooling” – Real domestic output, GDP as Price Level falls. AS Price level Investment Demand
Strengths of monetary policy • Speed and flexibility • Isolation from political pressure Focus on the Federal Funds Rate • The Federal Funds Rate • Recent Monetary Policy
Problems and Complications • Changes in Control-electronic banking and flow of funds • Changes in Velocity—cost of holding money • Cyclical Asymmetry—easy to get results with tight money policy
Monetary Policy And The International Economy √ In chapter 12, we learned Fiscal Policy may be weakened by an accompanying net export effect which works through change in (a) interest rates (b) in international value of the dollar (c) exports and imports. √ With Monetary Policy, the net export effect works to strengthen monetary policy actions. Exchange-rate changes which occur in response to interest-rate change act to increase the effect.
Monetary Policy and Net Export Effect
√ Monetary policy can also work to aid in reducing trade deficits since an easy money policy and lower interest rates causes net exports to increase and this aids in moving the trade balance closer to equality. √ But…a tight money policy with higher interest rates causes net exports to decrease and this will push the trade deficit higher. And so… Easy money Policy alleviates a trade deficit, but aggravates a trade surplus. But…Tight money policy aggravates a trade deficit, but alleviates a trade surplus.
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