AP MacroeconomicsMonetary Policy

Institutions that Carry out Monetary Policy

• A nation’s (or Union’s) Central bank • The US Federal Reserve, Bank of

Japan, European Central Bank, Bank of England…

Goals of Monetary Policy and the Institutions

• efforts to promote:• Full employment• Price stability• Long-run economic growth

• How do central banks try to achieve their goals?

• They control the money supply and interest rates.

My name is Janet Yellen.I am the Federal Reserve Chairwoman.

I help to enact Monetary Policy.

Janet Yellen here again.The Fed enacts Monetary Policy by manipulating

the money supply.PS Mr. Bharucha is the best!

Types of Monetary Policy

• Expansionary (Easy Money)– Monetary policy

designed to counteract the effects of recession and return the economy to full employment.

• Contractionary(Tight Money)– Monetary policy

designed to counteract the effects of inflation and return the economy to full employment.

What is the Fed?• It is the nation’s bank• Businesses don’t want to keep cash on

hand• They put it in the bank• Banks don’t want to keep so much cash on

hand either so they deposit much of it into their local Federal Reserve Bank

• Every bank has an account with the Fed

http://www.google.com/url?sa=i&rct=j&q=map+of+us+federal+reserve&source=images&cd=&cad=rja&docid=yNJQV3QBFpX7EM&tbnid=m4_N6AlRUWEPVM:&ved=0CAUQjRw&url=http://en.wikipedia.org/wiki/File_talk:US_Fed_Regions.PNG&ei=-v14UoOPNLfJsQThxIDQCw&bvm=bv.55980276,d.cWc&psig=AFQjCNGsT_Uv0gVHaseBQWEPyNkZAuavrw&ust=1383747437372071

Tools of Monetary Policy

• These are the items the Fed can change to enact MP.

• Required Reserve Ratio• The Discount Rate• Open Market Operations

(OMO)

All that is necessary for the triumph of evil is that good men do nothing.

--Edmund Burke

The Required Reserve Ratio

• The US runs on a fractional banking system.

• That means that a portion of all demand deposits must be stored as cash IN the bank (vault cash) or…

• Kept on reserve as Federal Funds in the bank’s account with the Fed.

• Either way, this money stored as cash or in an account with the Fed can NOT be loaned out.

Required Reserve Ratio (cont)

• There are two types of reserves:– Required—the money that the bank HAS to

have on hand or on reserve in the bank’s account with the Fed.

– Excess—the rest of the demand deposit.– The bank can NOT loan out required reserves.– The bank IS ABLE to loan out excess reserves.– Excess Reserves=Actual Reserves-required

reserves

Federal Funds Rate• The Fed Funds rate is the interest %

banks pay each other for overnight loans of Federal Funds

• As we go through this remember that each member bank HAS TO have a certain percentage of deposits in required reserve.

Why do banks need overnight loans?

• Banks are like any other business in that they seek to maximize profits. How do banks make profit?

• Banks make a profit by loaning out as much of their excess reserves as possible and charging interest to the borrower.

• What if they’ve loaned out too much and they don’t have enough “in reserve”???– Dun-Dun-Dun!!!– Then they’ll need to get some cash—fast!– How do banks get cash quick?

How do banks GET overnight loans?

• They can borrow from another bank.

• They can borrow from another bank that has excess reserves to loan out.

• If the bank goes to another bank to borrow money, they are using the Federal Funds market.

Federal Funds Rate• Why would one bank loan out money

to another bank?• Correct, profit.• What do banks charge on a loan to

make profit?• Correct, interest.• The Federal Funds Rate is the

interest rate banks charge each other for overnight loans

The Discount Rate• The interest % banks pay the Fed for

overnight loans in order to meet the required reserve– Decreasing the discount rate lowers the

cost of borrowing for banks.– This creates an incentive for banks to

loan more of their excess reserves. – If they loan out “too much” they can

borrow cheap money from the Fed in order to meet their reserve requirement.

– The effect of a decrease in the discount rate is to increase the money supply and is therefore expansionary.

The Discount Rate

• Increasing the discount rate raises the cost of borrowing for banks, thus creating an incentive for banks to loan less of their excess reserves. The effect is to decrease the money supply and is therefore contractionary.

The Discount Rate• The discount rate is a secondary tool

of monetary policy. • It functions as a substitute to the

Federal Funds market, providing banks with necessary liquidity when they are unable to access Fed Funds from other private sector banks.

The Discount Rate (cont.)• However, banks are often reluctant

to utilize the discount window because the Fed is seen as the “lender of last resort”

• The discount rate is usually higher than the fed funds rate.

Open Market Operations• The purchase and sale of government

securities by the Fed in order to increase or decrease banks’ excess reserves.

• OMO influences the Fed Funds rate, which is the interest % banks pay each other for overnight loans of Federal Funds

http://www.google.com/url?sa=i&rct=j&q=federal+reserve+buying+bonds&source=images&cd=&cad=rja&docid=s3xswkLusNgsiM&tbnid=SVI9GKN8sMFm9M:&ved=0CAUQjRw&url=http://www.kansascity.com/2013/09/18/4490724/federal-reserve-maintains-bond.html&ei=9E96UvOTDZGNkAesyYDYCw&bvm=bv.55980276,d.eW0&psig=AFQjCNEfIBxZ4nQ-j4V7apSGlYphhLfmNw&ust=1383829606350694

Open Market Operations

When the Fed buys bonds, excess reserves in the banking system increase and is therefore expansionary.

When the Fed sells bonds, excess reserves in the banking system decrease and is therefore contractionary.

• OMO is the primary tool of monetary policy.

Expansionary Monetary Policy to Counteract a Recession w/ reinforcing

effect on Net Exports

Res. Ratio Disc. Rate or Buy Bonds

ER ,therefore MS causing i% which leads to IG

so AD ,resulting in PL and GDPR ,making u%

AD = Aggregate DemandPL = Price LevelGDPR = Real Gross Domestic Productu% = Unemployment RateS$ = Supply of Dollars in FOREXM = Imports, XN = Net Exports

ER = Excess ReservesMS = Money Supplyi% = Nominal Interest RateIG = Gross Private InvestmentD$= Demand for dollars in FOREXX = Exports

=

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the increase in AD already caused by

the increase in IG.

cheaper more expensive

i%

i

QM

MS

MD

Q

i1

MS1

Q1

i%

IG

ID

I I1

i

i1

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

AD1

P1

Fed buys bonds, or Lowers discount rate

.: ER↑ .: MS .: i%↓

.: IG↑

.: AD.: GDPR↑ & PL↑

.: u%↓ & π%↑

Graphing Expansionary

Monetary Policy

Contractionary Monetary Policyto Counteract Inflation w/

reinforcing effect on Net Exports

Res. Ratio Disc. Rate Sell Bonds

ER ,therefore MS causing i% which leads to IG

so AD ,resulting in PL and GDPR ,making u%

AD = Aggregate DemandPL = Price LevelGDPR = Real Gross Domestic Productu% = Unemployment RateS$ = Supply of Dollars in FOREXM = Imports, XN = Net Exports

ER = Excess ReservesMS = Money Supplyi% = Nominal Interest RateIG = Gross Private InvestmentD$= Demand for dollars in FOREXX = Exports

=

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the decrease in AD already caused by

the decrease in IG.

more expensive cheaper

Expansionary Monetary Policyto Counteract a Recession w/ reinforcing effect on Net

Exports Page Intentionally not “Filled in” so you can practice!

Res. Ratio ___Disc. Rate___ _____Bonds

ER ,therefore MS causing i% which leads to IG

so AD ,resulting in PL and GDPR ,making u%

AD = Aggregate DemandPL = Price LevelGDPR = Real Gross Domestic Productu% = Unemployment RateS$ = Supply of Dollars in FOREXM = Imports, XN = Net Exports

ER = Excess ReservesMS = Money Supplyi% = Nominal Interest RateIG = Gross Private InvestmentD$= Demand for dollars in FOREXX = Exports

=

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the in AD already caused by

the in IG.