MONETARY MONETARY

POLICYPOLICYMonetary policy has two basic goals:

to promote "maximum" sustainable output and employment to promote "stable" prices

Why would the Fed want to change the money supply?

• Slow INFLATION INFLATION • (too much money chasing too few goods)(too much money chasing too few goods)

• Lower UNEMPLOYMENTUNEMPLOYMENT• (too many people out of work)(too many people out of work)

• Promote Growth in the Economy• Slow down an “over-heated” economy

– Adjusting for the normal business cycle

Typical Business Cycle

Long Term Growth

Monetary PolicyMonetary Policy• Fed is responsible for maintaining price stability

and employment• “Expansionary Monetary Policy”

– goal is to increase money supply• to reduce unemployment• to avoid deflation

• “Contractionary Monetary Policy”– goal is to decrease the money supply

• to reduce inflation• To prevent “bubbles”

3 Important Tools

1. Changing the Reserve Requirement

2. Changing the Discount Rate

3. Conducting “Open Market Operations”

The three tools are interactive

1. Reserve Requirementcurrently: 3-10%

• Raise the reserve requirementRaise the reserve requirement = LessLess money in circulation– slows the economy

• eventually brings price stability (lowers inflation)

• Lower the reserve requirementLower the reserve requirement = MoreMore money in circulation– More money to buy goods and services

• requiring more jobs to produce them

(lowers unemployment)

2. Changing the discount rate

• discount rate = interest rate on fed to bank loans (set by Fed)

• federal funds rate = interest rate on bank to bank loans (set by fed funds market)Raising the interest rate influences how much banks will decide to borrow from the fed (who will lend them money “out of thin air”, increasing money supply)

Keeping the discount rate low encourages borrowing

federal funds rate=interest rate on bank to bank loansdiscount rate=interest rate on fed to bank loans

When the federal funds rate is lower than When the federal funds rate is lower than the discount rate, who would you borrow the discount rate, who would you borrow from?from?

When the discount rate is lower than the When the discount rate is lower than the federal funds rate, who would you borrow federal funds rate, who would you borrow from? from?

• The Fed can encourage borrowing by The Fed can encourage borrowing by keeping rates lowkeeping rates low

Another bank

The fed

currently:currently: discount rate discount rate - .75%- .75%federal funds rate federal funds rate - 0-.25%- 0-.25%

2006 discount rate - 6.25% federal funds rate - 5.25%

What is the Fed trying to do?

Federal Open Market Committee Federal Open Market Committee (FOMC)(FOMC)

• controls controls Open Market OperationsOpen Market Operations– Open Market Purchases Open Market Purchases buysbuys government government

securities = securities = increasesincreases money supply money supply– Open Market Sales Open Market Sales sellssells government government

securities = securities = reduces reduces the money supplythe money supply

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Important Background Information

• U.S. Department of the Treasury– the agency of government responsible for

paying for government and its actions• collects taxes• borrows money if needed

– It borrows from the public by offering securities» securities: promises to repay with interest at some

future time

Open Market PurchasesOpen Market Purchases

• Fed offers to buy your Fed offers to buy your government security. government security. – ““Thin air” money is Thin air” money is

given to you.given to you.– Money supply Money supply

increasesincreases

Open Market Sales

• Fed offers to sell Fed offers to sell government securities government securities it holds. it holds. – You pay for it.You pay for it.– Your money Your money

“disappears” into the “disappears” into the FedFed

– Decreases the money Decreases the money supply.supply.