Today’s Warm Up

1. Today’s Warm Up Based on the functions of the Fed you studied yesterday, which do you think is most important and why?

2. Monetary Policy Tools Today’s LEQ: How do Federal Reserve decisions impact the stability of the economy?

3. Monetary Policy Tools Used to combat the instability of inflation and recession, the Fed uses tools of monetary policy Goals are to promote economic growth, full employment, and price stability

4. Monetary Policy Contractionary Expansionary • Used to combat inflation: • Decrease money supply • Decrease amount of credit available • Used to combat deflation: • Increase money supply • Increase amount of credit available

5. Money Creation The Fed is responsible for putting dollars into circulation This process is called Money Creation Not just printing paper currency or minting coins!

6. Pause: Money Supply Activity Refer to your chart… Use pages 258-259 and page 422 to answer the questions on money supply Be prepared to compare/contrast M1, M2, and M3

7. Three Monetary Policy Tools Reserve Requirement Setting Rates Open Market Operations

8. Tool 1: Reserve Requirement The Required Reserve Ratio (RRR) determines the fraction of deposits that must be kept on reserve & how much a bank can lend Set by the Fed to ensure banks have enough funds to supply customers’ withdrawal needs

9. RRR Example Let’s say the RRR = .1 or 10% You deposit $1,000 into your checking account This means that of your $1,000 demand deposit balance, the bank is allowed to lend $900

10. RRR Example

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

12. PAUSE: Money Creation Practice • Complete the activity on the bottom of page 426 • Figure 16.5: Money Creation • Suppose Joshua deposited only $500 of Elaine’s payment into his account. How much would the money supply increase then?

13. Excess Reserves Sometimes banks hold excess reserves which are greater than required amounts As a result, sometimes funds “leak out” of the money multiplier process & it’s impact is a bit lower in reality

14. Tool 1: Reserve Requirements Reserve requirements & the money supply have an inverse relationship

15. Tool 1: Reserve Requirements Reserve Requirement An increase in reserve requirements causes banks to increase reserves Money Supply Banks reduce lending, causing the money supply to contract

16. Tool 1: Reserve Requirements Money Supply Banks increase lending, causing the money supply to expand Reserve Requirement A decrease in reserve requirements causes banks to decrease reserves

17. Tool 2: Setting Rates Interest rates can be adjusted to encourage or discourage lending This will expand or contract the money supply

18. Tool 2: Setting Rates • Discount Rate – interest charged by the Fed on loans to banks • Federal Funds Rate – interest charged by banks on loans to other banks • Prime Rate – interest charged by banks on short-term loans to their best companies

19. Tool 2: Setting Rates When the Fed makes its decisions on monetary policy, it does so by setting a target for the federal funds rate The discount rate rises and falls with the funds rate; these changes are then reflected in the prime rate PAUSE: Which rate do you think is set higher – the discount rate or the federal funds rate and why?

20. Tool 2: Setting Rates Discount Rate > Funds Rate The Fed is the lender of last resort and wants banks to borrow from each other first These are short-term rates and changes have a limited impact on long-term growth of the economy

21. Tool 2: Setting Rates Federal Funds Rate An increase in the federal funds rate makes banks less willing to borrow from other banks Money Supply Banks reduce lending in order to build reserves, causing money supply to contract

22. Tool 2: Setting Rates Money Supply Banks increase lending, causing the money supply to expand Federal Funds Rate A decrease in the federal funds rate makes banks more willing to borrow from other banks

23. Tool 3: Open Market Operations The buying and selling of gov’t securities to alter the supply of money Considered the most important and most-used tool

24. What is a Government Bond? IOU Represent debt the gov’t must repay to an investor Typically pays fixed amount of interest for a fixed amount of time Safe investment but low rate of return

25. Bond Purchases • To increase the money supply, the Fed will purchase gov’t securities on the open market • Bought with a check drawn on Federal Reserve funds • Bond seller then deposits the money and it becomes part of the money creation process

26. Bond Sales • To decreasethe money supply, the Fed will sellgov’t securities back to bond dealers • Bought with checks drawn on the bond dealers’ own banks • The Fed processes these checks & the money is out of circulation

27. Bond Sales This operation reduces reserves & banks will lend less to keep reserves at required level The money multiplier process works in reverse & money supply declines more than the value of the initial securities purchase

28. Tool 3: Open Market Operations Bond Circulating Through bond sales, the Fed removes reserves from the banking system Money Supply Banks reduce lending, causing the money supply to contract

29. Tool 3: Open Market Operations Money Supply Banks increase lending, causing the money supply to expand Bond Circulating The Fed’s purchase of bonds increases reserves in the banking system

30. Extension Activity You will be working in groups of 2 or 3 Each group will be given a set of economic statistics: inflation, GDP, and unemployment You must analyze these statistics then summarize the appropriate monetary policy actions that should be taken

31. Presentations Explain where your economy is on the business cycle Recommend a monetary policy of expansion or contraction Explain what action should be taken for each monetary policy tool Select which tool you feel would be most effective and explain why