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Monetary Policy

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  1. Monetary Policy • Changing reserve requirements • altering minimum reserve requirements • altering the “discount” rate • Open market operations

  2. Reserve requirements • By lowering minimum reserve requirements, the Fed “signals” to banks that: • The economy is well • Further extension of credit to borrowers is beneficial--on the margin. • Banks can circulate more money through the economy-extend credit. • By raising minimum reserve requirements, the Fed “signals” to banks that: • The economy is deteriorating • Further extension of credit to borrowers is detrimental—on the margin. • Banks can circulate more (less) money through the economy.

  3. Reserve requirements • More money  More Income  rightward Shift of AD • Less money  Less Income  leftward Shift of AD

  4. Reserve requirements • Respectively, lowering or raising the discount rate has the same effects in the short run, as modifying reserve requirements of banks. • In the long run, supply (LAS) may shift right, if the additional money circulating through the economy generates sufficient new/additional Investment consumption.

  5. Open Market Operations • When the Fed’s Open Market Committee purchases securities in secondary financial markets, bank reserves increase, so interest rates fall—due to the higher supply of funds at banks. • This increases consumption and investment which increases AD, GDP, and CPI. • When the Fed’s Open Market Committee sells securities in secondary financial markets, bank reserves decrease, so interest rates increase due to the lower supply of funds at banks. • This decreases consumption and investment which decreases AD, GDP, and CPI.

  6. Open market operations: global effects • The dollar (Exchange rates) weakens as interest rates fall, which improves our nation’s net export position (trade balance) with respect to the rest of the world. This increases AD, GDP, and CPI. • The dollar (Exchange rates) strengthens as interest rates increase, which worsens our nation’s net export position (trade balance) with respect to the rest of the world. This decreases AD, GDP, and CPI.

  7. Summary • Interest rates and exchange rates adjust faster than prices (CPI/inflation), employment, and output (GDP). • Interest rates and exchange rates “signal” future economic expectations by C, I, G, and the rest of the world. • Fed policy is important information mechanism about the economy’s wellness: FRB signals if episodes of inflation, unemployment, or recession, may be averted.