Chapter 15: Monetary Policy

1. Chapter 15: Monetary Policy • Federal Reserve Board Chairperson • Federal Reserve Board (7) • Federal Open Market Committee (12) • Deliberate changes in money supply to influence interest rates, total level of spending in economy • Goal is to achieve & maintain price-level stability, full-employment, & economic growth

2. Tools of Monetary Policy • Open-market operations • Reserve ratio • Discount rate

3. Open-Market Operations • Bond markets are open to buyers & sellers of corporate & government bonds (securities) • Fed’s Open-market operations consist of buying bonds from or selling bonds to commercial banks & general public • The most important instrument for influencing the money supply

4. Reserve Ratio • Raising the reserve ratio increases amount of required reserves banks must keep  reduces money supply • Forces banks to reduce amount of checkable deposits • Lowering reserve ratio decreases amount of required reserves banks must keep  increases money supply • Transforms required reserves into excess reserves, enhancing ability of banks to create new money by lending

5. Discount Rate • Fed is “lender of last resort” • Short-term loans to commercial banks in need in its district (12) • Discount Rate: Interest rate Fed charges to commercial banks • Borrowing from Federal Reserve Banks by commercial banks increases reserves of commercial banks & enhances their ability to extend credit • Lowering discount rate increases money supply • Increasing discount rate decreases money supply

6. Easy Money Policy • Aka Expansionary Monetary Policy • To combat recession & unemployment, Fed decides to increase money supply. • How: • Buy securities • Lower reserve ratio • Lower discount rate

7. Tight Money Policy • Aka Restrictive Monetary Policy • To reduce spending & control inflation, Fed wants to reduce aggregate demand by contracting supply of money • How: • Sell securities • Increase reserve ratio • Raise discount rate

8. Effectiveness of Monetary Policy • Strengths: • Speed & Flexibility (v. Fiscal Policy) • Isolation from Political Pressure (14 year terms) • Shortcomings & Problems • Less control due to changes banking practices (bank reform & electronic transactions) • Changes in velocity • Velocity of money: number of times per year average dollar is spent on goods & services • Cyclical asymmetry: less reliable in pushing economy from recession

9. Targeting the Federal Funds Rate • Focus of Fed’s monetary policy to stabilize the economy • Interest rates in general rise & fall w/ Federal Funds rate • Prime interest rate: rate banks charge their most creditworthy customers, parallels FFR • By changing the FFR, Fed is changing economy’s overall interest rates • Fed announces changes in monetary policy by announcing changes for target FFR

10. Monetary Policy & International Economy • Net Export Effect • Expansionary monetary policy (lower FFR) decreases foreign demand for dollars, increases net exports & dollar depreciates • Restrictive monetary policy (higher FFR) increases foreign demand for dollars, decreases net exports & dollar appreciates