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Understanding Federal Reserve Monetary Policy: Goals, Tools, and Challenges

This overview delves into the complexities of the Federal Reserve's monetary policy, focusing on its primary goals: stable prices, full employment, and economic growth. It highlights the indirect tools the Fed uses, such as reserve requirements, discount rates, and open market operations, to influence the money supply. The role of money growth, inflation, and deflation is examined, emphasizing the challenges the Fed faces in achieving its targets amidst fluctuations in financial markets. Understanding these dynamics is crucial for comprehending the overall economy.

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Understanding Federal Reserve Monetary Policy: Goals, Tools, and Challenges

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  1. Federal Reserve Economics 71a Spring 2007 Mayo, Chapter 5 (skim) Lecture notes 2.5

  2. Federal Reserve • Goals • Stable prices • Full employment • Growth • Tools • Monetary policy • Bank regulation

  3. Money Growth and Inflation“Why monetary policy is tricky” • (Money growth) > (Economic growth) • Inflation • (Money growth) < (Economic growth) • Deflation • Getting this right is tricky

  4. The Federal Reserve and the Money Supply • The Fed does not set the money supply • Indirect tools • Reserve requirements • Discount rate • Open market operations • All are only indirect

  5. Reserve Requirements • Deposit $100 in bank • Bank must keep % (reserve) in vault • Loans out rest • Example 10%: Keep $10 (reserve), loan $90 • This $90 ends up at another bank • Keep $9, loan $81 • Money multiplier • Reducing the reserve requirement has big positive impact on the money supply • Rarely done

  6. Discount Rates • Banks can borrow reserves from the Fed • Interest rate Fed charges banks is called the discount rate • Reducing this increases reserves and also the money supply • Federal funds rate • Related interest rate • Interest banks charge eachother (bank to bank) • Only discount rate is set by Federal Reserve

  7. Open Market Operations • Federal reserve buys and sells government securities • Purchasing government bonds • Increases money supply • Reduces interest rates • Selling government bonds • Decreases money supply • Increase interest rates

  8. How Does this Market Work? • Treasury bill (Tbill) • Treasury bill pays $102 in 90 days • Price today is $100 • Interest = 2% • Federal reserve starts buying • Price goes up to $101 • Interest (102-101)/101 = approx 1%

  9. Monetary Targets • Money supply • Interest rates • Inflation rates

  10. The Federal Reserve and Financial Markets • Not really in its jurisdiction • Clearly linked to banking and monetary system • Should the Federal Reserve care about what is going on in other financial markets? • Can movements in other markets impact the “money supply”? (Stock market, Real estate) • Federal Reserve does worry about systemic risk

  11. Summary • Monetary policy is difficult • Tools are not precise • Don’t get to set the money supply • Interactions with financial markets (both local and globally) are important

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