Money Supply & The Fed

1. Money Supply & The Fed How the Fed “creates” money

2. Monetary Policy • The Fed conducts Monetary Policy by changing the nation’s money supply which alters short term interest rates Dot-Com Crash Housing Bubble 0.0% 1.0%

3. SUPPLY OF MONEY Supply of Money is fixed by the Fed When the Fed changes money supply => short term interest rates change

4. Increasing Money Supply MS1 MS2 MS1 MS2 Nominal Interest Rate i2 --------- i2 i1 --------------- --------------- MD Qty of $ Graphing The Money Market • Represents a short term, nominal interest rate • Think of it as the Federal Funds Market • Different than Loanable Funds Market! (don’t mix them up!) Decreasing Money Supply Nominal Interest Rate --------- i1 MD Qty of $

5. 3-Tools of Monetary Policy • The Fed has 3-tools to change money supply: • reserve requirement (currently 10.0%) • discount rate (currently 0.75%) • open-market operations (currently 0.00% target) • alters the Federal Funds Rate

6. Discount Rate & Federal Funds Rate • Discount rate: the interest rate the Fed charges banks for loans • Banks borrow money directly from the Fed at the discount rate (0.75%) • The Fed is the “lender of last resort” in a financial crisis (very important in 2008!) • Federal Funds Rate: the interest rate banks charge other banks for short term loans • This is the rate graphed in the money market ( currently 0.12%) • The Fed uses open market operations to alter it

7. Open-Market Operations • What:The primary way the Fed changes money supply • How: A process which involves the Fed buying & selling U.S. Government bonds • Bonds are also known as gov’t securities • Result: the “open-market” process alters the Federal Funds Rate

8. Open-Market Operations “in action” • To increasemoney supply: • the Fed buys government bonds (securities) from public • To decreasemoney supply: • the Fed sells government bonds (securities) to public Gov’t bonds Federal Reserve Public Market & Banks Money

9. Worksheet