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Monetary Policy

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  1. Monetary Policy

  2. Monetary Policy • The Federal Reserve’s control over the supply of money is the key mechanism to monetary policy. • Monetary policy is the use of money and credit controls to influence macroeconomic activity.

  3. Jobs AS Internal market forces Prices External shocks Growth Output AD International balances Monetary Policy DETERMINANTS OUTCOMES Policy levers: Fiscal policy Monetary policy

  4. The Federal Reserve System • Control of the U.S. money supply starts with the Federal Reserve System (the Fed).

  5. Federal Reserve Banks • The core of the Federal Reserve system consists of 12 Federal Reserve banks.

  6. Functions of Regional Fed Banks • Clear checks between private banks • Hold bank reserves • Provide currency • Provide loans (discounting)

  7. The Board of Governors • Key decision-maker for monetary policy. • Seven members appointed by President of U.S. for 14 year terms.

  8. Board of Governors (7 members) Federal Reserve banks (12 banks, 24 branches) Private banks (depository institutions) Structure of the Federal Reserve System

  9. The Federal Chairman • Most visible member of the Fed system. • Selected by the President for a four year term — can be re-appointed.

  10. The Federal Chairman • Alan Greenspan was appointed by President Reagan, re-appointed by Presidents Bush, Clinton, and Bush.

  11. Monetary Tools • The Fed has the power to alter the money supply. • The money supply(M1) consists of currency held by the public, plus balances in transaction accounts.

  12. Monetary Tools • The Fed has three basic tools of monetary policy: • Reserve requirements • Discount rates • Open-market operations

  13. Reserve Requirements • The Fed directly alters the lending capacity of the banking system by changing the reserve requirement. • Required reserves are the minimum amount of reserves a bank is required to hold by government regulation.

  14. Reserve Requirements • The ability of the banking system to create deposits is determined by the money multiplier and the amount of excess reserves.

  15. Reserve Requirements • A decrease in required reserves increases excess reserves.

  16. Reserve Requirements • Excess reserves are bank reserves in excess of required reserves.

  17. A Decrease in Required Reserves • A change in the reserve requirement causes: • A change in excess reserves. • A change in the money multiplier.

  18. A Decrease in Required Reserves • A lower reserve requirement increases the size of the money multiplier. • The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

  19. 1 Moneymultiplier = required reserve ratio A Decrease in Required Reserves • A lower reserve requirement increases the size of the money multiplier.

  20. The Impact of Reduced Reserve Requirement

  21. The Discount Rate • Discounting is Federal Reserve lending of reserves to private banks. • The discount rate is the rate of interest charged by Federal Reserve banks for lending reserves to private bank.

  22. The Discount Rate • Sometimes banks reserves run low and they must replenish their reserves temporarily.

  23. The Discount Rate • There are three sources of last-minute reserves: • Fed funds market – borrow from a reserve-rich bank. • Sell securities. • Discounting – obtaining reserve credits from the Federal Reserve System.

  24. The Discount Rate • By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

  25. Open-Market Operations • Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

  26. Open-Market Operations • Open-market operations are designed to affect portfolio decisions and the decision to hold money or bonds.

  27. Portfolio Decisions • Where should idle funds be held – in cash or some other asset?

  28. Hold Money or Bonds • The Fed attempts to influence whether individuals hold idle funds in transaction accounts or government bonds. • Changes in bond prices alter portfolio choices.

  29. Open Market Activity • Open market operations — the Federal Reserve purchases and sells government bonds to alter bank reserves. • Fed buys bonds — it increases bank reserves. • Fed sells bonds — it reduces bank reserves.

  30. Regional Federal Reserve bank Federal Open Market Committee Private bank Public An Open-Market Purchase Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check Step 3: Bank deposits check at Fed bank, as a reserve credit Step 2: Bond seller deposits Fed check

  31. Powerful Levers • To summarize, there are three policy levers of monetary policy: • Reserve requirements • Discount rates • Open-market operations

  32. Powerful Levers • The Fed has effective control of the nation’s money supply.

  33. Shifting Aggregate Demand • The ultimate goal of all macro policy is to stabilize the economy at its full-employment capacity. • Monetary policy may be used to shift aggregate demand.

  34. Shifting Aggregate Demand • Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

  35. Expansionary Policy • Monetary policy can be used to move the economy to its full-employment potential.

  36. Expansionary Policy • The Fed can increase AD by increasing the money supply by: • Lowering reserve requirements. • Dropping the discount rate. • Buying more bonds to increase bank lending capacity.

  37. Expansionary Policy • Banks make more loans so AD shifts to the right reflecting increased purchasing power.

  38. PRICE LEVEL (average price) RATE OF OUTPUT (real GNP per time period) Demand-Side Focus AS E2 E1 AD2 AD1 Q1 QF

  39. Restrictive Policy • Monetary policy can be used to cool an overheating economy.

  40. Restrictive Policy • Fed can reduce money supply and decrease AD by: • Raising reserve requirements • Increasing discount rate • Selling bonds

  41. Price vs. Output Effects • The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

  42. Aggregate Demand • Increases in the money supply shift AD to the right.

  43. Aggregate Supply • Aggregatesupply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

  44. Aggregate Supply • The shape of the AS curve determines the effectiveness of expansionary monetary policy.

  45. Aggregate Supply • Horizontal AS — output increases without any inflation. • Vertical AS — inflation occurs without changing output. • Upward sloped AS — both prices and output are affected by monetary policy.

  46. Aggregate Supply • With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

  47. PRICE LEVEL (average price per unit of output) 0 RATE OF OUTPUT (real GDP per time period) Contrasting Views of Aggregate Supply (a) The Keynesian view Aggregate supply P3 P1 AD3 AD2 AD1 Q1 QF

  48. P5 P4 Contrasting Views of Aggregate Supply (b) The Monetarist view Aggregate supply PRICE LEVEL (average price per unit of output) AD5 AD4 0 QN RATE OF OUTPUT (real GDP per time period)

  49. Aggregate supply P7 P6 Contrasting Views of Aggregate Supply (c) An eclectic view PRICE LEVEL (average price per unit of output) AD7 AD6 0 Q6 Q7 RATE OF OUTPUT (real GDP per time period)

  50. Policy Perspectives • The shape of the aggregate supply curve spotlights a central policy debate.