How effective is monetary policy as an economic tool?

What is monetary policy?

Actions taken by the Federal Reserve System to influence the levels of GDP and inflation through control of the U.S. money supply.

6 Characteristics of Money

1. Durability• Not easily destroyed

2. Portability• Easily transferred and carried

3. Divisibility• Easy to divide into smaller denominations

6 Characteristics of Money

4. Uniformity• Can count and measure it accurately

5. Limited Supply• Too much of it and it looses it value• Not enough to go around, and it’s not worth using as

money

6. Acceptability• Universally accepted and used as a form of payment.

What do we use money for?

1. Medium of exchange

2. Unit of account1. Used to compare values of goods/services

3. Store of value1. It doesn’t lose value over time (usually).

The Federal Reserve

12 independent regional banks that work together to lend to other banks in times of need.

Overseen by 7 Board of Governors Chair of Board of Governors: Ben Bernanke

Appointed by President; confirmed by the senate.

What does the Federal Reserve do? Serves as banker for the U.S. government. Maintains the checking account for the Treasury

Department. Social security checks, income tax refunds, etc.

Can issue currency. Clears checks (record whose account receives

money and whose account gives up money when a check is written) 2 days to clear a check 18 billion checks are cleared per year.

Federal Open Market Committee (FOMC) Meets 8 times per year Sets the federal funds rate

The interest rate that banks charge one another for loans. By controlling the Money supply

Sets the discount rate The interest rate at which banks can borrow money from

the Fed (it is higher than the federal funds rate)

The Fed Regulates the Money Supply Too much money circulating in the economy

leads to Inflation (higher prices) and Decreased value of money

It is the Fed’s job to keep the money supply stable, (and thereby prices stable)

How does the Fed regulate the money supply?1. Changing required reserve ratio (RRR)

• Decreasing RRR leads to increase in money multiplier• Increase in RRR leads to decrease in money multiplier

2. Changes the discount interest rate3. Changes the federal funds rate4. Buying/Selling government securities.

1. (They use this method most often)

How does the level of bank reserves affect the money supply? (Money Multiplier / Creation of Money)1. Banks create money by going about their regular

business:1. Bank reserves 20% of deposit and lends out the rest

(see Money creation chart p430)2. Money Multiplier: (cash deposit x 1)/RRR Where RRR =

required reserve ratio (% of deposit banks must keep on hand).

If RRR = .1 than 1/.1 = 10 For every $1 you deposit, $10 is created.In actuality the money multiplier is about 2 or 3.

Discount Rate and Federal Funds Rate Affects cost of borrowing If either rates increase, the cost of borrowing money

increases, money supply decreases. If either rates decrease, the cost of money

decreases, money supply increases.

Changes in these rates affects all other interest rates: credit cards, savings accounts, etc.

How does buying & selling government securities change the money supply? Buying and selling government securities in

open marekt operations. This is the most often used tool of

monetary policy.

When the Fed buys back government securities When the Fed buys back government

securities (bonds): MS increases. Fed buys, seller receives money, deposits that in

bank, money multiplier takes effect, increase MS.

When the Fed sells government securities When the Fed sells government securities

(bonds): MS decreases. Fed sells, collects money from the buyer, once the

Fed processes these payments the money is out of circulation, decreasing the MS.

How does the Fed know when to buy or sell gov’t securities? It monitors

the money supply. Market forces (economic variables like supply and

demand in each industry) Inflation (price levels): CPI, PPI

What are the most often used tools of the Federal Reserve Open market operations Changing the federal funds rate

How much does money cost?

The cost is the interest rate Even if you’re not borrowing, the interest rate

still affects you. You are giving up interest by not saving or investing.

Summarizing the Market for Money If the money supply is high; interest rates will

be low If the money supply is low; interest rates will

be high.

Summarizing Impact of Interest Rates on the economy If interest rates are high; spending and

investment will be low. If interest rates are low; spending and

investments will be high.

Terms

Easy or expansionary monetary policy The Fed is increasing the MS This will push interest rates down. Which will increase spending/investment Increasing GDP

Tightening of monetary policy The Fed is decreasing the MS This will push interest rates up. Which will decrease spending/investment Decreasing GDP