Monetary Policy

1
Monetary Policy

• Monetary policy is the deliberate change
  instituted in the money supply to influence
  interest rates and thus total spending in the
  economy. The goals of monetary policy are to
  achieve price level stability, full employment,
  and economic growth.

2
Tools of Monetary Policy

• The federal reserve has three (3) tools that it
  uses (depending on what is currently seen as
  necessary) to influence the money creation
  ability of the banking system. These are
• 1. Open Market Operations
• 2. Reserve Ratio Change
• 3. Discount Rate

3
Open Market Operation

• The federal reserves open market operations
  involve the buying or selling of government bonds
  to commercial banks or to the public. This is the
  MOST IMPORTANT instrument for influencing the
  money supply.

4
Buying Bonds

• Buying Bonds is an EXPANSIONARY MONETARY policy
• The Fed will do this to increase reserves in the
  banking system. This is how it works
• IF the Fed buys government securities (bonds)
  owned by banks the following occurs
• A. Banks sell bonds to the Fed reducing their
  assets by that amount
• B. The Fed will then pay the banks for their
  bonds increasing banks assets as RESERVES by the
  same amount
• C. This will increase the ability of the banks to
  lend, increasing the money supply, reducing
  interest rates as the supply of money increases,
  thus increasing C and Ig.
• The fed funds rate will decline. This is the
  target the fed is aiming for.

5
Buying bonds part II

• If the Fed buys government bonds from the general
  public (you or me) the following occurs
• A. we sell the bonds to the feds and receive from
  the Fed a check for that amount
• B. We deposit that check into our local bank
• C. As a result the checkable deposits of the bank
  increase, which increases its reserves.
• D. This results in an increase in lending, which
  increases the supply of money, which lowers
  interest rates, which increases C and Ig.
• The fed funds rate will decline and this is the
  target that the Fed is aiming for.

6
Buying bonds part III

• One note when the Fed buys bonds from a bank,
  all of the money received by the bank will go
  into reserves. The bank does not have to keep a
  reserve for this money as it is not a checkable
  deposit. When individuals deposit Fed money for
  bonds into the bank, the bank must hold a of it
  as reserves. This means that there is slightly
  less monetary creation potential with the second
  scenario. In practice, this doesnt affect the
  expansionary nature of the policy. Bank reserves
  increase in both cases.

7
Selling Bonds

• Selling Bonds by the Fed is a contractionary
  monetary policy. The purpose is to reduce bank
  reserves and curb the growth of the money supply.

8
Selling bonds to banks

• When the fed sells bonds to banks the following
  occurs
• A. The fed sells the bonds and receives a check
  from the bank against its cash reserves.
• B. The banks reserves are reduced by that amount.
• C. This, in turn, will reduce the ability of the
  bank (banking system) to make loans, reducing the
  money supply, increasing interest rates, and
  reducing C and Ig.
• The fed funds rate will increase-this is the
  feds target.

9
Selling bonds to the public

• If the fed sells bond to the public, the
  following occurs
• A. individuals or companies buy the bonds and
  write a check to the Fed
• B. The checks reduce the checkable deposits of
  the banks, reducing excess reserves in the
  process.
• C. This, in turn, reduces the ability of banks
  (banking system) to make loans, reducing the
  money supply, raising interest rates, and
  reducing C and Ig.
• The fed funds rate will increase which is the
  purpose of the policy change.

10
Why should banks and people buy and sell
securities to and from the FED

• The answer is the price of bonds and the interest
  rate of the bonds.
• As we have seen, bond price and interest rates
  are INVERSELY related
• So, when the FED buys bonds, the demand for them
  increases, the price rises, and the interest rate
  drops. This encourages banks and the public to
  sell the bonds to the FED.

11
Why?

• On the other hand, when the Fed sells bonds in
  the open market, the additional supply of bonds
  reduces the price and increases the interest
  rate, making them more attractive to potential
  buyers.
• The MAIN AIM of the FED is not to enrich bond
  buyers or sellers, but to CHANGE the FED FUNDS
  RATE as a tool for money supply change.

12
Tool Two The Reserve Ratio

• The fed can also manipulate the required reserve
  ratio for banks to influence the amount of money
  a bank MUST hold. This will influence the total
  amount of excess or loanable funds in the system

13
Raising the Reserve Ratio

• Suppose the federal reserve raises the reserve
  ratio from 20 to 30.
• If the bank has deposits of 100,000 it would
  keep reserves of 20,000 under the old ratio. But
  under the new one, it would need to keep 30,000
  thus reducing the amount it can loan
  significantly.

14
Raising the Reserve

• Several things might result from this.
• A. Banks would lend less money
• B. Banks would call in old loans
• Overall, the effect would be the same as the
  selling of securities. Raising the reserve would
  be contractionary monetary policy. It would
  reduce banks excess reserves, reduce lending,
  reduce the money supply, increase interest rates
  and reduce C and Ig.

15
Lowering the Reserve Ratio

• Suppose the Fed lowers the reserve ratio required
  of banks from 20 to 10
• If the bank has deposits of 100,000 it would
  have had to keep 20,000 under the old ratio, but
  only needs to keep 10,000 under the lowered
  ratio. This would increase the amount it could
  lend significantly.

16
How this affects money supply

• It changes the amount of excess reserves
  available to the banks to lend
• It changes the size of the monetary multiplier
• Remember the Monetary Multiplier is 1/RRR
  (required reserve ratio)
• Because of the power of this tool and its
  dramatic effects, it is infrequently used.

17
The Discount Rate

• The Fed is a central bank. As such, it is what is
  known as a lender of the last resort.
• This means that if a bank has an unexpected
  shortfall of cash, it can borrow these funds from
  the Federal Reserve.
• The Fed will charge the bank an interest rate.
  This rate is known as the DISCOUNT rate.

18
Discount Rate continued

• Since this borrowed money is not required to have
  a reserve all of this money would be available to
  the bank for lending.
• This increases the banks reserves, decreasing
  interest rates, increasing the money supply, and
  thus C and Ig.
• Since the Fed sets the discount rate, it can and
  does use it to encourage banks to borrow or to
  discourage banks from borrowing. This will affect
  the banks ability to lend. So this can be
  expansionary or contractionary depending.

19
Easy Money

• Easy money is an expression for expansionary
  Monetary Policy
• Using the 3 tools Easy Money would consist of the
  following
• BUY SECURITIES (BONDS) This allows banks to
  increase reserves
• LOWER THE RESERVE RATIO This allows banks to
  increase excess reserves
• LOWER THE DISCOUNT RATE This allows banks to
  increase reserves with from the Fed

20
PURPOSE

• The purpose of an EASY money policy is to make
  bank loans less expensive by lowering interest
  rates and more available by increasing the money
  supply and increase output, AD, and employment.

21
TIGHT MONEY

• Tight money is an expression for contractionary
  Monetary Policy
• Using the 3 tools Tight Money would consist of
  the following
• SELL SECURITIES This reduces banks reserves
• RAISE THE RESERVE RATIO This reduces banks
  reserves
• RAISE THE DISCOUNT RATE This inhibits banks
  ability to have extra funds to lend

22
PURPOSE

• The aim of TIGHT MONETARY POLICY is to reduce
  bank reserves, reduce banks abilities to lend,
  reduce the money supply, increase interest rates,
  and reduce the price level or stabilize it,
  reduce output, reduce employment, and reduce AD.

23
Relative Importance of the TOOLS

• Open Market Sales and Purchase of Bonds is the
  MOST IMPORTANT. It is flexible in that small or
  large amounts of bonds can bought or sold. It is
  subtle and less noticeable to the public etal..
  The fed also has extremely large amounts of bonds
  to sell and lots of money to buy with.

24
Relative Importance

• Changing the Reserve Requirements
• Perhaps the main reason the FED uses this tool
  sparingly is because it can severely impact bank
  earnings. Reserves earn no interest, and having
  no money to loan or having too much and not being
  able to loan it are essentially the same to a
  bank, so the FED seldom uses this approach.

25
Relative Importance

• The Discount Rate
• The discount rate is often raised or lowered by
  the FED, but since banks rarely acquire more than
  a few percentage points of reserves this way it
  has little impact. The fact is that most bank
  borrowing from the FED is the result of bank
  wanting to purchase bonds in open market
  operations.
• The discount rate is more of an announcement of
  intent about the general direction of Monetary
  Policy.

26
Easy Money Policy Problem and corrective action

• Problem Unemployment and recession
• Fed buys bonds, lowers RRR, or lowers the
  discount rate
• ?
• Excess reserves increase
• ?
• Money supply rises
• ?

27
continued

• Interest Rate falls
• ?
• Investment spending increases (Ig)
• ?
• Aggregate demand (AD) increases
• ?
• Real GDP increases by a multiple of the increase
  in Ig

28
Tight money policy Problem and corrective action

• Problem Inflation
• ?
• Fed sells bonds, increases RRR, or increases
  discount rate
• ?
• Excess reserves decrease
• ?
• Money supply falls
• ?

29
continued

• Interest rate rises
• ?
• Investment spending (Ig) decreases
• ?
• Aggregate demand (AD) decreases
• ?
• Inflation declines

30
Effectiveness

• Effectiveness of any policy in this large economy
  is problematic.
• However, monetary policy has been used more
  successfully than fiscal policy in the US for the
  last two generations

31
Strengths

• Speed and Flexibility
• Isolation from most Political Pressure
• Successfully used for most of the last three
  decades

32
Shortcomings and problems

• Changes in the way banking is done may cause loss
  of FED control
• Global markets and currency trading may be beyond
  the control of the FED
• The Velocity of money (V) may be changing.
• Cyclical Asymmetry

33
Fed Funds Rate

• This rate is used by the FED to stabilize the
  economy
• It is the rate banks charge each other for
  overnight loans.
• An increase in the fed fund rate signals a tight
  money policy.
• A decrease would signal an easy money policy

34
Why is this important?

• Most interest rates are based on this FED FUND
  rate.
• If prime rates move up or down this will affect
  all borrowers in the economy.
• The fed will sell bonds in the open market to
  increase the fed funds rate
• The fed will buy bonds in the open market to
  decrease the fed funds rate.

35
Exports and Monetary policy

• Net Export Effect of monetary policy
• Easy money policy
• Recession slow growth
• Easy money policy lower interest rate
• Decreased foreign demand for dollars
• Dollar depreciates
• Net Exports increase ergo AD increases
  strengthening the easy money policy

36
Net Export effect

• Tight Money Policy
• Problem inflation
• Tight money policy interest rates rise
• Increased foreign demand for dollars
• Dollar appreciates
• Net exports decrease
• AD shrinks, strengthening tight money policy

37
Assume a large trade deficit

• Easy money policy, which is appropriate for the
  alleviation of unemployment and sluggish growth,
  is compatible with the goal or policy of
  correcting a balance of trade deficit. That is,
  because expansionary policy results in lower
  interest rates, foreigners will give up or not
  purchase US securities. This will lower the
  demand for dollars, cheapening the dollar. This
  will cause demand for US goods as exports to
  increase. This will then reduce any balance of
  trade deficit the US has on its current account.

38
Assume a large trade deficit

• A tight money policy that is used to correct
  inflation conflicts with the goal of correcting a
  balance of trade deficit. Because tight money
  policy restrains money and interest rates rise,
  foreigners would demand US dollars for asset
  purchases, the dollar would appreciate in value,
  and US exports would become less competitive.

39
The Big Picture

• In your textbook on pages 300 and 301 is an
  elegantly structured graph of the economy showing
  the AD/AS theory of the price level, real output
  and how stabilization can occur using Fiscal and
  Monetary Policy. This is well worth some time to
  look at if you are serious about understanding
  the relationships between all the things we have
  discussed from chapter 11 through 15