Download Monetary Policy Tools - Appoquinimink High School

 Based
on the functions of the Fed you
studied yesterday, which do you think is
most important and why?
Today’s LEQ: How do Federal
Reserve decisions impact the
stability of the economy?
Used
to combat the instability of
inflation and recession, the Fed
uses tools of monetary policy
Goals are to promote economic
growth, full employment, and
price stability
CONTRACTIONARY
 Used
to combat
inflation:
• Decrease money
supply
• Decrease
amount of credit
available
EXPANSIONARY
 Used
to combat
deflation:
• Increase money
supply
• Increase amount
of credit
available
The
Fed is responsible for
putting dollars into circulation
 This process is called Money
Creation
Not just printing paper currency
or minting coins!
 Refer
to your chart…
 Use pages 258-259 and page 422 to
answer the questions on money supply
 Be prepared to compare/contrast M1, M2,
and M3
 Reserve
Requirement
 Setting Rates
 Open Market Operations
 The
Required Reserve Ratio (RRR)
determines the fraction of deposits that
must be kept on reserve & how much a
bank can lend
 Set by the Fed to ensure banks have
enough funds to supply customers’
withdrawal needs
 Let’s
say the RRR = .1 or 10%
 You deposit $1,000 into your checking
account
 This means that of your $1,000 demand
deposit balance, the bank is allowed to
lend $900
Let’s say the
bank lends that
$900 to Bob and
he deposits it
into his checking
account – Bob
now has $900 he
didn’t have
before and it’s
now included in
M1
You still have
your $1,000
demand deposit
account balance
Your initial
deposit to the
bank and the
subsequent loan
have caused the
money supply to
increase by
$1,000 + $900
for a total of
$1900
 This
process continues until the loan
amount, and hence the amount of new
money that can be created, becomes
very small
 How much can we increase the money
supply? This is given by the money
multiplier formula
• Initial cash deposit x 1/RRR
• $1,000 x 1/.1 = $10,000
 Complete
the activity on the bottom of
page 426
 Figure 16.5: Money Creation
• Suppose Joshua deposited only
$500 of Elaine’s payment into his
account. How much would the
money supply increase then?
 Sometimes
banks hold excess reserves
which are greater than required amounts
 As a result, sometimes funds “leak out” of
the money multiplier process & it’s
impact is a bit lower in reality
Reserve
requirements & the
money supply have an
inverse relationship
Reserve
Requirement
An increase in reserve
requirements causes
banks to increase
reserves
Money Supply
Banks reduce lending,
causing the money
supply to contract
Reserve
Requirement
A decrease in
reserve
requirements causes
banks to decrease
reserves
Money Supply
Banks increase
lending, causing the
money supply to
expand
Interest
rates can be adjusted to
encourage or discourage
lending
This will expand or contract the
money supply
Discount Rate – interest
charged by the Fed on
loans to banks
 Federal Funds Rate –
interest charged by
banks on loans to other
banks
 Prime Rate – interest
charged by banks on
short-term loans to
their best companies

 When
the Fed makes its decisions on
monetary policy, it does so by setting a
target for the federal funds rate
 The discount rate rises and falls with the
funds rate; these changes are then
reflected in the prime rate
 PAUSE: Which rate do you think is set
higher – the discount rate or the
federal funds rate and why?
 Discount
Rate > Funds Rate
 The Fed is the lender of last resort and
wants banks to borrow from each other
first
 These are short-term rates and changes
have a limited impact on long-term
growth of the economy
Federal Funds
Rate
An increase in the
federal funds rate
makes banks less
willing to borrow from
other banks
Money Supply
Banks reduce lending
in order to build
reserves, causing
money supply to
contract
Federal Funds
Rate
A decrease in the
federal funds rate
makes banks more
willing to borrow
from other banks
Money Supply
Banks increase
lending, causing the
money supply to
expand
 The
buying and selling of gov’t securities
to alter the supply of money
 Considered the most important and
most-used tool
Represent debt the gov’t must repay to an investor
Typically pays fixed amount of interest for a fixed
amount of time
 Safe investment but low rate of return


To
increase the money supply,
the Fed will purchase gov’t
securities on the open market
• Bought with a check drawn on Federal
Reserve funds
• Bond seller then deposits the money
and it becomes part of the money
creation process
To
decrease the money supply,
the Fed will sell gov’t securities
back to bond dealers
• Bought with checks drawn on the bond
dealers’ own banks
• The Fed processes these checks & the
money is out of circulation
 This
operation reduces reserves & banks
will lend less to keep reserves at
required level
 The money multiplier process works in
reverse & money supply declines more
than the value of the initial securities
purchase
Bond
Circulating
Through bond sales,
the Fed removes
reserves from the
banking system
Money Supply
Banks reduce lending,
causing the money
supply to contract
Bond
Circulating
The Fed’s purchase
of bonds increases
reserves in the
banking system
Money Supply
Banks increase
lending, causing the
money supply to
expand
 You
will be working in groups of 2 or 3
 Each group will be given a set of
economic statistics: inflation, GDP, and
unemployment
 You must analyze these statistics then
summarize the appropriate monetary
policy actions that should be taken
 Explain
where your economy is on the
business cycle
 Recommend a monetary policy of
expansion or contraction
 Explain what action should be taken for
each monetary policy tool
 Select which tool you feel would be most
effective and explain why