Download topic 15

Monetary Policy
I. 4 monetary goals
II. Monetary policy targets
III. The Money Market
- money demand (MD)
- money supply (MS)
a. Increasing and decreasing MS
IV. Open Market Operations
Monetary Policy
- The actions the FED takes, managing the money supply &
interest rates to pursue macroeconomic policy objectives
4 Monetary Policy Goals
1) Price stability
2) High employment
3) Economic growth
4) Stability of financial markets & institutions
Monetary policy targets
- Economic variables that the FED can affect directly
1) Money supply (MS)
2) Interest rates
The Money Market
- Shows that interest rates & the money supply are related
Vertical axis: interest rate
Horizontal axis: the quantity of money
The demand for money (MD): an inverse relationship between
interest rate & the quantity of money demanded
Why is MD downward sloping?
Shifts in money demand
2 most important determinants of money demand
1) real GDP
↑ in real GDP  ↑ in buying & selling  ↑ in MD
(Money is a medium of exchange)
↓ real GDP  ↓ MD
2) Price level
↑ Price level => ↑in money required for transactions
=> ↑ in MD
The money supply
M1 = currency + dem. dep.
Equilibrium in the money market
The effect of an ↑ or ↓ in MS
The FED impacting the money supply (MS)
Recall: Banks and the Creation of Money
Required Reserves – the amount of funds a member bank must keep on
reserve (deposited w/ the Federal) Reserve Bank in its district or as vault
cash.
-- reserve ratio = bank’s required reserve/bank’s demand deposit
liabilities
- the specified percentage of bank’s own demand deposit liabilities.
Ex: reserve ratio = 20% = 1/5
Required Reserve = .20 * 100,000 = $20,000
Also,
ACTUAL –
REQUIRED =
EXCESS
RESERVE
RESERVE
RESERVE
THE EXCESS RESERVES OF A BANK IS THE AMOUNT
AVAILABLE FOR LOANS.
Recall: the money supply (MS): M1 = currency + dem. dep.
- Bank’s ability to loan its excess reserves allows ↑ MS
(the creation of $)
- repaying a Loan → ↓ MS (destroying $)
The FED and Open Market Operations:
- Federal Open Market Committee (FOMC) buys & sells
securities in the open market to decrease & increase the MS –
open market operations
- 12 members of FOMC
- Treasury securities – Treasury bills, notes & bonds
- treasury bills – mature in 1 year or less
- treasury notes – mature in 2 to 10 yrs
- treasury bonds – mature in 30 years
-
US Treasury sells securities to borrow money
To ↑ MS => buy securities from the general public
To ↓ MS => sell securities to the general public
FED Buys Bonds
FED gets bond, gives $ → ↑ MS
Fed Buys bonds from banks
+ bond → add bond as asset
+ reserve → add to reserves of bank 1
Note: When banks reserves ↑ → ↑ in lending capabilities
(↑ in ability to create $)
→ ↑ MS
FED buying bonds from public
EX: Joe sells bonds on the open market to the FED
Joe
1.) Joe gives securities (- securities under Assets)
2.) Puts $ in bank ( + DD under Assets)
Joe’s Bank (Bank 1)
1.) Get Joe’s DD (+ DD Liability)
2.) Puts $ from DD in reserves (+ Reserves Assets)
FED
1.) Get securities (+ securities Assest)
2.) ↑ Bank 1’s reserving (+ Liability)
Note: Whether FED buys bonds from banks or the public
=> ↑ banks reserves
=> ↑ bank’s ability to create $
=> ↑ MS
In contrast,
FED Selling Securities →↓ reserves → destroying $ → ↓ MS
Recall, we know:
↑ MS → ↓i → ↑ C & ↑ I → ↑ AD
and
↓ MS → ↑ i → ↓ C & ↓I → ↓AD
Note: OMO in which the FED buys securities to ↑ MS is an example of
expansionary monetary policy
- Used to fight a recession
- Goal to stimulate AD
- lower interest rates => ↑ C & ↑ I
In contrast: OMO in which the FED sells securities to ↑ MS is an
example of contractionary monetary policy
- Used to reduce inflation rate