Download How the Federal Reserve uses Fiscal and Monetary Policy to

How the Federal Reserve uses Fiscal and Monetary
Policy to Stabilize the Economy
Fiscal Policy
Government taxation
Government spending
Monetary Policy: Three “Tools”
1) Raising or lowering the amount of “Fractional or
required reserves” banks must hold
“No reserves are required on the first $12.4 million. Between $12.4 million and $79.5
million, deposits are subject to a 3% reserve. Above $79.5 million they are subject to a 10%
reserve.”
·
Increasing the (reserve requirement) ratios reduces the volume of deposits that can be
supported by a given level of reserves and, in the absence of other actions, reduces the money
stock and raises the cost of credit.
·
Decreasing the ratios leaves banks initially with excess reserves, which can induce an
expansion of bank credit and deposit levels and a decline in interest rates.
2) Raising or lowering the Discount (the interest rate
it charges banks for loans obtained directly from the
Federal Reserve) ---- Interest Rates
LOWERING INTEREST RATES
The Fed is trying to maintain a "healthy" economy. If the economy is "very slow" the Fed might
decide to lower interest rates that will in turn make money more available to businesses, home
buyers, and consumers.
By lowering interest rates, it becomes cheaper to borrow money and less lucrative to save,
encouraging individuals and corporations to spend. So, as interest rates are lowered, savings
decline, more money is borrowed, and more money is spent. Moreover, as borrowing increases,
the total supply of money in the economy increases. So the end result of lowering interest
economic activity - a good side effect.
On the other hand, lowering interest rates also tends to increase inflation. This is a negative
side effect because the total supply of goods and services is essentially finite in the short term and with more dollars chasing that finite set of products, prices go up. If inflation gets too high,
then all sorts of unpleasant things happen to the economy. Therefore, the trick with interest rate
manipulation is not to overdo it and inadvertently
If the Fed wants to lower interest rates, it buys a lot of securities, infusing the
banking system with cash (kind of like in the old days when the Fed actually controlled
the amount of money on the market). With more money available, interest rates
decrease.
RAISING INTEREST RATES
If the economy is "heating up" and in the opinion of the Fed -- growing too quickly, they will raise interest
rates to "slow things down".
By raising interest rates it becomes more expensive to borrow money and easier to save,
encouraging individuals to spend
As interest rates increase, savings increase, less money is borrowed and less money is spent- growth of
the economy is slowed
3) Open Market Operations- the Buying and Selling
of Bonds and Securities
If the Fed BUYS bonds in the open market, IT INCREASES THE MONEY SUPPLY IN THE
ECONOMY by swapping out bonds in exchange for cash to the general public. This increases the
money supply
If the Fed buys bonds, prices are pushed higher and interest rates decrease
Conversely, if the Fed SELLS bonds, it DECREASES THE MONEY SUPPLY BY REMOVING CASH
FROM THE ECONOMY IN EXCHANGE FOR BONDS.
If the Fed sells bonds, it pushes prices down and rates increase.
Essentially, OMOs have the same effect of lowering rates/increasing money supply or raising
rates/decreasing money supply as direct manipulation of interest rates.
The real difference, however, is that OMO is more of a fine-tuning tool for the economy that
adjusting interest rates because the size of the U.S. Treasury bond market is utterly vast and OMO
can apply to bonds of all maturities to affect money supply.