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Notes on Monetary Policy
Monetary is always conducted by _________, and only affects ____ through _____________________.
If the Fed wants to fight a recession by increasing the money supply, determine the use of the three
tools and explain who the money supply increase would happen.
Increase the
Money Supply…
Action by Fed?
Open Market Operations
Discount Rate
Reserve Requirement
How is the money
supply change
made?
If the Fed wants to fight inflation by decreasing the money supply, determine the use of the three tools
and explain who the money supply decrease would happen.
Decrease the
Money Supply…
Action by Fed?
How is the money
supply change
made?
Open Market Operations
Discount Rate
Reserve Requirement
Notes on Monetary Policy
Monetary is always conducted by the FED, and only affects AD through INVESTMENT SPENDING.
If the Fed wants to fight a recession by increasing the money supply, determine the use of the three
tools and explain who the money supply increase would happen.
Increase the
Money Supply…
Action by Fed?
How is the money
supply change
made?
Open Market Operations
Discount Rate
Reserve Requirement
Buy government securities
(T-bills)
When the Fed buys bonds,
a deposit demand is
created. Banks can make
more loans after they set
aside the required reserves
and the money supply is
increased.
Lower discount rate
Lower required
reserves percentage
When the requirement
percentage is lower,
banks have more
excess reserves to
make loans and money
supply is increased.
When the discount rate
is lower, banks can
borrow funds from the
Fed at lower cost. They
can make more loans
and money supply is
increased.
If the Fed wants to fight inflation by decreasing the money supply, determine the use of the three tools
and explain who the money supply decrease would happen.
Decrease the
Money Supply…
Action by Fed?
How is the money
supply change
made?
Open Market Operations
Discount Rate
Reserve Requirement
Sell government securities
(T-bills)
When the Fed sells bonds,
buyers use their funds from
a deposit demand. Banks
have fewer excess reserves
to lend money and the
money supply is decreased.
Raise discount rate
Raise required reserves
percentage
When the requirement
percentage is higher,
banks have fewer
excess reserves to
make loans and money
supply is decreased.
When the discount rate
is higher, banks can
borrow less at a higher
cost. They make fewer
loans and money
supply is decreased.
The Federal Reserve Bank
“The Fed”
The Central Bank of the US was created in 1913.
Dual Mission
o
o
Board of Governors
Chairperson (appointed by the President, approved by the Senate)
Currently =
Famous prior chairpersons = Paul Volcker, Alan Greenspan, Ben Bernanke
The Fed distributes currency though 12 “Fed” Banks:
A=
B=
C=
E=
F=
G=
I=
J=
K=
D=
H=
L=
The Fed also monitors all FDIC banks of the US and acts as a Deposit Institution for Member Banks.
Job #1: ______________________________
Moving cash in and out of the economy through the New York bond market
The Fed BUYS BONDS so that the public has more cash. BB=BB
The Fed SELLS BONDS to remove cash from the economy. SB=SB
Job #2: _____________________________
A higher FFR target slows down inter-bank borrowing and therefore public borrowing.
A lower FFR target speeds up inter-bank borrowing and therefore public borrowing.
Job #3: _____________________________
A higher DR means that banks pay more to borrow from the Fed.
A lower DR means that banks pay less to borrow from the Fed.
Job #4: _____________________________
A high RR means that banks have to hold more in vaults and therefore limit private loans.
A low RR means that banks can hold less in vaults and therefore expand private loans.
The Federal Reserve
“The Fed”
The Central Bank of the US was created in 1913.
Dual Mission
o Keep the economy growing
o Keep inflation under control
Board of Governors
Chairperson (appointed by the President, approved by the Senate)
Currently = Janet Yellen
Famous prior chairpersons = Paul Volcker, Alan Greenspan, Ben Bernanke
The Fed distributes currency though 12 “Fed” Banks:
A= Boston
B= New York
C= Philadelphia
E= Richmond
F= Atlanta
G= Chicago
I= Minneapolis
J= Kansas City
K= Dallas
D= Cleveland
H= St. Louis
L= San Francisco
The Fed also monitors all FDIC banks of the US and acts as a Deposit Institution for Member Banks.
Job #1: Open Market Operations
Moving cash in and out of the economy through the New York bond market
The Fed BUYS BONDS so that the public has more cash. BB=BB
The Fed SELLS BONDS to remove cash from the economy. SB=SB
Job #2: Federal Funds Rate
A higher FFR target slows down inter-bank borrowing and therefore public borrowing.
A lower FFR target speeds up inter-bank borrowing and therefore public borrowing.
Job #3: Discount Rate
A higher DR means that banks pay more to borrow from the Fed.
A lower DR means that banks pay less to borrow from the Fed.
Job #4: Reserve Requirements
A high RR means that banks have to hold more in vaults and therefore limit private loans.
A low RR means that banks can hold less in vaults and therefore expand private loans.
The Federal Reserve and Interest Rates
Interest Rates affect Gross Investment…
Gross Investment is a component of AD/GDP…
Interest Rates are manipulated through the Money Supply!
Bond Markets (The Open Market Operations conducted by the Open Market Committee)
• The Fed can buy and sell bonds from the public or FDIC banks.
• If the Fed sells bonds, the nation gets bond certificates; the Fed gets the cash and thus removes it from the
money supply available to the people.
• If the Fed buys bonds, the nation gets cash and the Fed gets back the bond certificates. More money supply
is given to the public and more money can be spent.
“Targeting” the Fed Fund Rate (FFR)
• Banks that belong to the FDIC, must balance their accounts each day. Some days they have extra “cash”
and can lend it to other banks, other days they need “cash” and must borrow from other banks. Banks
charge each other interest for such loans, and the loans last for 24 hours. This is the “Fed Fund” and banks
can negotiate the interest rates collected.
• During recessions, the Fed wants banks to be able to borrow more easily and they announce lower
“targets” for the FFR. Banks comply.
• During inflation, the Fed wants banks to be able to borrow less easily and they announce higher “targets”
for the FFR. Banks comply.
• The Fed cannot set the FFR, only target what range they prefer. From 2009 to early 2015, the FFR target
has been 0.0% to 0.25% for FFR loans. This is the lowest it can be.
Setting the Discount Rate (DR)
• Banks that belong to the FDIC can get financial help during local and national emergencies where there
might be a shortage of money supply. They go to the nearest Fed Bank “discount window” and borrow cash
from the Fed itself.
• The Fed will charge an interest rate for such a loan. High rates discourage borrowing and thus reduce the
money supply. Low rates encourage borrowing and thus increase the money supply.
Reserve Requirement (RR)
• Banks must hold a percentage of all private deposits in the vaults (the “reserve”).
• This cannot be used for loans.
• Raising the Reserve Requirement forces banks to reduce loans.
• Lowering the Reserve Requirement allows banks to create more loans.
Acting as a Federal deposit institution for member banks (FDIC)
• The 12 Fed banks now allow member banks to deposit funds as the Fed bank and collect interest on the
“savings accounts”.
• High interest payments can push banks to keep the money in the Fed bank and not risk it on loans to the
public. This would reduce the money supply.
• Low interest payments can push banks to use the money through public loans, thus increasing the national
money supply.
Interest Rate Basics
Fed Funds Rate
FDIC member banks loan each other overnight funds in order
to balance deposit accounts each day. The interest rate they
use to loan each other this money is the Fed Fund Rate.
The Federal Reserve "targets" this rate by suggesting its
raising or lowering and uses bonds to accomplish the targets.
The Federal Reserve measures the rate in "basis points".
100 basis points = 1%.
(LIBOR)
The London Interbank Offered Rate is used worldwide to help
establish loans between banking institutions. Being used more in
newer texts and functions like an international FFR.
Discount Rate
FDIC member banks, and other eligible institutions, may borrow
short term loans directly from the Federal Reserve. This is
the "discount window", and is set above the Fed Fund Rate.
Banks do not like to use the window, since it appears to be
a move of "last resort" to have to turn to the federal government
for loan funds. The FOMC sets the Discount Rate.
Prime Rate
This is the interest rate banks charge their most "credit
worthy" borrowers. Historically, the prime rate, in the US,
has been set about 3% above the Fed Fund Rate.
Private Rates
These loan rates are set by supply and demand, the abilities
of companies to loan out private monies, and subsidized
federal monies. Examples would include car companies
"selling" "zero interest" loans, special student rate loans, etc.
When companies use these tactics, they hope to regain
profit with time limits to the special rates, less bargaining on
the overall product price, heavy late payment fees, etc.
Any rate below the Fed Fund Rate probably has some kind
of financial trick attached to the contract.