Download Monetary Policy

Chapter 15: Monetary Policy
15-10 Open Market Operations
Monetary Policy Outline
What is money?
What is the structure of the banking
system?
How do banks create money?
How does the Fed control the money
creation process?
How does controlling the money
supply (Ms) affect the economy.
S. Reineck Diana
1
Monetary Policy
Altering the money supply to
stabilize aggregate output,
employment, and the price level
Responsibility of the Fed – the
federal reserve system
Banks create and destroy money but
the Fed controls the money creation
process.
S. Reineck Diana
2
How the Fed controls Ms
Tools of Monetary Policy
Open-market Operations
Changing the reserve ratio
Changing the discount rate
S. Reineck Diana
3
Chapter 15: Monetary Policy
15-10 Open Market Operations
Open-Market Operations
Another BIG Hairy Deal
S. Reineck Diana
4
Open-Market Operations
Responsibility of the FOMC
(Federal Open Market Committee)
» Fed board + 5 Fed bank presidents
» Meets monthly
Able to make subtle changes
Lots of flexibility
Main way the Fed affects interest
rates – target the fed funds rate
S. Reineck Diana
5
Open-Market Operations
The buying and selling of
government securities by the Fed.
Directly affect the reserve standings
of the banks.
Reserves are used to make
loans/create money.
S. Reineck Diana
6
Chapter 15: Monetary Policy
15-10 Open Market Operations
What is Money?
Public’s Hands
Dollars as cash in
circulation or in
checkable deposits
are the money
supply, M1.
Money Supply
S. Reineck Diana
7
What is Money?
Fed’s Hands
Public’s Hands
Dollars at the Fed
are not part of the
money supply
Dollars as cash in
circulation or in
checkable deposits
are the money
supply, M1.
Money Supply
S. Reineck Diana
8
Fed Buys Securities
Fed’s Hands
Public’s Hands
$$
Bonds
Money Supply
Increases
S. Reineck Diana
9
Chapter 15: Monetary Policy
15-10 Open Market Operations
Fed Sells Securities
Fed’s Hands
Public’s Hands
$$
Bonds
Money Supply
Decreases
S. Reineck Diana
10
Fed Buys Securities
From commercial banks
• Bank gives up securities
• Fed pays bank
• Banks have increased reserves
S. Reineck Diana
11
Purchase from a bank
New reserves
$1000
$1000
Excess
reserves
20%
reserve
ratio
$5000
Bank system lending
S. Reineck Diana
Increase in Ms = $5000
12
Chapter 15: Monetary Policy
15-10 Open Market Operations
Fed Buys Securities
From commercial banks
• Bank gives up securities
• Fed pays bank
• Banks have increased reserves
From individual
• Individual gives up securities
• Fed pays individual
• Individual deposits check in bank
• Banks have increased reserves
S. Reineck Diana
13
Purchase from the public
New reserves
$1000
$800
Excess
reserves
$4000
Bank system lending
S. Reineck Diana
$200
Required
reserves
$1000
Initial
Deposit
Increase in Ms = $5000
14
Open-Market Operations
Changing bank reserves changes the
money supply.
Changing the money supply changes
the interest rates
» Specifically, the federal funds rate
» Federal funds rate is the rate banks
charge one another on overnight
loans of reserves.
S. Reineck Diana
15
Chapter 15: Monetary Policy
15-10 Open Market Operations
Real rate of interest, i
Sm1
Sm2
10
8
6
0
Dm
Quantity of money demanded and supplied
S. Reineck Diana
16
Open-Market Operations
Also affect bond prices and therefore
bond yields (interest rates).
If the Fed sells bonds, supply of
bonds increases.
» Bonds prices fall, i-rates up.
If the Fed buys bonds, demand for
bonds increases.
» Bonds prices up, i-rates down.
S. Reineck Diana
17
Dual effect of
Open-Market Operations
Fed. Sells Bonds
Supply of Bonds
Increases;
Prices Down
Excess Reserves
Decrease
Interest rates UP
S. Reineck Diana
18