Download Chapter 28 - Monetary Policy and Bank Regulation

PRINCIPLES OF ECONOMICS
Chapter 28 Monetary Policy and Bank Regulation
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FEDERAL RESERVE SYSTEM (FED)
Some of the most influential decisions regarding
monetary policy are made at the FED behind these
doors.
FEDERAL RESERVE SYSTEM (FED)
The FED is the central bank of the United States established
in 1913 to regulate the private banking system and the supply
of money
Unique Features of the FED
• Decentralization: 12 districts across country
• Independent of the US government
• Decision-maker about amount of money in circulation
and short-term interest rates
• Semi-public institution
• Policy goal: to sustain economic growth with zero
inflation
THE FEDERAL RESERVE SYSTEM
THE FEDERAL RESERVE SYSTEM
Janet Yellen, Chair
UC, Berkeley Professor of
Economics
Stanley Fischer, Vice Chair
MIT, Professor of Economics
FUNCTIONS OF THE FED
Clearing interbank payments
Regulating the banking system
Assisting banks in difficult financial times
Managing the nation’s foreign exchange rates
and foreign exchange reserves
FUNCTIONS OF THE FED
Control of mergers between banks
Examination of banks to ensure that they are
financially sound
Setting the short-term interest rate
Lender of last resort
MONETARY POLICY
Monetary Policy: FED’s action of managing
the money supply and the interest rate
Expansionary or Easy Monetary Policy:
Drop the interest rate to boost planned
investment and consumption, thus increasing
the GDP
Contractionary or Tight Monetary Policy:
Raise the interest rate to reduce planned
investment and consumption, thus curbing
inflation
MONETARY POLICY
The FED uses three instruments to
manage the money supply and interest
rates:
Reserve Requirement
Discount Window
Open Market Operations
RESERVE REQUIREMENT
Reserve Requirement is the percentage of
deposits that banks must hold at their
accounts in the FED.
If the FED wants to increase the money
supply, it lowers the Reserve Requirement. As
a result, banks would hold less Required
Reserve and keep more Excess Reserve. To
lend the additional Excess Reserve, banks will
drop the rate of interest on business and
consumer loans.
DISCOUNT WINDOW
Banks can borrow from the FED. The interest
rate they pay on loans from the FED is the
Discount Rate.
If the FED wants to increase the money supply,
it would lower the discount rate, which
encourages banks to borrow more from the
FED. To lend these additional reserves, banks
will drop the interest rate on business and
consumer loans.
OPEN MARKET OPERATIONS
Open Market Operations: The FED’s
purchase and sale of government bonds to
member banks.
The FED held over $2.4 trillion of US
government bonds as of February 4, 2015.
To increase the money supply, the FED buys
more government bonds from member banks.
Banks receiving additional reserves from the
FED will lower the interest rate to lend them to
households and business.
EXPANSIONARY MONETARY POLICY
To increase the money supply and reduce
the interest rate, the FED could
• Lower the Reserve Requirement
• Lower the Discount Rate
• Buy government securities from member
banks
CONTRACTIONARY MONETARY POLICY
To decrease the money supply and
increase the interest rate, the FED could
• Raise the Reserve Requirement
• Raise the Discount Rate
• Sell government securities from member
banks
MONETARY POLICY
The original equilibrium occurs at E0.
An expansionary monetary policy will shift the
supply of loanable funds to the right from the
original supply curve (S0) to the new supply curve
(S1) and to a new equilibrium of E1, reducing the
interest rate from 8% to 6%.
A contractionary monetary policy will shift the
supply of loanable funds to the left from the
original supply curve (S0) to the new supply (S2),
and raise the interest rate from 8% to 10%.
MONETARY POLICY
MONETARY POLICY
a. The economy is in recession. An expansionary monetary
policy will reduce interest rate and increase investment
and AD, moving the economy toward the potential GDP
with a relatively small rise in the price level.
a. The economy is producing above the potential GDP,
experiencing rapid inflation. A contractionary monetary
policy will increase the rate of interest, depressing
investment and dropping AD. The economy will move to
an new equilibrium with smaller GDP and lower price
level.
MONETARY POLICY
MONETARY POLICY
In expansionary monetary policy the central bank causes
the supply of money to increase, which lowers the interest
rate, stimulating additional borrowing for investment and
consumption, and raising the AD. The result is a higher
price level and and a larger GDP.
In contractionary monetary policy, the central bank causes
the supply of money and credit to decrease, which raises
the interest rate, discouraging borrowing for investment
and consumption, and dropping the AD. The result is a
lower price level and a smaller GDP.
MONETARY POLICY
MONETARY POLICY
Through the episodes shown here, the Federal Reserve
typically reacted to higher inflation with a contractionary
monetary policy and a higher interest rate, and reacted to
higher unemployment with an expansionary monetary
policy and a lower interest rate.
VELOCITY OF MONEY
Velocity is the nominal GDP divided by the money supply for a
given year. Different measures of velocity can be calculated by
using different measures of the money supply. Velocity, as
calculated by using M1, has lacked a steady trend since the
1980s, instead bouncing up and down.
MONETARY POLICY: LONG-RUN EFFECT
With a vertical AS, monetary policy is ineffective in the
long-run. An expansionary policy shifting the AD will have
no effect of GDP, but causes the price level to rise.