Download Monetary Policy

Monetary Policy
Involves controlling the money
supply to change the level of GDP
or the rate of inflation.
The Money Supply
 The money supply is increased when
banks make loans.
 The more loans banks make the more
money there is in circulation.
 The banking system can create loans in
multiples of an original loan.
 The money supply is decreased when a
bank or the public buys government
bonds.
Banking Reserves
 Reserves are the amount of deposits that a
bank has accepted but not loaned out.
 Required reserves are the amount a bank
must keep on hand by law. The required
reserve ratio determines this amount.
 Excess reserves are whatever the bank
has over and above the required reserves.
It is the amount that a bank can loan out or
use to purchase government securities
(bonds).
Money Creation
 Money creation (putting new money into
circulation) occurs when banks make
loans to the public.
Monetary Policy Tools
 The Federal Reserve controls the
amount of excess reserves and money
creation through use of its three tools.
 Reserve Requirements
 Discount Rate
 Open Market Operations
Federal Reserve Tools
 Required Reserve Ratio – the percentage of
demand deposits a bank must keep on hand
for customers’ withdrawals.
 It determines how much of a bank’s deposits
are available for loans and the size of the
money multiplier.
 The money multiplier determines the amount of
new money that will be created by the banking
system (1/RR)
 Least used of the Fed’s tools because it is the
most powerful and disruptive.
Federal Reserve Tools
 Discount Rate – the interest rate the
Fed will charge a bank for a loan.
 If the Fed lowers the discount rate banks
would be encouraged to borrow from the
Fed (the bank could loan that money out
to the public at a higher rate and make
money doing so).
 The more loans a bank makes the more
the money supply grows and vice versa.
 Least effective tool.
Federal Reserve Tools
 Open Market Operations – the Fed
purchases or sells securities (government
bonds) to banks and the public, which changes
the amount of money available from the public
and banks for loans.
 The Fed would purchase securities to pump in
money to increase economic growth.
 The Fed would sell securities to soak up
money from the economy (anti-inflationary).
Banks or the public now have a bond instead
of cash and spending is slowed down.
 Most used tool.
Macroeconomic Effects of
Monetary Policy
 A change in the supply of money
changes the interest rate.
 Interest rates are the cost of borrowing
money.
 A high supply of money lowers the
interest rate and gives businesses more
opportunities for investment spending
(buying capital goods) and vice versa.
Macroeconomic Effects of
Monetary Policy
 The Fed will follow an easy money policy
(an increase in the money supply) when
the economy is in a recession.
 The Fed will follow a tight money policy
(a decrease in the money supply) when
the economy is experiencing inflation.
 The goal of monetary stabilization
policies are to smooth out fluctuations in
the business cycles.
Problems of Timing
 If expansionary policies take effect while
the economy is already expanding, the
result could be higher inflation.
 Inside lags refer to the delay in
implementing monetary policy.
 It is difficult to accurately identify and
recognize economic problems.
 It takes additional time to enact the
appropriate policy. (This is more of a fiscal
policy problem, since the FOMC can act
much more quickly)
Problems of Timing
 Outside lags refer to the time it takes for
monetary policy to have an effect.
 The outside lag is short for fiscal policy but
lengthy for monetary policy.
 Monetary policy primarily affects business
investment plans which are made far in advance.
 Monetary policy is still preferred because of the
inside lag caused by the President and
Congress having to agree on budgetary
matters.
Bank balance sheets or
T-Accounts
 Illustrates the relationship between
assets and liabilities held by a bank.
 They can be used to explain the money
creating potential of banks through the
fractional reserve system.
 Assets – the property, possessions and
claims on others held by the bank (reserves,
loans, securities)
 Liabilities – the debts and obligations of the
bank to others (demand deposits, loans from
the Fed)
Bank balance sheets or
T-Accounts
Assets
reserves $10,000
Liabilities
DDA $10,000
(reserve ratio 10%)
Assets
Liabilities
RR $1,000
DDA 10,000
ER $9,000
BANK 1
Assets
Liabilities
RR $1,000
DDA 10,000
ER
loans $9,000
Assets
RR $900
ER $8,100
Liabilities
DDA $9,000
Total money supply = $10,000+9,000
BANK 2
Assets
RR $900
ER
Loans $8,100
Liabilities
DDA 9,000
Total Expansion of the money supply =
$9,000 x 10 (1/.10) = $90,000