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Bellringer— Money Supply Activity Money Supply Activity Write-up • What happened to the price of the item auctioned b/t the 1st and 3rd auctions? • What happened to the amount of “money” in the classroom b/t the 1st & 3rd auction? • What gave the seeds and beans their value? • When students had more money to spend, what happened in the successive auctions? • What do you think would have happened to the price if the number of items offered for sale in the 3rd auction would have increased from 1 to 100? • Under what conditions is increasing the supply of money inflationary? • Under what conditions is increasing the money supply not inflationary? Monetary Policy The Power of the Fed… 10:23 a.m. MT, Monday, February 26, 2007 youtube.com HONG KONG - Former U.S. Federal Reserve Chairman Alan Greenspan warned Monday that the American economy might slip into recession by year's end. He said the U.S. economy has been expanding since 2001 and that there are signs the current economic cycle is coming to an end. 6:57 PM EST, Tuesday, February 27, 2007 Brutal day on Wall Street (Tuesday, Dow tumbles 416, biggest one-day point loss since 2001, as investors eye China. By Alexandra Twin, CNNMoney.com senior writer NEW YORK (CNNMoney.com) -- Stocks slumped Tuesday on worries about economic growth at home and abroad, sending the Dow industrials to their biggest point drop since the day the market reopened after the Sept. 11 attacks. A big decline in Chinese stocks, weakness in some key readings on the U.S. economy and news that Vice President Dick Cheney was the apparent target in a Taliban suicide bombing attack in Afghanistan all fueled the selling on Wall Street. The Federal Reserve uses three tools to control monetary policy: 1. Reserve Requirement 2. Discount Rate 3. Open-market Operations But, before we look at the individual tools, let’s review by looking at a graph of the macroeconomy. On your white board, graph me a graph of the macroeconomy in recession. The percentage of the dollar-amount of deposits that banks are required to keep in their own vaults or on reserve with the Federal Reserve. Reserve Requirement • By changing how much member banks must keep on reserve, the Fed again can control the money supply and how much is available for banks to loan out, interest rates, and spending. • When the Fed lowers the percentage, the banks can release more of their reserves in the form of loans. • When the percentage is raised, this essentially restricts the money supply. The Discount Rate is the rate at which the Federal Reserve charges member banks for borrowing money. Banks do this through what is called, the discount window. Discount Rate • By changing what it costs member banks to borrow money from the Fed, the Fed can encourage/discourage borrowing by banks, which affects the availability of loans for people and businesses. • This rate determines the prime rate (interest rate for bank’s best commercial customers) on which many other interest rates are founded. • It also affects the Federal Funds Rate The Federal Funds Rate is the rate that banks charge other banks for borrowing money overnight. These are called, overnight drafts. The Federal Funds Rate • On any given day, banks with insufficient reserves can borrow from banks with excess reserves. • The interest rate on these loans is the federal funds rate. • The FOMC uses OMOs to target the fed funds rate we’ll look at this graphically later). • Changes in the fed funds rate cause changes in other rates and have a big impact on the economy. The Fed Funds rate and other rates, 1970–2011 Fed Funds 20 Prime 3 Month T-Bill 15 (%) Mortgage 10 5 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 Open-market Operations (OMO) is the buying and selling of government securities. Maturity--less than a year Maturity--one to ten years Maturity--more than ten years Open Market Operations • This is the most used tool of monetary policy. • Conducted by the Federal Open Market Committee (FOMC). • The buying and selling of government securities affects the expansion and contraction of the money supply, which affects interest rates and therefore the overall spending in the economy. Open-Market Operations (OMO) Fed buys bonds… • Money into economy, Fed gets bond • Expands money supply • Thus, this is called Expansionary/Loose/Easy Monetary Policy Fed sells bonds… • Money to Fed, Individuals get bonds • Contracts money supply • Thus, this is called Contractionary/Tight Monetary Policy REVIEW • When the Fed conducts open market purchases, • A) it buys Treasury securities, which increases the money supply. • B) it buys Treasury securities, which decreases the money supply. • C) it sells Treasury securities, which increases the money supply. • D) it sells Treasury securities, which decreases the money supply. REVIEW • Which list contains only actions that increase the money supply? • A) make open market purchases, raise the reserve requirement ratio • B) make open market purchases, lower the reserve requirement ratio • C) make open market sales, raise the reserve requirement ratio • D) make open market sales, lower the reserve requirement ratio New Graph Time!!! Money Supply. Is there a graph? Of course there is! This is an economics class isn’t it? It is called--MONEY MARKET Nominal Interest Rate MS i Q MD Q$ MONEY MARKET Nominal Interest Rate MS MS1 i i1 MD Q Q$ MONEY MARKET An increase in the money supply (MS) is a shift to the right. MS What entity can change the money supply? Banks i Md Q Money Market Indirectly, though, the Federal Reserve can help in what three ways: 1. Reserve Requirement 2. Discount Rate 3. Open-market Operations (Federal Funds Rate) If the FED lowers the RR, what happens to the money supply? MS INCREASES Nominal Interest Rate This causes i Nominal i1 interest rates to go DOWN. MS Q MS1 An increase is always a shift to the RIGHT!! MD Q$ MONEY MARKET As interest rates go down, this causes Consumption and Investment to go UP WHY? Nominal Interest Rate MS This causes i Nominal i1 interest rates to Q go DOWN. MONEY MARKET MS1 An increase is always a shift to the RIGHT!! MD Q$ Open Market Operations Graphic Organizers Insert Money Mrkt. Graph Graph of Macroeconomy here Insert Money Mrkt. Graph Graph of Macroeconomy here Now, I’m going to show you how to answer a FRQ by using just a flowchart and a graph and NO SENTENCES! To speed up the economy, The FED can: RR MS Nominal Interest Rate MS MS1 i i i1 Md AD C I Q$ Money Market Graph of Macro Now, show me on your white board what the Fed does to the RR to lower inflation To speed up the economy, The FED can: DR MS Nominal Interest Rate MS MS1 i i i1 Md AD C I Q$ Money Market Graph of Macro Now, show me on your white board what the Fed does to the DR to lower inflation To speed up the economy, The FED can: Buy Bonds MS Nominal Interest Rate MS MS1 i i i1 Md AD C I Q$ Money Market Graph of Macro Now, show me on your white board what the Fed does to the OMO to lower inflation But it’s not all about Monetary Policy… And who oversees Fiscal Policy Fiscal Policy? I know your head is probably swimming now, but this is why it is important to study and do well in economics… Average LSAT Scores for 10 majors with more than 2,000 students taking the exam 1. Economics 2. History 3. English 4. Engineering 5. Journalism/Foreign Language 6. Finance 7. Psychology 8. Accounting 9. Political Science 10. Communication/Arts 155.3 154.0 153.7 152.7 152.5 152.2 151.9 151.8 151.6 150.7 TICKET OUT THE DOOR Problem: Following an income tax increase, the Federal Reserve announces a goal of significantly increased growth rates in the money supply. If the Federal Reserve achieves its goal, explain in detail the short-run effects of the Fed’s actions on each of the following. Show on a graph. A) Interest rates B) Output and employment C) Prices ANSWER: