Download Money and Banking

The FED and
Monetary Policy
1
Fiscal Policy
Actions taken by Congress to
stabilize the economy
Business
Tools
Taxes
Spending
4
Monetary Policy
Actions taken by The Federal
Reserve to stabilize the economy
Business
Monetary Policy
=
Changes in
Money Supply
=
Federal Reserve
4
How the Government Stabilizes the Economy
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How the FED Stabilizes the Economy
These are the three tools that the
FED uses to shift Money Supply
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Tools
Open Market Operations
Discount Rate
Required Reserve Ratio
What is Money Supply?
All the physical money
in the economy
The FED uses all
these tools
specifically to
affect the
Money Supply
The Money Market
(Supply and Demand for Money)
2
First, Let’s talk about
the Demand for money
When we talk money, I
mean liquid money, in your
pocket or checking
account, that you can use
to buy goods and services.
Interest - The price paid for the use of
borrowed money. Also, money earned by
deposited funds.
Interest Rate - Percentage of interest
collected on a debt or investment
So, if interest rates are high, do you want to invest
your money, or do you want to keep it in your pocket
to spend on goods and services?
The Demand for Money
At any given time, people demand a certain amount of
liquid assets (money) for everyday purchases
The Demand for money shows an inverse
relationship between interest rates and the
quantity of money demanded
At 20% interest rate there is a
strong incentive to invest my
money in a savings account.
low demand for liquid money
At 2% interest rate there is
less incentive to invest, and
more incentive to keep and
use my money.
high demand for liquid money
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1. What happens to the quantity demanded of money
when interest rates increase?
Quantity demanded falls because individuals would
prefer to have interest earning assets (investments)
2. What happens to the quantity demanded when
interest rates decrease?
Quantity demanded increases. There is less incentive
to convert cash into interest earning assets
Interest rates are affected by the Federal reserve,
the money supply, the economy, and business
cycles.
Now let’s talk
Monetary Policy
When the FED adjusts the money supply to
achieve macroeconomic goals
8
Tools of the FED
1. Open Market Operations
2. Discount Rate
3. Required Reserve Ratio
The FED uses all these tools
specifically to affect the Money Supply
The Supply for Money
The U.S. Money Supply is set by the Board of
Governors of the Federal Reserve System (FED)
Interest
Rate (ir)
SMoney
20%
The FED is a nonpartisan
government office that sets and
adjusts the money supply to adjust
the economy
This is called Monetary
Policy.
5%
2%
DMoney
200
Quantity of Money
(billions of dollars)
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Video: The FED Today
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The role of the Fed is to “take away the punch
bowl just as the party gets going”
13
Tools of the FED
1. Discount Rate
2. Required Reserve Ratio
3.Open Market Operations
The FED uses all these tools
specifically to affect the Money Supply
#1 Discount Rate
The FED acts as a lender of last resort when banks and the
economy are in financial emergencies.
Discount Rate - The interest rate that the Federal Reserve
charges other banks when they need to borrow money
Example:
If Banks of America needs $10 million, they borrow it from
the U.S. Treasury (which the FED controls) but they
must pay it back with 3% interest.
To increase the Money supply, the FED should
_________
Decrease the Discount Rate (Easy Money Policy).
To decrease the Money supply, the FED should
Increase the Discount Rate (Tight Money Policy).
_________
#2 The Required Reserve Ratio
Required Reserve Ratio - the fraction of deposits that
banks must keep on reserve.
If you make a deposit at a
bank, only some of that
money has to be kept
readily available in
reserve. The bank may
loan out the rest to
individuals.
The Fed sets the
Reserve Ratio, the
fraction of people’s
money that must be kept
available at the bank.
The excess of that money is loaned out to
individuals, put back into the economy, and often
ends up as deposits in other banks, possibly to be
loaned out again!
The Money Multiplier
Example: Assume the reserve ratio in the US is 10%
You deposit $1000 in the bank
The bank must hold $100 (required reserves)
The bank lends $900 out to Bob (excess reserves)
Bob deposits the $900 in his bank
Bob’s bank must hold $90. It loans out $810 to Jill
Jill deposits $810 in her bank
SO FAR, the initial deposit of $1000 caused the
CREATION of another $1710 (Bob’s $900 + Jill’s $810)
Increasing the Required Reserve Ratio lowers the
money supply.
Decreasing the Required Reserve Ratio increases
the money supply.
#3 Open Market Operations
Open Market Operations - The buying and selling of
government securities (bonds) to alter the supply of
money
Buy Bonds = Increase Money Supply
Sell Bonds = Decrease Money Supply
Buying Bonds
from open market
increases money
supply
Selling Bonds
brings new investors
decreases money
supply
More liquid money in
the economy
Less liquid money in
the economy