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Monetary Policy: Regulating Money Supply Review Quiz Trade Quiz #1: What are the two conflicting responsibilities of the Federal Reserve? Maximizing GDP & Employment while at the same time keeping inflation low Review Quiz #2: What are two ways the Fed has some political independence when it comes to making their decisions? 14-year term of office Don’t rely on money from Congress to keep running Review Quiz #e: How many members of the Fed Board of Governors are there? 7 Review Quiz #4: How many District Branches of the Federal Reserve system are there? 12 Review Quiz Trade Quiz #5: What is the “discount rate?” The interest rate that the Federal Reserve charges on direct loans to the 12 District Banks Review Quiz Trade Quiz #6: Who is on the Federal Open Market Committee (FOMC? The 7 members of the Board of Governors and 5 of the presidents of the District Banks Review Quiz Trade Quiz #7: What important decisions does the FOMC make? What the FFR should be and how much money there should be in the economy? Federal Reserve Structure Discount Rate=Interest rate that the Fed lends money directly to District Banks (rarely used) MeetsFederal 8 timesReserve a year to vote on Monetary Federal Open Board of Policy Market Committee= Governors (7 members) Ben Bernanke Chairman 7 Governors + 5 District Bank Presidents—meets 8 times per year Federal Funds Rate = Interest rate that the 12 District banks charge Each other on overnight loans SF Fed Building—Market Street 12 District Federal Reserve Banks Boston San Francisco New York Atlanta Chicago Dallas, etc. Member Banks All national banks Some state banks The Money Market Supply of Money is fixed by the Fed The Money Market Interest Rate (FFR) Fed “controls” money supply through monetary policy S-Money Demand for money is downward sloping D-Money as interest rates ↓ more $ is demanded Qty $ Modern-day economies are almost entirely run on CREDIT—it’s all about borrowing CONSTANTLY 2 Types of Monetary Policy • LOOSE Monetary Policy (increasing the money supply) • TIGHT Monetary policy (decreasing the money supply) Two Tools of Monetary Policy 1. Discount Rate Changes • Changing the interest rate at which District Banks borrow directly from the Fed Two Tools of Monetary Policy 2. Open Market Operations – Federal Reserve action to buy or sell Treasury bonds -- This changes the money supply, which shifts the Federal Funds Rate *Demonstration Loose (aka Expansionary) Monetary Policy • First, the Fed lowers the discount rate (i.e. 3% to 2%) • Next, the Fed uses Open Market Operations to increase money supply --the Fed Buys government bonds from anyone selling them Interest Rate (FFR) Price Level MS1 MS2 Affects ADpeople borrow & spend more FFR1 --------2 FFR ------------------- AS1 MD Qty of $ AD2 AD1 Real GDP Important Fact: Time Lag FYI: Both Fiscal Policy (6-12 months) and Monetary Policy (12-24 months) have a time lag Translation: they do not have immediate effect Tight (aka Contractionary)Monetary Policy • First, the Fed raises the discount rate (i.e. 4.5% to 5.0%) • Next, the Fed uses Open Market Operations to decrease money supply --the Fed Sells government bonds to willing investors Interest Rate (FFR) MS2 Price Level MS1 AS1 Affects ADpeople borrow & spend less 2 FFR------------- FFR1--------------- MD Qty of $ AD1 AD2 Real GDP Economic Issue Policy Type (Moderately Loose, Aggressively Loose, Moderately Tight, Aggressively Tight, or Take No Action) What action What would What change What action in Open Market would the the Fed want in the Money Operations Fed take to happed to Supply would be needed to would be regarding the Federal bring about needed to Discount Funds Rate the desired bring about Rate (increase or change in FFR the desired (increase or change in (increase or decrease) Money Supply decrease) decrease) (Buy or Sell Treasury Bills) 1. Inflation rises to 10% 2. GDP growth is at 0.9%; the inflation rate is 1.8% 3. GDP growth rate is 2.1% and the inflation rate is 3.5% 4. Consumer confidence is falling; retail sales very weak; unemployment at 8.1% 5. GDP growth is at 4.2%; inflation is at 3.6% Decrease Money Supply Aggressively Tight Increase Discount Rate Increase FFR Moderately Loose Decrease Discount Rate Decrease FFR Increase Money Supply None OR Increase Discount Rate None OR Increase FFR None OR Decrease Money Supply None OR Sell T-Bills Decrease Discount Rate Decrease FFR Increase Money Supply Buy T-Bills Increase FFR Decrease Money Supply None OR Moderately Tight Aggressively Loose Moderately Tight Increase Discount Rate Sell T-Bills Buy T-Bills Sell T-Bills 18 News Clips http://video.msn.com/video.aspx?mkt=en-us&vid=2d392a8b-ac77-4e73-8999c31db8966b68 ***(4:29) good clip when Fed was considered cutting FFR from 1.5% http://video.msn.com/video.aspx?mkt=en-us&vid=5dc4a263-0085-4db0-aecb-81f39870a9 (roundtable on FFR increase to 4.75%) (7:40) http://video.google.com/videosearch?q=federal%20funds%20rate %20suze%20orman&rls=com.microsoft:*&oe=UTF-8&startIndex=&start Page=1&um=1&ie=UTF-8&sa=N&hl=en&tab=wv# (Suze Orman on FFR) (4:32) http://www.asterpix.com/v/8654211/fed-cuts-interest-rates/ ***(first 45 seconds of 2 minute clip) Economic Issue 1. Inflation rises to 10% 2. GDP growth is at 4.2%; inflation is at 3.6% 3. GDP growth is 2.1% and the inflation rate is 3.5% 4. Consumer confidence is falling; retail sales very weak; unemployment at 8.1% 5. GDP growth is at 0.9%; inflation rate is 1.8% Policy Type (Moderately Loose, Aggressively Loose, Moderately Tight, Aggressively Tight, or Take No Action) Aggressive Contractionary Moderate Contractionary Take no action OR Mod. Contractionary Aggressive Expansionary Moderate Expansionary Action on Open Market Operations (Buy or Sell Treasury Bills Effect on Federal Funds Rate (increase or decrease Effect on the Money Supply (increase or decrease) Sell T-Bills Decrease Money Supply Increases FFR Sell T-Bills Decrease Money Supply Increases FFR None None OR OR Sell T-bills Decrease MS Buy T-Bills Increase Money Supply Buy T-Bills Increase Money Supply None OR FFR Decreases FFR Decreases FFR Monetary POLICY Monetary Policy will shift AD curve Economy in recession AS1 Price Level Loose monetary policy needed AD1 Real GDP AD2 Buys Securities & lowers discount rate Money becomes cheaper; Interest rates go down AD shifts right Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3% Loose or Tight Monetary policy needed? Solution: Interest Rate Tight Monetary Policy MS2 MS1 Price Level AS1 Affects AD i2 AD1 --------- i1 --------------- AD2 MD End Result: Lower GDP & less inflation! Qty of $ Real GDP Situation: GDP growth at -2.0%, Unemployment 9% Loose or Tight Monetary policy needed? Loose Monetary Policy Interest Rate MS1 MS2 Price Level AS1 Affects AD i1 --------- i2 --------------MD Qty of $ AD1 Real GDP AD2 Loose Monetary Policy LOWERS Discount Rate 1. Fed _________ 2. Open-Market Operations BUYS Securities Fed _________ Interest Rate Price Level MS1 MS2 AS1 Affects AD i1 --------- AD2 i2 --------------MD Qty of $ AD1 Real GDP Tight Monetary Policy RAISES 1. Fed _________ Discount Rate 2. Open-Market Operations SELLS Securities Fed _________ Nominal Interest Rate MS2 Price Level MS1 AS1 Affects AD i2 --------AD1 i1 --------------MD Qty of $ AD2 Real GDP