Download Contractionary Monetary Policy

Monetary Policy Tools
Monetary Policy
• Federal Reserve Act of 1913 created the Federal
Reserve System
– “The Fed” provides the U.S. banking system with the
stabilizing influence of a central bank
– 1977 amendment: to “promote effectively the goals of
maximum employment, stable prices, and moderate longterm interest rates”
• The Fed conducts monetary policy
– Creates quantity of money that responds to the demands
of the economy
– Changing short-term interest rates and quantity of money
[Note: we will not have a discussion of institutional aspects
of money.]
The Fed
• Congress established as an independent
organization
• Income from investments and banking
services
• Three components:
– The Board of Governors
• sets overall direction of the Fed and its policies
• 7 members appointed to 14 year terms by the president with the
advise and consent of the Senate
– The Federal Open Market Committee (FOMC)
• conducts monetary policy
• 12 members, 7 members from the Board plus 4 rotating district bank
presidents and the president of the NY District Bank
– The Federal Reserve Banks
• regulates and provide a variety of services for banks
• 12 regional banks
Open Market Operations
• Primary tool to manage money supply
– Currency—dollar bills and coins issued by the Federal Reserve
System and the Treasury
– Deposits at commercial banks and other depository institutions
• Buy and sell government securities (Treasury bonds and bills) to
commercial banks and general public
• Does not issue government securities, can obtain in the open
market
• Open market operations put currency, Federal Reserve notes,
into or out of circulation
• Example: When you buy a bond from the Fed for $10,000,
you write a check and take money out of the economy
Reserve Ratio
• Used infrequently
• Banks hold some fraction of deposits on reserve to
meet customers’ cash needs
• Banks must meet the Fed’s reserve requirements
– Current reserve requirement: about 10%
– Banks hold at least $10 for every $100 of deposits
• Alter reserve requirement, change money supply
– Decrease required reserves increases money in circulation
– Increase required reserves decreases money in circulation
• some banks sell securities or call in loans
• disruptive to customers
Discount Rate
• Discount Rate: interest rate at which the Fed loans
money to banks
• Many short term interest rates tied to it
• Discount rate changes move money supply in
opposite direction
– Increases in discount rate decrease money supply by
decreasing borrowing (interest rates rise)
– Decreases in discount rate increase money supply by
increasing borrowing (interest rates fall)
• Changes in discount rates foreshadow the Fed’s
policy intentions
Expansionary Monetary Policy
• Increase money supply when economy “too slow”
– Buy securities (open market operations)
– Reduce reserve ratios (not likely)
– Lower the discount rate
• Works through interest rates (price of money)
– Money supply increases, more money so price of borrowing
(interest) falls
– Discount rate decreases, banks borrow more money and
money supply increases (interest rates tied to it fall)
• Interest rates fall, spending increases
– Plant and equipment (by firms)
– New housing
– Consumer durables (especially autos)
• Increased spending stimulates production, which
reduces unemployment and increases GDP, which
increases income, which stimulates spending…
Contractionary Monetary Policy
• Decrease money supply if economy “too fast”
– Sell securities (open market operations)
– Increase reserve ratio (not likely)
– Raise discount rate
• Contractionary monetary policy effective with
rapidly increasing GDP and inflation
• Decreases investment and slows economic
expansion
• If economy sluggish, recession will deepen
• Cost-push inflation, tight (contractionary) policies
have little impact on slowing inflation
Monetary Policy in Action
• Many argue price stability is the Fed’s primary goal
• If the economy tends toward full employment, monetary
policy’s greatest impact is on price level
• Tradeoffs can exist between unemployment and inflation
– Unemployed means not enough money to spend and the
Fed can stimulate spending through expansionary policies
– But too much money chasing too few goods increases
prices (inflation)
• Excessive growth in money supply a root cause of
inflation
– Friedman argued that given long term impacts of fluctuations in
money supply, best is constant increase
– 3% per year “the rule”