Download Introduction to Monetary Policy

Introduction to Monetary
Policy
Mr. Way, 2/16/12
CA Standard 12.3.4
Understand the aims and tools of
monetary policy and their
influence on economic activity
(e.g., the Federal Reserve).
What is monetary policy?
• Actions taken by the “monetary authority”
(in our case the Federal Reserve) of a
country to control the money supply.
• Their stated goals are usually to keep
prices steady or to lower unemployment.
• Monetary policy is largely described as
“expansionary” (raising money supply) or
“contractionary” (lowering money supply)
How does the money supply affect
the economy?
• The money supply refers to the availability
of money.
• The more money there is in the supply, the
cheaper it is to borrow (low interest rates)
• The less money there is, the more
expensive it is to borrow (high interest)
What does the interest rate have to
do with the economy?
• When interest rates are low:
– Businesses are more likely to take out loans to startup or expand operations (hire people)
– People are more likely to buy things on credit
(therefore encouraging business to expand/hire more
people).
– People are less likely to save money in the bank,
since it pays a low interest rate. Less savings = more
spending = businesses expand = more jobs.
• The opposites are all true when interest rates
are high.
What can the Fed do to affect the
money supply?
• “Open market operations,” i.e. buy and sell
treasury bonds.
• Change the “discount rate”
• Change federal reserve requirements.
Open Market Operations
• The simplest of the three is buying and
selling bonds on the open market.
• When the government buys bonds, it is
adding money into the supply.
Buy bonds = Boom
• When the government sells bonds, it is
taking money out of the supply.
Sell bonds = Shrink
Federal Reserve Requirements
• Are laws made by the Fed stating what
percentage of peoples’ saving banks must store
in their vaults instead of lending out.
• For example, suppose that the reserve
requirement is 50%.
• This means that if I put $100 in the bank, they
must hold on to $50 and are free to loan out $50
to somebody else.
• If the requirement is 20%, they would hold onto
$20 and loan out $80.
Reserve Requirements and the
Money Multiplier
• Banks are able to multiply the money supply
based on the reserve requirement:
• Assume the rate is 50%, and I bank $100
• The bank reserves $50 and loans out $50.
• The $50 they loaned out will make its way to
another bank, which will reserve $25 and loan
out $25.
• That $25 loan will make its way to yet another
bank, which will reserve $12.5 and loan out
$12.5. This cycle will continue until $0.01
Calculating the Reserve
Requirements Money Multiplier
• To calculate the change in the money
supply from money a bank receives:
• Divide the amount the bank received by
the percentage the bank must reserve
• Ex. 50% reserve requirement on $100:
• ($100 / .5) = $200
• Ex. 20% reserve requirement on $100:
• ($100 / .2) = $500
Effects of changes in Reserve
Requirement Ratio
• As you can see, lowering the reserve
requirement from 50% to 20% has the
potential to more than double the size of
the money supply!
• Given that there are about $829 billion
dollars in circulation, even a tiny decrease
in the reserve requirement would mean
the “creation” of billions of new dollars.
The “Discount Rate”
• This refers to the special, low interest rate
that special “member banks” get to use
when borrowing from the Fed.
• By lowering the discount rate, the Fed
encourages banks to borrow more money
from it
• When banks have borrowed more money,
they are more likely to lend out more
money as well, increasing the supply.
The Federal Reserve Pyramid
Scam (wake up, people!)
Discount
Rate
2%
Rate big banks charge
small banks
3.5%
Interest rate your local branch pays
To its corporate headquarters
6%
Interest Rate Average Americans
End Up Paying on Loans
8%
• Discount Rate is what the
Fed charges to big banks
• Big banks charge smaller
banks a higher rate
• Smaller banks loan
money to individuals at
an even higher rate
• (Why can’t we borrow
directly from our
government?
Why do we have to pay
interest to 2-3 middle
men?)
Conclusion
• Monetary policy can radically alter the money
supply, with serious impacts on the economy.
• For small changes in money supply, adding and
subtracting with open market operations are
favored.
• For large changes in the money supply,
multiplying and dividing it by changing the
reserve requirement may be necessary.
• When banks are not loaning money even when
they are legally allowed to, the fed will the lower
the discount rate (increasing banks’ profit
margins, and encouraging them to loan more)