Monetary Policy

 Monetary policy is the deliberate change instituted in the money supply to influence interest rates and thus total spending in the economy. The goals of monetary policy are to achieve price level stability, full employment, and economic growth.

Tools of Monetary Policy

    The federal reserve has three (3) tools that it uses (depending on what is currently seen as necessary) to influence the money creation ability of the banking system. These are: 1. Open Market Operations 2. Reserve Ratio Change 3. Discount Rate

Open Market Operation

 The federal reserve’s open market operations involve the buying or selling of government bonds to commercial banks or to the public. This is the MOST IMPORTANT instrument for influencing the money supply.

Buying Bonds

       Buying Bonds is an EXPANSIONARY MONETARY policy The Fed will do this to increase reserves in the banking system. This is how it works: IF the Fed buys government securities (bonds) owned by banks the following occurs: A. Banks sell bonds to the Fed reducing their assets by that amount B. The Fed will then pay the banks for their bonds increasing banks assets as RESERVES by the same amount C. This will increase the ability of the banks to lend, increasing the money supply, reducing interest rates as the supply of money increases, thus increasing C and Ig.

The fed funds rate will decline. This is the target the fed is aiming for.

Buying bonds part II

      If the Fed buys government bonds from the general public (you or me) the following occurs: A. we sell the bonds to the feds and receive from the Fed a check for that amount B. We deposit that check into our local bank C. As a result the checkable deposits of the bank increase, which increases its reserves.

D. This results in an increase in lending, which increases the supply of money, which lowers interest rates, which increases C and Ig.

The fed funds rate will decline and this is the target that the Fed is aiming for.

Buying bonds part III

 One note: when the Fed buys bonds from a bank, all of the money received by the bank will go into reserves. The bank does not have to keep a reserve for this money as it is not a checkable deposit. When individuals deposit Fed money for bonds into the bank, the bank must hold a % of it as reserves. This means that there is slightly less monetary creation potential with the second scenario. In practice, this doesn’t affect the expansionary nature of the policy. Bank reserves increase in both cases.

Selling Bonds

 Selling Bonds by the Fed is a contractionary monetary policy. The purpose is to reduce bank reserves and curb the growth of the money supply.

Selling bonds to banks

     When the fed sells bonds to banks the following occurs: A. The fed sells the bonds and receives a check from the bank against its cash reserves.

B. The banks reserves are reduced by that amount.

C. This, in turn, will reduce the ability of the bank (banking system) to make loans, reducing the money supply, increasing interest rates, and reducing C and Ig.

The fed funds rate will increase-this is the fed’s target.

Selling bonds to the public

     If the fed sells bond to the public, the following occurs: A. individuals or companies buy the bonds and write a check to the Fed B. The checks reduce the checkable deposits of the banks, reducing excess reserves in the process.

C. This, in turn, reduces the ability of banks (banking system) to make loans, reducing the money supply, raising interest rates, and reducing C and Ig.

The fed funds rate will increase which is the purpose of the policy change.

Why should banks and people buy and sell securities to and from the FED    The answer is the price of bonds and the interest rate of the bonds. As we have seen, bond price and interest rates are INVERSELY related So, when the FED buys bonds, the demand for them increases, the price rises, and the interest rate drops. This encourages banks and the public to sell the bonds to the FED.

Why…?

  On the other hand, when the Fed sells bonds in the open market, the additional supply of bonds reduces the price and increases the interest rate, making them more attractive to potential buyers.

The MAIN AIM of the FED is not to enrich bond buyers or sellers, but to CHANGE the FED FUNDS RATE as a tool for money supply change.

Tool Two: The Reserve Ratio

 The fed can also manipulate the required reserve ratio for banks to influence the amount of money a bank MUST hold. This will influence the total amount of excess or loanable funds in the system

Raising the Reserve Ratio

  Suppose the federal reserve raises the reserve ratio from 20% to 30%.

If the bank has deposits of $100,000 it would keep reserves of $20,000 under the old ratio. But under the new one, it would need to keep $30,000 thus reducing the amount it can loan significantly.

Raising the Reserve

    Several things might result from this.

A. Banks would lend less money B. Banks would call in old loans Overall, the effect would be the same as the selling of securities. Raising the reserve would be contractionary monetary policy. It would reduce banks excess reserves, reduce lending, reduce the money supply, increase interest rates and reduce C and Ig.

Lowering the Reserve Ratio

  Suppose the Fed lowers the reserve ratio required of banks from 20% to 10% If the bank has deposits of $100,000 it would have had to keep $20,000 under the old ratio, but only needs to keep $10,000 under the lowered ratio. This would increase the amount it could lend significantly.

How this affects money supply

    It changes the amount of excess reserves available to the banks to lend It changes the size of the monetary multiplier Remember the Monetary Multiplier is 1/RRR (required reserve ratio) Because of the power of this tool and its dramatic effects, it is infrequently used.

The Discount Rate

   The Fed is a central bank. As such, it is what is known as a lender of the last resort.

This means that if a bank has an unexpected shortfall of cash, it can borrow these funds from the Federal Reserve.

The Fed will charge the bank an interest rate. This rate is known as the DISCOUNT rate.

Discount Rate continued

   Since this borrowed money is not required to have a reserve all of this money would be available to the bank for lending.

This increases the banks reserves, decreasing interest rates, increasing the money supply, and thus C and Ig.

Since the Fed sets the discount rate, it can and does use it to encourage banks to borrow or to discourage banks from borrowing. This will affect the banks ability to lend. So this can be expansionary or contractionary depending.

Easy Money

     Easy money is an expression for expansionary Monetary Policy Using the 3 tools Easy Money would consist of the following: BUY SECURITIES (BONDS): This allows banks to increase reserves LOWER THE RESERVE RATIO: This allows banks to increase excess reserves LOWER THE DISCOUNT RATE: This allows banks to increase reserves with $ from the Fed

PURPOSE

 The purpose of an EASY money policy is to make bank loans less expensive by lowering interest rates and more available by increasing the money supply and increase output, AD, and employment.

TIGHT MONEY

     Tight money is an expression for contractionary Monetary Policy Using the 3 tools Tight Money would consist of the following: SELL SECURITIES: This reduces banks reserves RAISE THE RESERVE RATIO: This reduces banks reserves RAISE THE DISCOUNT RATE: This inhibits banks ability to have extra funds to lend

PURPOSE

 The aim of TIGHT MONETARY POLICY is to reduce bank reserves, reduce banks’ abilities to lend, reduce the money supply, increase interest rates, and reduce the price level or stabilize it, reduce output, reduce employment, and reduce AD.

Relative Importance of the TOOLS

 Open Market Sales and Purchase of Bonds is the MOST IMPORTANT. It is flexible in that small or large amounts of bonds can bought or sold. It is subtle and less noticeable to the public etal.. The fed also has extremely large amounts of bonds to sell and lots of money to buy with.

Relative Importance

Changing the Reserve Requirements Perhaps the main reason the FED uses this tool sparingly is because it can severely impact bank earnings. Reserves earn no interest, and having no money to loan or having too much and not being able to loan it are essentially the same to a bank, so the FED seldom uses this approach.

Relative Importance

The Discount Rate The discount rate is often raised or lowered by the FED, but since banks rarely acquire more than a few percentage points of reserves this way it has little impact. The fact is that most bank borrowing from the FED is the result of bank wanting to purchase bonds in open market operations.

 The discount rate is more of an announcement of intent about the general direction of Monetary Policy.

Easy Money Policy: Problem and corrective action

  Problem: Unemployment and recession Fed buys bonds, lowers RRR, or lowers the discount rate  ↓  Excess reserves increase  ↓  Money supply rises  ↓

continued

 Interest Rate falls  ↓  Investment spending increases (Ig)  ↓  Aggregate demand (AD) increases  ↓  Real GDP increases by a multiple of the increase in Ig

Tight money policy: Problem and corrective action

 Problem: Inflation  ↓  Fed sells bonds, increases RRR, or increases discount rate  ↓   Excess reserves decrease ↓  Money supply falls  ↓

continued

 Interest rate rises  ↓  Investment spending (Ig) decreases  ↓  Aggregate demand (AD) decreases  ↓  Inflation declines

Effectiveness

  Effectiveness of any policy in this large economy is problematic.

However, monetary policy has been used more successfully than fiscal policy in the US for the last two generations

Strengths:

   Speed and Flexibility Isolation from most Political Pressure Successfully used for most of the last three decades

Shortcomings and problems:

    Changes in the way banking is done may cause loss of FED control Global markets and currency trading may be beyond the control of the FED The Velocity of money (V) may be changing. Cyclical Asymmetry

Fed Funds Rate

    This rate is used by the FED to stabilize the economy It is the rate banks charge each other for overnight loans.

An increase in the fed fund rate signals a tight money policy. A decrease would signal an easy money policy

Why is this important?

    Most interest rates are based on this FED FUND rate. If prime rates move up or down this will affect all borrowers in the economy.

The fed will sell bonds in the open market to increase the fed funds rate The fed will buy bonds in the open market to decrease the fed funds rate.

Exports and Monetary policy:

       Net Export Effect of monetary policy Easy money policy: Recession; slow growth Easy money policy = lower interest rate Decreased foreign demand for dollars Dollar depreciates Net Exports increase ergo AD increases strengthening the easy money policy

Net Export effect

       Tight Money Policy Problem: inflation Tight money policy: interest rates rise Increased foreign demand for dollars Dollar appreciates Net exports decrease AD shrinks, strengthening tight money policy

Assume a large trade deficit:

 Easy money policy, which is appropriate for the alleviation of unemployment and sluggish growth, is compatible with the goal or policy of correcting a balance of trade deficit. That is, because expansionary policy results in lower interest rates, foreigners will give up or not purchase US securities. This will lower the demand for dollars, cheapening the dollar. This will cause demand for US goods as exports to increase. This will then reduce any balance of trade deficit the US has on its current account.

Assume a large trade deficit:

 A tight money policy that is used to correct inflation conflicts with the goal of correcting a balance of trade deficit. Because tight money policy restrains money and interest rates rise, foreigners would demand US dollars for asset purchases, the dollar would appreciate in value, and US exports would become less competitive.

The Big Picture

 In your textbook on pages 300 and 301 is an elegantly structured graph of the economy showing the AD/AS theory of the price level, real output and how stabilization can occur using Fiscal and Monetary Policy. This is well worth some time to look at if you are serious about understanding the relationships between all the things we have discussed from chapter 11 through 15