MonetaryPolicy

15C H A P T E R

GOALS OF MONETARY POLICY

…to assist the economy in achieving a full-employment, noninflationary level of total output

CONSOLIDATED BALANCE SHEET OFTHE FEDERAL RESERVE BANKS

ASSETS• Securities• Loans to Commercial Banks

LIABILITIES•Reserves of Commercial

Banks• Treasury Deposits• Federal Reserve Notes

TOOLS OF MONETARY POLICY

Open-Market OperationsBuying Securities From commercial banks...

• Bank gives up securities• FED pays bank• Banks have increased reserves

From the public...• Public gives up securities• Public deposits check in bank• Banks have increased reserves

TOOLS OF MONETARY POLICY

Open-Market OperationsSelling Securities To commercial banks...

• FED gives up securities• Bank pays for securities• Banks have decreased reserves

To the public...• FED gives up securities• Public pays by check from bank• Banks have decreased reserves

New reserves$800

ExcessReserves

$4000Bank System Lending

FEDERAL RESERVEPURCHASE OF BONDS

Purchase of a$1000 bondfrom a bank...

$200Requiredreserves

$1000Initial

Deposit

Total Increase in Money Supply ($5000)

TOOLS OF MONETARY POLICY

Open-Market Operations

The Reserve RatioRaising the Reserve Ratio• Banks must hold more reserves• Banks decrease lending• Money supply decreases

Lowering the Reserve Ratio• Banks may hold less reserves• Banks increase lending• Money supply increases

TOOLS OF MONETARY POLICY

Open-Market Operations

The Reserve Ratio

The Discount RateEasy Money Policy

• Buy Securities• Decrease Reserve Ratio• Lower Discount Rate

TOOLS OF MONETARY POLICY

Open-Market Operations

The Reserve Ratio

The Discount RateEasy Money PolicyTight Money Policy

• Sell Securities• Increase Reserve Ratio• Raise Discount Rate

TOOLS OF MONETARY POLICY

Open-Market Operations

The Reserve Ratio

The Discount RateEasy Money PolicyTight Money Policy

• Sell Securities• Increase Reserve Ratio• Raise Discount Rate

Discuss relativeimportance

of each control

MONETARY POLICY, REAL GDP,AND THE PRICE LEVEL

Cause-Effect Chain• Money supply impacts interest

rates• Interest rates affect investment• Investment is a component of

AD• Equilibrium GDP is changed

Real domestic output, GDP

Dm

InvestmentDemand

Rea

l rat

e of

inte

rest

, i

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

MONETARY POLICY AND EQUILIBRIUM GDPSm1

AS

AD1(I=$15)

P1

10

8

6

0

Sm2

AD3(I=$25)

P2

If the Money SupplyIncreases to Stimulatethe Economy…Interest Rate DecreasesInvestment IncreasesAD & GDP Increases with slight inflation

Pri

ce le

vel

AD2(I=$20)

P3

Sm3

Increasing money supply continues the growth – but, watch Price Level.

Money Market•Investment•Equilibrium GDP

Effects of an easy money policy

Effects of a tight money policy

MONETARY POLICY AND EQUILIBRIUM GDP

MONETARY POLICY IN ACTIONStrengths of monetary policy• Speed and flexibility• Isolation from political

pressureFocus on the Federal Funds Rate

The Federal Funds Rate

The Prime Interest Rate

Recent Monetary Policy

Problems and Complications

Lags

Changes in Velocity

Cyclical Asymmetry

“Artful Management”

or “Inflation Targeting”

MONETARY POLICY AND THEINTERNATIONAL ECONOMY

• Net export effect• Macro stability and

the trade balance• The “Big Picture”

ENDBACK

monetary policy open-market operations reserve ratio discount rate easy money policy tight money policyFederal funds rateprime interest ratevelocity of moneycyclical asymmetryinflation targeting

Copyright McGraw-Hill/Irwin, 2005