Monetary Policy• Using the amount of money and credit

available to consumers to influence the economy

The Federal Reserve System

• The Federal Reserve Bank (The Fed) is central bank of the U.S.

• designed to oversee the banking system • and regulate the quantity of money in the

economy

• The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act:

• Maximum employment• stable prices (control inflation)• Stabilize interest rates

• Role has expanded to include: • Regulate the banking and financial systems

Federal Reserve and Monetary Policy

1. Amount of money in economy determines amount of spending

• Too much =• inflation • Too little =• recession

Fed manages money supply by…..• Influence lending among banks and other

financial institutions

Monetary PolicyExpansionary Monetary Policy= expand credit =

lower ….interest rates = cheaper to ….borrow money = economic growth or contraction?

Contractionary Monetary Policy = restrict credit higher …..interest rates = more expensive to ….borrow money = economic growth or contraction ?

Three Tools of the Federal Reservea) Reserve Requirementb) Discount Rate c.)Open Market Operations (Federal Funds Rate)

Reserve Requirement

• the FED requires banks to hold a certain….• amount of money from circulation– The bank may not …..– loan this money to any customers.– Least used of the three tools

Expansionary Monetary Policy Using Reserve Requirement

• If the Fed decreased the Reserve Requirement, then banks would be allowed to……

• Loan out more money. The Money supply would….

• Increase. Consumers would ….• Borrow more and spend more and the

economy would…….• Expand (grow)

Contractionary Monetary Policy Using Reserve Requirement

• Discount Rate • Banks borrow directly from Fed• Least powerful of 3 tools – but a change

in DR does signal a change and can create a desired reaction

Expansionary Monetary Policy Using the Discount Rate

• If the Fed lowers DR, it is cheaper for…..• banks to borrow money . So banks will …..• pass on savings to customers and lower …..• their interest rates and the money supply

will….• Increase and there is more spending and the

economy will…..• Expand (grow)

Contractionary Monetary Policy Using the Discount Rate

4. Open Market Operations- Most used tool of the Feda)Fed buys and sells US government securities

and US Bonds (define bond –The government needs money so they “Borrow “ the money from the publicYou buy a $1000 bond from the govt. with 10%

interest. The govt agrees to pay you back the $1000 plus

$100 from interest

Expansionary Policy = buy bonds- Fed buys $1000 bond from Joe. So the

money supply …..- Inceased. Joe gave up his bond but now has

$1000 in cash Contractionary = sell bonds- Fed sells $1000 bond to Joe. So the money

supply……- Decreased. Joe now has a bond but $1000

less in cash

Fed’s effect on INTEREST RATES Intro to Money Market Graphs a) Expansionary ; buy bonds ; increase MS ; decrease IR

Int Rate

Q of Money

MS 1 MS 2

MD

b) Contractionary ; sell bonds ; decrease MS ; increase IR

MS 2 MS 1

MD

When the Fed uses OMO to buy / sell bonds, it is manipulating the Federal Funds Rate (What is it?)

Federal Funds – reserve balances of financial institutions held at

12 Regional Fed BanksIf a bank can not meet its “reserve requirement”

– it can borrow reserve funds from other banks

a)FFR – the interest rate banks pay when they borrow from each other

5. FOMC sets “TARGET” rate for FFR - Uses OMO to adjust MS to adjust FFR “at or

near target”

a)How does this affect you, me, and the rest of the economy?

Use of OMO and FFR……. “sets off a chain of events…..”

a) Expansionary Monetary Policy (using OMO and the FFR)

i. FOMC buys securities and the MS will …..ii. Increaseiii. This will decrease FFR which means banks will ….iv. Pay less to borrow and therefore will…..v. Pass on savings to customers and lower their ….vi. Interest rates and the money supply will ….vii. Increase. Customers will borrow……viii.More and spend…….ix. More and the economy will…..x. Expand (grow)

• Contractionary