Money Supply & The Fed
How the Fed “creates” money
The Federal Reserve primary job is the manage the nation’s
MONEY SUPPLY (MS) to achieves their 2 goals
Too much money leads to INFLATION
Too little money leads to Deflation
Monetary Policy• The Fed conducts Monetary Policy by changing the nation’s money supply (MS) which then
alters short term interest rates– Federal Funds = 1.0%
Dot-Com Crash
1.0% 0.0%
HousingBubble
1.0%
Money Market
At any moment in time, Money Supply (MS) is fixed by the Fed
Using monetary policy the Fed can shift MS right or left to change short term interest rates (federal funds rate)
Money Demand (MD)= desire to “hold” money•Similar to M1
•As interest rates ↓ => cost to “hold money” ↓
Increasing Money Supply
MD
MS2NominalInterestRate
Qty of $
MS1MS1
MD
NominalInterestRate
Qty of $
MS2
---------i1
---------------i2 ---------------i1---------i2
Decreasing Money Supply
Graphing The Money Market
Represents a short term, nominal interest rateThink of it as the Federal Funds MarketDifferent than Loanable Funds Market! (don’t mix them up!)
3-Tools of Monetary Policy
• The Fed has 3-tools to change money supply:– reserve requirement (currently 10.0%)
– discount rate (currently 1.75%)
– open-market operations (currently 1.00% target)• alters the Federal Funds Rate
Discount Rate & Federal Funds Rate
• Discount rate: the interest rate the Fed charges banks for loans– Banks borrow money directly from the Fed at the discount rate (1.0%)– The Fed is the “lender of last resort” in a financial crisis (very important in 2008!)
• Federal Funds Rate: the interest rate banks charge other banks for short term loans– This is the rate graphed in the money market ( currently 0.25%)– The Fed uses open market operations to alter it
Worksheet
Open-Market Operations
• What: The primary way the Fed changes money supply
• How: A process which involves the Fed buying & selling U.S. Government bonds – Bonds are also known as gov’t securities
• Result: the “open-market” process alters the Federal Funds Rate
Open-Market Operations “in action”
• To increase money supply: – the Fed buys government bonds (securities) from public
• To decrease money supply:– the Fed sells government bonds (securities) to public
Federal Reserv
e
Gov’t bonds
Money
PublicMarket &
Banks
Expansionary Monetary Policy
MD
NominalInterestRate
Qty of $
MS1
---------i1
MS2
---------------i2
Affects AD
LRAS1PriceLevel
RealGDP
AD1
SRAS1
------------------
P1
Y1
Money Market AS/AD Model
-------------
AD2
P2
Y2
E1
E1
E2
E2
Bernanke Interview Part I