Monetary Policy

DEFINED
Effort to stabilize the economy by regulating
the money supply
Goals of Monetary Policy

Full
Employment

Stable Prices

Sustainable
Economic Growth
2 Conflicting Goals?

Maximum output
Stable Prices
& employment

What makes these 2-Goals in direct conflict?

High GDP & Low Unemployment (goal #1) increase inflationary pressures
 Monetary Policy
Policy changes affect
the nations supply of
money and credit.

Actions have real

short- and long-term
effects on the economy.
2 Types of Monetary Policy
LOOSE Monetary Policy
Goal: to increase the money supply
MS => Interest rates => AD => GDP

TIGHT Monetary policy

Goal: to decrease the money supply
MS => Interest rates => AD => GDP
 Important Fact: Time Lag
FYI: Both Fiscal Policy (6-12
months) and Monetary Policy (12-
24 months) have a time lag

Translation: they do not have

immediate effect
 Tight Monetary Policy
Step #1: Raise the discount rate

Step #2: Open Market Operations to DECREASE

money supply Fed SELLS government bonds

Federal Government bonds

Reserve
Money supply
7
 Economic Situation:
GDP growth at +5.0%, Inflation rising, Unemployment 3%

Loose or Tight Monetary policy needed?

Solution: Tight Monetary Policy

End Result: Lower GDP & less inflation!

Tight Monetary Policy

RAISES Discount Rate
1. Fed _________

2. Open-Market Operations

SELLS Securities
Fed _________
 Loose Monetary Policy
Step #1: Lower the discount rate

Step #2: Open Market Operations to INCREASE

money supply the Fed BUYS government bonds

Government bonds
Federal
Reserve
Money supply
9
Situation: GDP growth at -2.0%, Unemployment 9%

Loose or Tight Monetary policy needed?

Loose Monetary Policy

Loose Monetary Policy

LOWERS
1. Fed _________ Discount Rate

2. Open-Market Operations

BUYS Securities
Fed _________
 Policy Type
(Moderate Expansionary, Effect on
Action on Effect on
Economic Issue Aggressive Expansionary, Open Market the Money Federal
Moderate Contractionary, Operations Supply Funds Rate
Aggressive Contractionary, (Buy or Sell (increase or (increase or
Take No Action) Treasury Bills decrease) decrease
Decrease
1. Inflation rises to Aggressive Sell T-Bills Money Increases
10% Contractionary Supply FFR

2. GDP growth is at Decrease Increases

Moderate Sell T-Bills Money
4.2%; inflation is FFR
Contractionary Supply
at 3.6%

3. GDP growth is 2.1% Take no action None None None

and the inflation rate OR OR OR OR
is 3.5% Mod. Contractionary Sell T-bills Decrease MS FFR

4. Consumer confidence
Aggressive Increase Decreases
is falling; retail sales very Buy T-Bills Money
weak; unemployment at Expansionary Supply
FFR
8.1%

5. GDP growth is at Increase Decreases

Moderate Expansionary Money FFR
0.9%; inflation rate is Buy T-Bills
Supply
1.8%
Federal Open Market Committee
Sets and directs U.S. monetary
policy
Seven governors
Five presidents (New York and
four others on a rotating basis)
Nonvoting presidents participate
fully
Final interest rate decision is
made by the 12-member Federal
Open Market Committee (FOMC)
Federal Open Market Committee (FOMC)
Main policy-making part of Federal Reserve
Meets 8-times to vote on Monetary Policy
 Key Tools of Monetary Policy
Discount Rate
The interest rate charged by the Federal Reserve to banks
that borrow on a short-term (usually overnight) basis
Reserve Requirements
The amount of money banks must keep on reserve at the
Fed
Open Market Operations
Buying and selling Treasury securities between the Fed
and selected financial institutions in the open market
Most important tool; directed by the FOMC
Key Federal Reserve Interest Rates
Federal Funds Rate
The market-based interest rate which
banks charge each other on overnight
loans of their reserve balances held at
the Fed. The Fed achieves this rate
through Open Market Operations.
Discount Rate
Applies to short-term loans made
directly to commercial banks from the
Federal Reserve System.
Typically set at 1 percentage point
above the Federal Funds Rate.
Interest rate change usually indicates
change in the monetary policy
 The Federal Funds Rate
The federal funds rate is an interbank overnight interest rate (the interest rate
banks borrow money from each other).
How does the Fed control it? Open Market Operations the buying and selling
U.S. government securities to raise and lower the interest rate.
This action increases or decreases the federal funds rate, which changes the
money supply.

Securities = stocks, bonds, other assets

Decrease $ supply = Federal Reserve Bank to sell some securities

Increase $ supply = Federal Reserve Bank to buy some securities

Federal Funds Rate = rate at which banks lend $ to one another overnight
Reserve Requirement
Percentage of a banks deposits that it must keep on
hand
Holding money takes it out of circulation
This tool is rarely used.
The Feds Main Tools
What are the consequences?
Lower interest rates/more money leads to more
spending and investment, higher prices in the long
run.
Higher interest rates/less money leads to less
spending and investment, lower prices in the long
run.
Volatile monetary policy leads to uncertainty about
future economic conditions and discourages
economic activity.
Effects of Low Interest Rates
Generally, low interest rates
stimulate the economy because
there is more money available
to lend.
Consumers buy cars and houses.
Businesses expand, buy
equipment, etc.

Why does the Fed lower

interest rates?
If inflation is in check, lower
rates stimulate economic activity,
thus boosting economic growth.
 Effects of High Interest Rates
The Fed raises interest rates
as an effective way to fight
inflation.
Inflationa sustained rise in
the general price level; that
is, all prices are rising
together.
Consumers pay more to
borrow money, dampening
spending.
Businesses have difficulty
borrowing; unemployment
rises.