Chapter 16 - Interest Rates and Monetary PolicyOPTIONAL: http://www.federalreserveeducation.org/fed101/policy/basics.htm Show
OUTLINE
The first thing we need to do is to develop another graph: the money market. Then we will add this new graph to two other graphs and we will have to use THREE GRAPHS TO SHOW HOW MONETARY POLICY WORKS: Expansionary Monetary Policy: Increasing the MS to decrease UE: Contractionary Monetary Policy: Decreasing the MS to decrease IN: REVIEW: The Money MarketSo, what is that first graph? Expansionary monetary policy used to fight unemployment (UE):
Contractionary monetary policy used to fight inflation:
So, all that remains is: HOW does the Fed change the money supply? Or what are OMO, DR, RR, and the term auction facility? Introduction to Monetary PolicyObjectives of Monetary PolicyThe fundamental objective of monetary policy is to aid the economy in achieving full-employment output with stable prices (low inflation).To do this, the Fed changes the nation’s money supply. To change money supply, the Fed manipulates size of excess reserves held by banks (see chapter 15). In chapter 15 we discussed how banks use their excess reserves to create money. In this chapter, we will see how the Fed uses the four tools available to it to change the amount of excess reserves and thereby change the money supply. REVIEW / PREVIEW (one more time): If there is HIGH UNEMPLOYMENT in the economy, the appropriate monetary policy policy and its effect illustrated on our graphs would be:
FIRST: Chapter 16 SECOND: Chapter 15 THIRD: Chapter 10 FINALLY: Chapter 12 and 13 To increase the MS the fed must increase the ER of banks. Then banks could make more loans and create more money. To do this they would use an easy money policy. Easy Money Policy: If the MS increases: If the interest rates decline: If investment increases: Balance Sheet of the FedTo understand how the Fed controls the money supply we first have to look at the Consolidated Balance Sheet of the Federal Reserve Banks. We studied the balance sheet of banks in chapter 15 and used them to show how banks create money. Here we will use the balance sheet of the Fed and the balance sheet of banks to show how the Fed and control the excess reserves of banks and thereby control the money supply. [I know I have already said this several times, and I will probably say it again. It must be important.] The Tools of Monetary PolicyThe Fed has Four Major "Tools" of Monetary Policy Open Market Operations (OMO) For several reasons, open market operations give the Fed most control over the money supply of the three "tools" and therefore it is the tool most often used. If you ever read an article in the newspaper that says "the fed lowered interest rates yesterday", it really means the fed used its Open Market Operations to BUY bonds which increased the excess reserves of banks and therefore bank have more lending ability and the money supply will increase.
3) The CHANGES to the Fed's balance sheet will be:
3) The CHANGES to the bank's balance sheets will be: Four tools of the fed: 1. OMO Changing the Reserve Ratio (RR) The reserve ratio is another "tool" of monetary policy. It is the fraction of reserves required relative to their customer deposits.1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks' lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.
What is the potential MS?Formulas:
What is the potential MS?Formulas: Four tools of the fed: 1. OMO Discount Rate The third "tool" is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed.1. An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves. Four tools of the fed: 1. OMO Term Auction Facility The fourth tool is a new tool, but very similar to changing the discount rate1. This tool was introduced in December 2007 in response to mortgage debt crisis. Targeting the Federal Funds RateThe Federal funds rate is the interest rate that banks charge each other for overnight loans. You will often hear it mentioned in news reports. Monetary Policy, Real GDP, and the Price Level: How Policy Affects the EconomyA. Cause effect chain:1. Money market impact is shown in Key Graph 16.5.a. Supply of money is assumed to be set by the Fed. HOW CONTRACTIONARY MONETARY POLICY WORKSTight money policy, or contractionary monetary policy, designed to decrease inflation: 1. occurs when Fed tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period.
Keynesian Cause-Effect Chain of Monetary Policy: FED
C. Textbook Graph (figure 16.5) 1. Using the textbook's "Key Graph 15.2", how would we illustrate expansionary MP?a. If the MS is Sm1 in graph 1 Monetary Policy: Evaluation and IssuesA. Strengths of monetary policy: Why is the supply curve for money vertical?a curve that shows the relationship between the amount of money supplied and the interest rate; because the central bank controls the stock of money, it does not vary based on the interest rate, and the money supply curve is vertical.
How does interest rate affect supply curve?rate increases lower aggregate demand. If so, then equilibrium supply will be reduced, with price adjusting according to the change in the price elasticity of demand. the interest rate would reduce supply and increase price.
Why does the money demand curve slope downward with interest rates on the vertical axis?Money demand curve is negatively sloped as there is a negative relationship between the quantity of money demanded and the interest rate. In other words, the money demand curve is downward sloping because of the interest rate, which represents the opportunity cost of holding money.
When the money market is drawn with the value of money on the vertical axis if the price level is above the equilibrium level there is an?downward, because at higher prices people want to hold more money. When the money market is drawn with the value of money on the vertical axis, if the value of money is below the equilibrium level, the value of money will rise. right, raising the price level.
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