Monetary Policy
Chapter 15
GOALS OF MONETARY POLICY
…to assist the economy
in achieving a fullemployment,
noninflationary level of
total output
CONSOLIDATED BALANCE SHEET OF
THE 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 Operations
Buying 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 Operations
Selling 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
FEDERAL RESERVE
PURCHASE OF BONDS
New reserves
Purchase of a
$1000 bond
from a bank...
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
reserves
$1000
Initial
Deposit
Total Increase in Money Supply ($5000)
TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
Raising 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 Rate-Interest rate
Charged to member banks for loans
Easy Money Policy
• Buy Securities
• Decrease Reserve Ratio
• Lower Discount Rate
TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
The Discount Rate
Tight Money Policy
• Sell Securities
• Increase Reserve Ratio
• Raise Discount Rate
Federal Funds Rate
Interest rate banks charge each
other for overnite loans
 Prime interest rate-interest rate
charged by Fed
 Fed. Funds rate is prime + 1 or 2 %
points
 If Fed wants to decrease FFR, then it
buys bonds
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Increases S of reserves----FFR drops
Monetary Policy & International
trade
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Net Export effect
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Easy $ policy---decreases interest rate
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___securities, ___ RR, ____DR
What happens to imports?
Exports?
AD?
GDP?
Balance of trade--
Tight $ policy
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___securities, ___RR, ___DR
Imports?
Exports?
AD?
GDP?
Balance of trade
MONETARY POLICY AND EQUILIBRIUM GDP
Real rate of interest, i
Sm1 Sm2 Sm3
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
AS
Price level
Investment
Demand
P3
P2
P1
AD3(I=$25)
AD2(I=$20)
AD1(I=$15)
Real domestic output, GDP
0
Amount of investment, i
If the Money Supply
Increases to Stimulate
the Economy…
Interest Rate Decreases
Investment Increases
AD & GDP Increases
with slight inflation
Increasing money supply
continues the growth –
but, watch Price Level.
Effectiveness of MP
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Strengths
Isolated from politics
Quickly “fix” econ
1980’s/1990’s budget
deficit meant FP was
not used
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Weaknesses
Increasing
globalization makes
MP harder
No guarantee that
banks will loan
excess—leakage
MP can’t totally move
US out of recession
Change in velocity
DIFFERENT VIEWS OF MP
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Artful Management
Alan Greenspan
Manage Supply of
Money based on
data
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Inflation Targets
Goal 1-2%
inflation for 2
years
Increased
accountability
instead of just
based on
personality
EFFECTIVENESS OF POLICIES

Depends on demand for money
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The steeper the demand for money—
more interest rates will have impact
Most direct policy—Open Market
Operations
 Others—more time; depends on
banks
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