IV. Monetary Policy - demand and supply of money; tools; causes and effects of monetary policy
Daniel Trauner
*Key Terms are in BOLD*
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1. Interest Rate – the “price” of borrowing money
a. Determined by the supply/demand of loans (money)
b. The Federal Reserve determines the supply (M1) of money
2. The Demand for Money
a. Demanded for transactions (buying stuff)
b. Held as an asset (held for its value)
3. Bond Prices
a. Interest rates and bond prices are inversely related
b. Bonds are bought and sold in financial markets
c. Bonds are sold at “face value” with a fixed interest rate
4. Total Demand for Money
5. The Fed’s Tools
a. Open-Market Operations (OMOs) – the buying and selling of government bonds by the
Fed, to and from banks and the public
i. The Federal Bank of New York conducts OMOs
ii. Buying bonds increases the money supply
1. Purchasing PUTS
iii. Selling bonds decreases the money supply
1. Selling SOAKS
b. The Reserve Ratio – the required amount of reserves a bank must have
i. Rarely used, as changing the reserve ratio drastically changes the money supply
(powerful)
c. The Discount Rate – the rate at which commercial banks borrow money from the Fed
i. Changing the Discount Rate also affects the Federal Funds Rate (rate at which
banks borrow from each other), and the Prime Rate (rate at which people
borrow from banks)
d. Term Auction Facility – anonymous borrowing from the Fed
i. This also allows banks to increase reserves, but it is done anonymously (allows
banks to borrow without their investors knowing)
ii. The Fed auctions off a limited pool of money at the lowest bid for everybody
iii. Relatively new tool, see http://www.ny.frb.org/markets/tslf.html
6. The Federal Funds Rate – defined above (see Discount Rate)
a. Temporary excess reserves are used for lending
b. Fed controls the Federal Funds Rate primarily through the use of OMOs
i. Fed buys bonds to decrease the Federal Funds Rate
ii. Fed sells bonds to increase the Federal Funds Rate
7. Expansionary (Easy) vs. Contractionary (Tight) Monetary Policy ↑ ↓
a. Expansionary (Easy) Monetary Policy – used during a recession
i. Consists of:
1. OMOs (buy)
2. Reserve Ratio (↓)
3. Discount Rate (↓)
4. Term Auction Facility (yes)
ii. Results:
1. Reserves (↑)
2. Supply of Money (↑)
3. Federal Funds Rate (↓)
4. Prime Rate (↓)
5. Gross Private Domestic Investment (↑)
6. Aggregate Demans (shifts right)
7. Price level (↓)
b. Contractionary (Tight) Monetary Policy – used during a period of inflation
i. Consists of:
1. OMOs (sell)
2. Reserve Ratio (↑)
3. Discount Rate (↑)
4. Term Auction Facility (no)
ii. Results:
1. Reserves (↓)
2. Supply of Money (↓)
3. Federal Funds Rate (↑)
4. Prime Rate (↑)
5. Gross Private Domestic Investment (↓)
6. Aggregate Demans (shifts left)
7. Price level (↑)
c. The Taylor Rule – The Fed tries to keep a 2% inflation rate
8. Pros and Cons of Monetary Policy
a. Pros
i. Speed and flexibility
ii. Insulated from politics
b. Cons
i. Recognition and operational lags
ii. Works better when removing inflation rather than recovering from a recession –
“You can lead a horse to water, but you can’t make the horse drink”
9. Remember: Three Major Graphs (Know how effects on one affect the others!)
a. Market for Money
b. Investment Demand
c. Aggregate Demand – Aggregate Supply
(With ratchet effect below)