CHAPTER 15
MONETARY POLICY
Overview and Tool #1
Monetary Policy Consists of:

Deliberate change in the money supply to influence
interest rates and thus the total level of spending in
the economy.
The Goals of Monetary Policy



Maintain Price-level stability (control inflation)
Full employment
Economic Growth
The Balance Sheet of the Federal
Reserve
Chapter 15 focuses on the following two components
of the Balance Sheet:

Assets

Liabilities
Assets of the Federal Reserve

Securities (Government Bonds)
Treasury Bills (Short-term)-


Treasury Notes (Mid-term)


Maturing in 1-10 years
Treasury Bonds (Long-term)



maturing in less than 1 year
Maturing in more than 10 years
Loans to Commercial Banks
Federal Reserve Securities



Bought from the Treasury
Acquired from Commercial Banks and the Public
Mainly bought and sold to influence the size of
Commercial Bank reserves and therefore, the ability
of banks to create money by lending.
Loans to Commercial Banks


Commercial Banks occasionally borrow from the
Federal Reserve. This is an Asset for the Fed and a
Liability for the Commercial Bank.
By borrowing in this way, Commercial Banks increase
their reserves.
Liabilities of the Federal Reserve



Reserves
Treasury Deposits
Federal Reserve Notes
Reserves of Commercial Banks

Commercial Banks are required to hold reserves,
and these reserves are held by the Federal Reserve
Banks.
 This
is a liability for the Fed and an Asset to the
Commercial Bank
Treasury Deposits of the Federal

The U.S. Treasury keeps its deposits in the Federal
Reserve Banks and writes checks to pay its obligations.
These treasury deposits are Assets to the Treasury and
Liabilities to the Federal Reserve Banks
 Treasury deposits are replenished by depositing tax receipts
and money borrowed from the public or from Commercial
Banks through the sale of Bonds.

Federal Reserve Notes

Consists of the supply of paper money in circulation.
 It
constitutes claims against the assets of the Federal
Reserve Banks. The Fed thus treats these notes as a
Liability
Monetary Policy

Goal:
 To
understand how the Fed can influence the money
creating abilities of the Commercial Banking System
Tools of Monetary Policy

The Fed has three tools of Monetary Control that it
can use to alter the reserves of Commercial Banks:
 Open-Market
Operations
 The Reserve Ratio
 The Discount Rate
1st Tool: Open-Market Operations



Buying Government Bonds from Commercial Banks
and the general public.
Selling Government Bonds to Commercial Banks and
the general public.
The Fed’s most important instrument for influencing
the money supply.
Open-Market Operations: Buying Securities

When the Fed Buys Securities (from Commercial
Banks or the Public) the reserves of the Commercial
Banks will increase.
Open-Market Operations: Buying
Securities

The Fed buying Securities from Commercial Banks:
 Commercial
Bank gives up Government Bonds to the
Fed.
 Fed pays for those Bonds and thus increases the
reserves of the Commercial Bank by the amount of the
purchase.
 This increases the Lending Ability of the Commercial
Banks
Open-Market Operations: Buying Securities

The Fed buying Securities from the Public:
 Impact on the Commercial Bank reserves is much the same as
when the Fed buys from the Commercial Bank.
 Increases the reserves of the Commercial Bank, therefore
lending ability of the Commercial Bank increases.







Example:
Company owns Government Bonds
Company sales Bonds to the Federal Reserve
Company gets check drawn on the Federal Reserve Bank
Company deposits the check in its own Commercial Bank
Commercial Bank sends check to Federal Reserve for collection and receives
the funds from the Federal Reserve
Banks Reserves have increased
Open-Market Operations: Buying
Securities


When the Fed purchases government bonds from the
public, the supply of money is increased directly,
because of an increased amount of “checkable”
deposits in the economy.
This also increases the Lending ability of the
Commercial Banking System
Open-Market Operations: Buying
Securities


When the Fed purchases securities from Commercial
Banks, it increases the actual reserves and the excess
reserves of Commercial Banks by the entire amount of
the Bond purchase.
When the Fed purchases Bonds from the public, it
increases actual reserves but also increases checkable
deposits when the seller places the Fed’s check into
their personal checking account.
Example: Purchase from Public



Fed purchases a $1000 bond from the public
Increases checkable deposits by $1000, and hence,
the actual reserves of the banking system
Assume a 20% reserve ratio
 The
excess reserves would be $800
 $200 would have to be held as reserves
Key Points:



When the Federal Reserve Banks buy securities in the
Open-Market, Commercial Banks reserves are
increased.
When banks lend out their excess reserves, the
nation’s money supply will rise.
When the Fed buys $1000 bond, this results in $5000
in additional money whether purchased from
commercial bank or the public.
FEDERAL RESERVE
PURCHASE OF BONDS
Purchase of a
$1000 bond
from a bank...
New reserves
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
reserves
$1000
Initial
Deposit
Total Increase in Money Supply ($5000)
Open-Market Operations:
Fed Selling Securities


Selling Securities to Commercial Banks
Selling Securities to the Public
Open-Market Operations:
Fed Selling Securities

Selling to Commercial Banks
 Fed
gives up securities
 The commercial banks acquire the securities
 Commercial bank pays for the securities with checks
drawn against their deposits (their reserves held by
Federal Reserve Banks)
 Fed “collects” those checks by reducing the commercial
banks reserves
Open-Market Operations:
Fed Selling Securities

Selling securities to the public:
 Consider
a company that wants to buy a government
bond. The company buys the bond from the Fed and
pays with a check drawn on its commercial bank account.
 The Fed clears this check by reducing the commercial
bank’s reserves
 The commercial bank returns the canceled check to the
company, the company’s checkable deposit is reduced.
Open-Market Operations:
Summary
 The
sale of $1000 bond to a commercial bank reduces
the system’s actual and excess reserves by $1000.
 Fed’s sale of $1000 to the public, reduces bank’s excess
reserves by $800 because checkable-deposit money is
reduced by $1000 - - The commercial bank deposits are
reduced by $1000. Hence, the bank has to keep $200
less in reserves (assuming 20% reserve ratio).
Key Points:


When the Federal Reserve Bank sells securities in the
Open-Market, commercial bank reserves are
reduced.
If all excess reserves are already lent out, this
decline in commercial bank reserves produces a
decline in the nation’s money supply.
Key Points:

What makes commercial banks or the public want to
buy government securities?
Price of the bond and their interest rate
 When the Fed buys bonds, the demand for them increases
(bond price goes up), and interest rate on the bond declines
 High bond prices and low interest rates prompt banks and
individuals to sell the bonds.
 Conversely: When the Fed sales bonds, results in lower bond
prices and higher interest rates.
