Monetary Policy
the “Fed”
Alan Greenspan
Remember, our goal is to keep the aggregate demand curve (AD)
stable and intersecting the short-run aggregate supply curve (SRAS)
at full employment (FE). This is where the economy operates at its
most efficient potential.
PL
FE
SRAS
PL1
AD
O
Q1
GDPr
But do to the ups and downs of the business cycle, the aggregate demand curve
constantly moves to the right or left, causing economic instability.
FE
PL
PLe
SRAS
AD2
AD1
O
GDPr
per year
Peak
Peak
Trough
Time
Qe
GDPr
To stabilize the economy Federal Reserve carries
out monetary policy.
Monetary policy; the deliberate changes in the
money supply to influence interest rates and thus
the total level of spending in the economy.
Only “fiscal or monetary
policy” can get me back on
my feet and allow “Sam” to
get back up.
Goals of
Monetary Policy
Maintain;
• price-level
stability
• Fullemployment
• Economic
growth
“Help”
“When the economy is partying hard
(inflation), it’s the job of the Fed to take away
the punch bowl.”
When the economy is not partying at all
(recession), the Fed job is to
“spike the punch.”
Tools Of Monetary Policy
1. Open Market Operations
- This is the main tool of monetary policy.
- It consists of the buying and selling of
government securities.
Open-Market Operations during
a recession
 When the Fed buys bonds from commercial
banks, banks give up some of their
securities and the Fed pays money for those
securities. Thus they increase the excess
reserves of the commercial banks by the
amount of the purchase. Commercial banks
are then able to loan out more money from
their excess reserves. This increases Ig,
which stimulates the economy.
 When the Fed buys bonds from the public, the
public gives up the securities and the Fed gives
them money. Some of this increased wealth is
consumed (MPC) and some is saved (MPS).
 The amount consumed stimulates the
economy.
 The amount that is saved is deposited in
commercial banks, which increase the bank’s
excess reserves, which stimulates the
economy.
2. The Reserve Ratio
- The most powerful & seldom used
- Lowering the reserve ratio transforms RR into
ER, which enhances the banks ability to create
New money through lending.
RR - Atomic Bomb of Monetary Policy
Atomic Bomb of Monetary Policy
Suppose the banking system has $500 billion in DD.
The RR is 12% & AR are $60 billion. There are no ER
in this system, thus no new loans can be made
(500 x .12 = 60).
Now, what if the Fed lowers the RR to 10%, what
would be the affect on the banking system?
Banks will have to keep $50 billion in reserve, so ER will
increase from zero to $10 billion, and more new loans will be
made.
Atomic Bomb of Monetary Policy
Why is it called the atomic bomb of
monetary policy?
Because changing the RR will also changes the Mm. In the
example at 12% RR, the Mm equaled 8.33, but when the Fed
changed the RR to 10% the Mm increased to 10. Changing
the reserve ratio not only increase ER for loans, it also
increased the multiple by which those loans will increase the
money supply.
3. The Discount Rate
- The interest rate that the Federal Reserve charges
commercial banks for emergency loans
Discount Rate:
When the Fed provides loans to commercial
banks, 100% of those funds are excess
reserves (not subject to the reserve ratio).
Banks can loan out all of these funds.
A lowering of the discount rate encourages
commercial banks to increase excess
reserves by borrowing from the Fed. These
excess reserves are then loaned out and
increases the money supply.
Easy money Policy:
When the economy faces a recession the Fed
will decide to increase the money supply,
called easy money policy.
• Lower the reserve ratio; changing required reserves to
excess reserves.
• Lower the discount rate; enticing borrowing to increase
excess reserves.
• Buy securities; increasing excess reserves and the
DI of the public. Fed will do this 9-10 times!
Money Market
Investment Demand
MS MS2
RIR
DI
RIR
1
10%
10
8%
8
6%
6
0
Pl
DM
AS/AD
AD
AD
1
2
P
P2
AS
0
QID1 QID2
Qm
Qm
E2
E1
1
QR Q* GDPr
Buy
Bonds
MS
I.R.
QID
AD
Y/Emp/PL
Tight money Policy:
When the economy is suffering from
inflationary pressures the Fed will decide to
decrease the money supply, called tight
money policy.
• Increasing the reserve ratio; changing excess reserves to
required reserves.
• Raise the discount rate; discouraging borrowing to increase
excess reserves.
• Sell securities; decreasing excess reserves and the
DI of the public. The Fed will do this 9-10 times.
Investment Demand
Money Market
RIR
Dm
MS2MS1
10
RIR
Di
10%
8
8%
6
6%
0
Price level
AS/AD
P1
AS
AD1
AD2
P2
Qm
QID2 QID1
Qm
E1
E2
Q* QI
Sell
Bonds
MS
I.R.
QID
AD
Y/Empl./PL
Strengths of Monetary Policy
1. Speed and flexibility –Compared to fiscal policy
monetary policy can be quickly altered. The
buying & selling of bonds can occur on a daily
basis.
2. Isolation from political pressures – because the
Board of Governors serve 14 year terms.
They can enact unpopular
policies which
might get a member of Congress fired, but is
best for our economy’s health.
3. Success since the 1980s – a tight money
policy helped bring inflation from 13.5% in 1980
to 3.2% in 1983. An easy money policy helped
the economy recover from the 2000 recession.
Shortcomings of Monetary Policy
Kiss my tail! I wont
drink!
Cyclical Asymmetry “You can lead a horse
To water but you can’t make him drink”
An easy money policy during depression does
not guarantee that banks will give out loans if
people don’t have jobs.
Does not account for Velocity of money;
During inflation, when the Fed restrains
the money supply, velocity may increase.
During a recession, when the Fed increases the money supply, the
public may hold more money due to lower interest rates & fear.
Less Control by the Fed in future;
Increased global banking may led to policies that are inappropriate for
domestic monetary policy.
The End