Monetary PolicyEntering Bernanke’s Domain

Fundamental Questions◦ What is money?◦ Where does money come from?◦ What role do banks play in the macro economy?

Important Vocab◦ Transactions Account◦ Bank Reserves◦ Required Reserve Ratio◦ Excess Reserves

Key Ideas◦ Bank Failure◦ Creation of the Federal Reserve◦ Deposit Creation

Reviewing Money & Banks

How does the government control the amount of money in the economy?

How does the money supply affect macroeconomic outcomes?

Monetary policy: the use of money and credit controls to influence macroeconomic activity

Fundamental Questions of Monetary Policy

Federal Reserve Banks◦ 12 banks in various regions◦ Each acts as central banker for private banks in

region Main Functions of Reserve Banks

◦ Clearing checks between private banks◦ Holding bank reserves◦ Providing currency◦ Providing loans

The Federal Reserve System

Board of Governors◦ 7 members◦ 14-year terms◦ Not accountable to any specific elected official

The Fed Chairman◦ Appointed by president◦ Generally non-political appointee◦ Generally reappointed by subsequent presidents

Federal Reserve System (cont’d)

Three Basic Tools of Monetary Policy◦ Reserve Requirements◦ Discount Rates◦ Open-market Operations

Monetary Tools

Basics◦ Available Lending of Banking System = excess

reserves X money multiplier◦ Money multiplier = 1/required reserve ratio◦ By changing the reserve requirement, the Fed can

directly alter the lending capacity of the banking system

Changes in Required Reserves◦ A change in the reserve requirement causes:

A change in the amount of excess reserves A change in the money multiplier

Reserve Requirements

Definition: In order to maximize lending power, banks

need to have a quick source of reserves Three Sources of Last-Minute Reserves

◦ Federal Funds Market Borrowing money from another bank with large

reserves◦ Securities Sales

Selling off government bonds◦ Discounting

Borrowing directly from Fed Discount rate:

Discount Rate

Most immediate method of affecting reserves◦ Principal mechanism for day-to-day alterations of

reserve amounts Portfolio Decisions

◦ Money vs. Bonds Definition of O-M O: Buying vs. Selling Bonds

Open-Market Operations

Expansionary Policy◦ Shifting AD curve to the right to increase output in

order to reach full employment potential Restrictive Policy

◦ Shifting AD curve to the left to reduce excessive demand

◦ Raising Reserve Requirements◦ Increasing Discount Rate◦ Increasing Interest Rates

Interest-Rate Targets◦ Interest rates link changes in money supply to shifts

in Aggregate Demand

Shifting Aggregate Demand

Successful monetary policy depends on:◦ Aggregate Demand Shifting in response to monetary

policy◦ Aggregate Supply having the correct shape

Aggregate Demand◦ Only rarely do consumers fail to respond to changes in the

money supply Ex. Great Depression

Aggregate Supply◦ The effects of the AD shift caused by monetary policy

depend on the shape of the AS curve Horizontal AS Vertical AS Sloped AS

Using Sloped AS, expansionary policy causes some inflation and restrictive policy causes some unemployment

Price vs. Output Effects

Discretionary Policy vs. Fixed Rules◦ Discretionary policy

Positive and Negative shocks are frequent occurences Counter-cyclical Policy = Stability

◦ Fixed Rules The Fed’s discretion is dangerous because it is likely

to project the AS curve incorrectly Fixed Rules = Stability

◦ Eclecticism Combination of two approaches:

Flexible rules + Limited Discretion = Stability Ex. Paul Volcker and Congress

Policy Implications