Monetary Policy

How does the Fed really influence the economy?

Monetary Policy

“Monetary Policy” is the things that the Federal Reserve does to influence the economy.

The Federal Reserve has four main tools it uses to do this.

1. Money Creation

All banks can “create” money.Because banks do not just hold the

money they take in, but instead invest it, they create the illusion of more money.

Remember the demonstration.

2. Reserve Requirements

Reserve Rate: The percentage of the money deposited in a bank that the bank must keep on hand.

The Federal Reserve can also adjust the reserve rate to influence the economy.

By increasing or decreasing the Reserve Rate, they can reduce or increase the amount of money available in the economy.

Especially when you take into account “money creation”.

3. Setting Rates

The Federal Reserve sets:The rate of interest for banks borrowing

money from the Federal Reserve The “Discount Rate”

The rate of interest for banks borrowing money from each other( influenced, not directly set)

The minimum amount of interest a bank can charge its customers

The “Prime Rate”

4. Open Market Operations

Bond Purchases: If the Fed buys a bunch of bonds, it puts more money into the economy.

Bond Sales: If the Fed sells a bunch of bonds, it takes money out of the economy.

Monetary Policy and Macroeconomic Stabilization

By deciding to add or subtract money from the economy, the Fed influences the economy, but it isn’t always easy to know what to do and when to do it.

On top of that there are two other big problems

Timing

If the Fed acts to soon, it can cause a bad spike in the economy.

If it acts to late, it can worsen the problem.

Policy Lags

Trying to change the economy is like trying to change the TV by asking your little brother to get up and change it. It’ll probably get done, but you don’t quite

know whenLag means the delay between when

something is done and when its effects begin.

Policy Lags (cont)

Three things make it tough:Recognizing there is a problem (inside lag) It takes time to enact a policy (inside lag) It takes time for that policy to become

effective (outside lag)

Conclusion

Because of all of this, it is often better for the Fed to decide to be “Laissez Faire” or to let the economy fix itself.

Unless it is going to be a big problem, then the Federal Reserve will get actively involved.