MONETARY POLICY

OPERATED BY THE FEDERAL RESERVE

GOALS: PROMOTE PRICE STABILITY (LOW INFLATION) PROMOTE FULL EMPLOYMENT (LOW UNEMPLOYMENT RATE)

TOOLS USED BY THE FEDERAL RESERVE

CHANGING THE REQUIRED RESERVE RATIO (% OF DEPOSITS, OR RESERVES) KEPT IN THE VAULT

CHANGING THE INTEREST RATES THE “FED” CONTROLS

CHANGING THE MONEY SUPPLY

TO FIGHT A RECESSION, THE FED WOULD:

LOWER THE REQUIRED RESERVE RATIO – GIVES BANKS MORE RESERVES TO LOAN

LOWER THE FED’S TWO INTEREST RATES IT CONTROLS * borrowing from the Fed * interbank lending

BOTH MOVES DESIGNED TO STIMULATE BORROWING AND SPENDING

BUT THE FED’S BIGGEST TOOL IS MONEY CREATION

FED WILL PRINT MONEY IN HOPES PEOPLE WILL SPEND IT – THEREBY INCREASING SALES FOR BUSINESSES AND MOTIVATING BUSINESSES TO HIRE MORE WORKERS

FED’S RECENT MONETARY POLICY

2007, I

2007, III

2008, I

2008, III

2009, I

2009, III

2010, I

2010,III

2011, II

2011, IV

2012, II

2012, IV0

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1

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M base fed fd rt

$ bils. %

IF FED THINKS THE ECONOMY NEEDS TO BE SLOWED – EXPANDING TOO FAST:

“TAKING AWAY THE PUNCH BOWL”

INCREASE THE REQUIRED RESERVE RATIO

INCREASE INTEREST RATES

REDUCE THE AMOUNT OF MONEY IN CIRCULATION

RESULT – FEWER LOANS AND SPENDING

ISSUES WITH MONETARY POLICY

FED CAN MOVE QUICKLY IN IMPLEMENTING ITS POLICIES

BUT POLICIES TAKE TIME TO HAVE AN IMPACT – ANYWHERE FROM 12 TO 18 MONTHS

REASON – WORKS THROUGH THE LENDING PROCESS

ALSO, FED POLICIES CAN “BACKFIRE”

“EASY” MONEY POLICY CAN LEAD TO HIGHER INFLATION AND INVESTMENT “BUBBLES

* EASY MONEY IN EARLY 1970S LEAD TO HIGH INFLATION OF LATE 1970S * EASY MONEY OF EARLY 2000s LED TO HOUSING BUBBLE ?

ALSO, A “TIGHT” MONEY POLICY CAN:

RAISING INTEREST RATES AND CUTTING THE MONEY SUPPLY CAN LEAD TO A RECESSION

* VOLCKER AND RECESSION OF EARLY 1980S * GREEENSPAN/BERNANKE BEGAN RAISING INTEREST RATES IN LATE 2004 – CAUSED HOUSING BUBBLE TO “POP”?

FED HAS SPARKED CONTROVERSY

SOME SAY “END THE FED”

* COMMON CURRENCY BACKED BY GOLD * MUCH HIGHER REQUIRED RESERVE REQUIREMENTS * PRIVATE INSURANCE FOR DOPOSITS

BOTTOM LINE: MONETARY POLICY IS VERY POWERFUL

BUT, FED HAS TO WORRY ABOUT WINNING THE CURRENT BATTLE YET LOSING THE NEXT

NOBEL PRIZE WINNING ECONOMIST MILTION FRIEDMAN OFTEN SAID THE FED’S BACK AND FORTH POLICIES (EASY FOLLOWED BY TIGHT, ETC) LED TO MORE VOLATILE BUSINESS CYCLES

ISSUES HAVE COME TO FOREFRONT WITH “TOO BIG TO FAIL”

“Moral Hazard” – if banks know will be “bailed out”, will take more risk?

Possible solutions? * let them fail – but brings down entire economy? * restrict lending and investments - but hinders economic growth? * restrict size of banks – but lose some advantages; business goes to foreign banks?