Unformatted text preview: Monetary Policy
How central banks use their powers to stabilize the economy and keep inflation under control Monetary policy influences interest rates and money supply
s s s Monetary policy seeks to stabilize the economy by influencing bank reserves and thereby affecting the ability of the banking system to extend credit By influencing the supply of money and credit, the Fed can also influence short-term interest rates The "Federal Funds" rate is the interest rate depository institutions charge for short term (usually overnight) loans to each other of deposits at regional Federal reserve banks. This rate is directly affected by the changes in availability of bank reserves. The Tools of Monetary Policy
Changes in Reserve Requirements: This is rarely used s Changes in the Discount Rate the Fed charges to depository institutions for loans s Open Market Operations: Sales and Purchases of government securities by the Fed that absorb or replenish bank reserves s Lender of Last Resort: Temporary Credit to depository institutions and security dealers
s Expansionary Monetary Policy: Action by the Fed to increase bank reserves and the money stock or the rate of growth of these variables. Short interest rates decline. s Contractionary Monetary Policy: Actions by the Fed to decrease bank reserves and the money stock or the rate of growth of these variables. Short term interest rates rise
s The Federal Open Market Committee (FOMC) Sets Goals for Open Market Operations
It meets 8 times each year to set goals for monetary policy and to plan open market operations Open Market Operations:
Most transactions are with securities dealers in New York that are mainly branches of large banks s Open market purchases increase bank reserves as the Fed pays for the securities it buys by crediting the accounts of depository institutions at regional Fed banks s Open market sales decrease bank reserves as the Fed debits the accounts of depository institutions to charge them for securities they buy
s Open market purchases: When the Fed pumps $1 billion of new excess reserves into the banking system by buying securities, the federal funds rate will immediately fall. The money stock could increase by $10 billion in new deposits when the required reserve ratio is 10%. s Open Market sales: A decrease in bank reserves from open market sales causes the federal funds rate to rise. Each $1 of reserves take out of the banking system could reduce the money stock by as much as $10 when the required reserve ratio is 10%.
s An expansionary monetary policy can be used to increase aggregate demand and restore full employment for an economy in equilibrium below potential real GDP
Price Level (Index Number) Aggregate Supply 125 E2 120 2 E1 New Aggregate demand Initial Aggregate demand 5.5 6 Real GDP (Trillions of Base Year Dollars) 0 5.0 Potential real GDP A contractionary monetary policy can be used to prevent aggregate demand from increasing and overheating the economy or to reduce aggregate demand in an already overheated economy
Price Level (Index Number) Aggregate Supply 125 E2 120 2 E1 New Aggregate demand Initial Aggregate demand 5.5 6 Real GDP (Trillions of Base Year Dollars) 0 5.0 Potential real GDP Short run effects of monetary policy:
Short-term interest rates will rise or fall --long-term interest rates depend on inflationary expectations and are not under direct control of the Fed s The supply of credit and money will change albeit with a lag. Sometimes it takes the banking system and the economy several months to respond to change in monetary policy.
s Long-term effects of monetary policy:
Long term effects depend the impact of Fed policies on inflationary expectations. s Long term effects also depend on changes in the equilibrium money stock and its rate of turnover (velocity). s To prevent inflation or recessions the money stock must grow in line with the rate of growth of potential real GDP after adjustment for changes in velocity.
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