Day 11 - Monetary Policy, Monetarism, Bank Regulation and Deregulation
How do changes in the money supply, and the price of money (the interest rate) affect the economy?
Interest Rates and the Economy:
Interest rates higher, firms borrow less for investment,
Investment decreases, GDP falls
Interest rates lower, firms borrow more for investment,
Investment increases, GDP increases
Keynes relied more on Fiscal policy.
He expected that during times of depression there would be a
No matter how much the money supply increased, there would be no change in the interest rate.
-monetary policy does not help as much when economy is alright, but in recession, monetary policy
isn’t as helpful
when economy collapses and there is liquidity trap, no matter how much we lower interest rates
(today, almost 0), people will still hold on to their money…not investing
He also felt that during a recession business expectations could also negate the efforts of expansionary
monetary policy…businesses don’t want to expand because of the business environment, regardless of
“Increasing the money stock to increase investment is much like pushing on a string”
How the Fed Creates Currency/Reserves
– How do they get into the economy?
This is Monetary
Fed has three
primary tools to affect the money supply:
Open Market Operations
Buying and selling bonds in the capital market.
Changing the Discount Rate
The rate at which the Fed lends reserves to member banks… Fed Funds rate.
.rate at which
banks borrow from each other.
.raising discount rate makes it harder for banks to make more
loans (more reserves, more loans)
Changing the Reserve Requirement
The amount of reserves the FED requires banks to hold in reserve.
The Fed uses these to create
Increasing or Decreasing the money supply.
In 2003,2004, 2005, FED tried to raise the discount rate, to limit the amount of money banks could
loan to people, trying to prevent housing bubble, but banks kept loaning, housing bubble getting worse
-when recession hit, FED tried to lower discount rates to encourage investment (2006, 2007, 2008)
Federal Funds Rate:
The rate banks borrow and lend reserves at on a very short term (usually
The FED targets this rate when it conducts its monetary policy.
The most commonly used tool is Open Market operations.
The other tools are rarely applied.