Lecture 11 - Day 11 - Monetary Policy, Monetarism, Bank...

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Day 11 - Monetary Policy, Monetarism, Bank Regulation and Deregulation Monetary Policy 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 liquidity trap : (Figure 17.3) No matter how much the money supply increased, there would be no change in the interest rate. 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 interest rates. “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 Policy. 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. Changing the Reserve Requirement The amount of reserves the FED requires banks to hold in reserve. The Fed uses these to create Monetary Policy : Increasing or Decreasing the money supply. Federal Funds Rate: The rate banks borrow and lend reserves at on a very short term (usually overnight) basis. 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. The Federal Funds Market and Open Market Operations . The Fed Sells Bonds – Reserves in banking system Decrease: This is Contractionary Monetary Policy (interest rates are going up) The Fed Buys Bonds – Reserves in Banking System Increase: This is Expansionary Monetary Policy (Interest rates are going down)
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Monetarism: Like the Classical Economists (and unlike Keynesians) they use the equation of exchange from the Quantity Theory of Money : MV = PQ . Like the Classicals, they are concerned with the relationship between M and P…does raising the money supply lead to inflation? Milton Friedman: Nobel Prize Winner in 1976, formerly Economist at the University of Chicago, founded Monetarism in 1950’s. According to Monetarism, Short-run growth can be gained by altering the money supply…but the key to effective monetary policy is the velocity of money, V. Monetarists believe the FED misuses monetary policy…they should be focusing on recessions and inflation, but they should focus on monetary aggregates, not interest rates like the Federal Funds Rate. Monetary policy, through creating new money by the FED, may help in the short run, but in the
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Lecture 11 - Day 11 - Monetary Policy, Monetarism, Bank...

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