Monetary Policy

Monetary Policy

The Federal Reserve’s control over the supply of money is the key mechanism to monetary policy.

Monetary policy is the use of money and credit controls to influence macroeconomic activity.

The Federal Reserve System

Control of the U.S. money supply starts with the Federal Reserve System (the Fed).

Federal Reserve Banks

The core of the Federal Reserve system consists of 12 Federal Reserve banks.

Functions of Regional Fed Banks

Clears checks between private banks

Holds bank reserves

Provides currency

Provides loans (discounting)

The Board of Governors

Key decision-maker for monetary policy.

Seven members appointed by President of U.S. for 14 year terms.

Structure of the Federal Reserve System

The Federal Chairman

Most visible member of the Fed system.

Selected by the President for a four year term — can be re-appointed.

Alan Greenspan was appointed by President Reagan, re-appointed by Presidents Bush and Clinton.

Monetary Tools

The Fed has the power to alter the money supply.

The money supply (M1) consists of currency held by the public, plus balances in transaction accounts.

Fed has ONE basic tool of monetary policy:

Reserve Requirements

The Fed directly alters the lending capacity of the banking system by changing the reserve requirement.

Required reserves are the minimum amount of reserves a bank is required to hold by government regulation.

The ability of the banking system to create deposits is determined by the money multiplier and the amount of excess reserves.

A Decrease in Required Reserves

A change in the reserve requirement causes:

A change in excess reserves.

A change in the money multiplier.

Reserve Requirements

A lower reserve requirement increases the size of the money multiplier.

The Impact of Reduced Reserve Requirement

The Discount Rate

Reserves earn no interest.

Banks have an incentive to maintain the minimum possible level of excess reserves.

Sometimes banks reserves run low and they must replenish their reserves temporarily.

There are three sources of last-minute reserves:

Discounting is Federal Reserve lending of reserves to private banks.

The discount rate is the rate of interest charged by Federal Reserve banks for lending reserves to private bank.

Excess Reserves and Borrowings

Open-Market Operations

Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

Open-market operations are designed to affect portfolio decisions and the decision to hold money or bonds.

Open Market Activity

The Federal Reserve purchases and sells government bonds to alter bank reserves.

By buying bonds — Fed increases bank reserves.

By selling bonds — Fed reduces bank reserves.

An Open-Market Purchase

Powerful Levers

To summarize, the Fed controls bank reserves through Open-market operations, and this determines the banks’ ability to create money.

The Fed has effective control of the nation’s money supply.

Shifting Aggregate Demand

The ultimate goal of all macro policy is to stabilize the economy at its full-employment capacity.

Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Monetary policy may be used to shift aggregate demand.

Expansionary Policy

The Fed can increase AD by increasing the money supply by:

Lowering reserve requirements?

Dropping the discount rate?

Buying more bonds, increasing bank lending capacity!

Banks make more loans so AD shifts to the right reflecting increased purchasing power.

Demand-Side Focus

Restrictive Policy

Monetary policy can be used to cool an overheating economy.

Fed can reduce money supply and decrease AD by:

Price vs. Output Effects

The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

Aggregate Demand

Increases in the money supply shift AD to the right.

Aggregate Supply

The total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

The shape of the AS curve determines the effectiveness of expansionary monetary policy.

Horizontal AS — output increases without any inflation.

With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

Contrasting Views of Aggregate Supply

Policy Perspectives

The shape of the aggregate supply curve spotlights a central policy debate.

Fixed Rules or Discretion?

Should the Fed try to fine-tune the economy with constant adjustments of the money supply?

Or should the Fed instead simply keep the money supply growing at a steady pace?

Discretionary Policy

The economy is constantly beset by expansionary and recessionary forces.

There is a need for continual adjustments to money supply.

Fixed Rules

Critics of discretionary monetary raise objections linked to the shape of the AS curve.

AS curve could be vertical or at least upward sloping.

With an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.

Fixed rules for money-supply management are less prone to error than discretionary policy.

The money supply should increase by a constant (fixed) rate each year.

The Fed’s Eclecticism

The Fed currently uses a pragmatic, eclectic approach.

Flexible rules

Limited discretion

Mixes money-supply and interest-rate adjustments to do whatever is necessary to promote price stability and economic growth.