Before  the  Fed  

•  30,000  currencies  in  the  US  in  1913  •  Even  drug  stores  had  own  currency  •  Currencies  backed  by  gold  or  gov’t  bonds  •  Not  enough  cash  at  @mes-­‐-­‐>banks  collapsed  a  lot  •  People  didn’t  trust  banks  so  the  Fed  was  created  as  

the  bank  of  banks  -­‐  the  bank  of  the  US  gov’t  

The  Goals  of  the  Federal  Reserve  

•  Regula@ng  the  money  supply  •  Serving  as  the  government’s  bank  

•  Supervising  FDIC  banks.  – Clearing  checks  –  loans  

The  Money  Supply:  Types  of  Money  

M1:    Money  that  is  readily  made  into  cash  or  is  cash.  

M2:    M1  +  savings  CDs,  money  markets,  savings  deposits.  

M3  and  L:    M1  +  M2  +  large  CDs,  stort  term  treasury  bonds  and  other    “near  money.”  

Monetary  Policy  and  Aggregate  Demand  

Easy  Money  Policy  

 Low  interest  rates,  makes  money  cheap.    Increases  consumer  spending  and  business  spending.  

Tight  Money  Policy    Higher  interest  rates  makes  money  expensive.  

 Decreases  consumer  spending  and  business  spending.  

What  is  the  Fed?  

•  Created  in  1913  •  Poli@cally  independent  •  Goals:  max.  employment,  stable  prices,                                                      &  sustainable  growth  

•  Conducts  monetary  policy  –  Controls  money  supply  (qt.  of  $)  –  Changes  short-­‐term  interest  rates  (affects  qt.  of  $)    

Open  Market  Opera8ons  

•  Main  tool:  buy/sell  gov’t  securi@es  (treasury  bonds,  currency)  to  put  them  into/out  of  circula@on  

•  Buy  to  increase  flow  of  money/credit  

•  Sell  to  reduce  flow  of  money/credit  •  E.g.    When  you  buy  a  bond  from  the  Fed  for  

$10,000,  you  write  a  check  and  take  money  out  of  the  economy    

Reserve  Ra8o  

•  Used  infrequently  b/c  has  strong,  direct  effects  •  Banks  hold  some  frac@on  of  deposits  on  reserve  to  meet  customers’  

cash  needs  •  Banks  must  meet  Fed  reserve  req.  

–  Currently  about  10%  –  Banks  hold  at  least  $10  for  every  $100  of  deposits  

•  Alter  reserve  req.,  change  money  supply  –  Decrease  required  reserves  increases  $  in  circula@on  –  Increase  required  reserves  decreases  $  in  circula@on  

•  some  banks  sell  securi@es  (e.g.  bonds)  or  call  in  loans  

Discount  Rate  

•  interest  rate  at  which  Fed  loans  money  to  banks    

•  Many  short  term  interest  rates  (IR)  @ed  to  it  

•  Discount  rate  changes  move  money  supply  in  opposite  direc@on  –  Increases  in  discount  rate  decrease  money  supply  by  

decreasing  borrowing  (IR  rise)  –  Decreases  in  discount  rate  increase  money  supply  by  

increasing  borrowing  (IR  fall)  

•  Changes  in  discount  rates  foreshadow  Fed  policy  inten@ons  

Expansionary  MP  

•  Increase  money  supply  when  economy  “too  slow”    –  Buy  securi@es  (open  market  opera@ons)  –  Reduce  reserve  ra@os  (not  likely)  –  Lower  the  discount  rate  

•  Works  through  interest  rates  (price  of  money)  –  Money  supply  increases,  more  money  so  price  of  borrowing  (interest)  falls  –  Discount  rate  decreases,  banks  borrow  more  money  and  money  supply  increases  (interest  

rates  @ed  to  it  fall)  •  Interest  rates  fall,  spending  increases  

–  Plant  and  equipment  (by  firms)    –  New  housing    –  Consumer  durables  (especially  autos)    

•  Increased  spending  s@mulates  produc@on,  which  reduces  unemployment  and  increases  GDP,  which  increases  income,  which  s@mulates  spending…  

Contrac8onary  Monetary  Policy  

•  Decrease  money  supply  if  economy  “too  fast”  –  Sell  securi@es  (open  market  opera@ons)  –  Increase  reserve  ra@o  (not  likely)  –  Raise  discount  rate  

•  Contrac@onary  MP  effec@ve  with  rapidly  increasing  GDP/infla@on  

•  Decreases  investment  &  slows  economic  expansion  

•  If  economy  sluggish,  recession  will  deepen  

•  Cost-­‐push  infla@on,  @ght  (contrac@onary)  policies  have  liele  impact  on  slowing  infla@on  

Monetary  Policy  in  Ac8on  

•  Many  argue  price  stability  is  Fed’s  primary  goal  •  If  economy  tends  toward  full  employment,  MP’s    greatest  impact  is  

on  price  level  •  Tradeoffs  between  unemployment/infla@on    

–  Unemployed  means  not  enough  money  to  spend  &  Fed  can  s@mulate  spending  through  expansionary  policies    

–  Too  much  money  chasing  too  few  goods  increases  prices  (infla@on)  •  Excessive  growth  in  money  supply  a  root  cause  of  infla@on  

–  Friedman  argued  that  given  long  term  impacts  of  fluctua@ons  in  money  supply,  best  is  constant  increase  

–  3%  per  year  “the  rule”  

Federal Reserve Bank of Atlanta

Monetary Policy and Economic Indicators

Presented By:

Alan Melchior, Ph.D. Economic and Financial Education Specialist

Federal Reserve Bank of Atlanta

What Is This??

Peak

Recession

Trough

Expansion

TIME

REA

L G

DP

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Federal Reserve Bank of Atlanta

Key topics

Tools of monetary policy

Economic objectives and goals

Using economic indicators to pursue economic goals through monetary policy

Let’s start at the very beginning…

Bank Panic of 1907

Federal Reserve Act of 1913

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What is the broad purpose?

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Financial system stability

Economic stability

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Types of Policy

Fiscal policy Taxing and spending by the President and Congress, affecting the government’s budget

Monetary policy Changing the growth of the money supply to achieve price stability and long-run economic growth

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FOMC

Federal Open Market Committee

• 7 Governors • 1 NY Fed President • 4 voting positions rotate among other 11 Fed Presidents

8 meetings a year

What does the FOMC decide?

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Tools of monetary policy

Reserve requirements

•  little used

Discount window

Open market operations (federal funds rate)

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Reserve Requirements

Portion of funds banks are required to hold in reserve

Not changed for monetary policy since early 1990s

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Discount Window

Loans directly to banks • Short-term

Discount rate—generally higher than federal funds rate

Set by Board of Governors with regional requests

Changing role of discount window

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Open market operations

Federal funds rate

Overnight rate between financial institutions

• Fed not directly lending • Buys and sells treasuries

Established by FOMC

Primary dealers

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How do open market operations work? Banks provide most money in

overnight market

Fed expands or contracts amount of money

• Expand = buy Treasuries • lower interest rate

• Contract (shrink) = sell Treasuries • higher interest rate

Why?

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Reserves Affect Money, Credit, and Interest Rates

When reserves go up (if the Fed buys government securities), money and credit increase and short-term interest rates may fall.

When reserves go down (if the Fed sells government securities), money and credit decrease and short-term interest rates may rise.

Reserves Money Credit

Short-Term Interest Rates

Reserves Money Credit Short-Term Interest Rates

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=

=

=

=

=

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Interest Rates Affect Economic Activity

Short-term interest rates

Spending and investment

GDP and price levels

Employment

When interest rates go down, people and businesses borrow and spend more, increasing GDP and therefore employment. Additional demand for goods and services could cause price levels to rise.

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Interest Rates Affect Economic Activity

Short-term interest rates

Spending and investment

GDP and price levels

Employment

When interest rates go up, people and businesses borrow and spend less, which can decrease GDP and therefore employment. However, the decrease in demand for goods and services should cause price levels to stabilize, thus bringing down inflation.

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What does changing interest rates do?

The car analogy

• Increasing interest rates = brakes on the economy

• Lowering interest rates = gas pedal on the economy

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What are the Fed’s goals for the macroeconomy?

Economic growth

Stable prices

Maximum employment