Chapter 14

Presentation 1- Monetary Policy

Ways the Fed Controls the Money Supply

• 1. Open Market Operations (**Most used)

• 2. Changing the Reserve Ratio

• 3. Changing the Discount Rate

Open Market Operations

• Buying or selling government securities (bonds, treasury bills) by the Fed from the general public or commercial banks

Buying Securities

• When the Fed buys bonds from the commercial banks or the public, this increases the reserves of the bank

• This allows the banks to make more loans

Selling Securities

• When the Fed sells securities, the amount of reserves in the banking system goes down

• There is now less money to loan out

Changing the Reserve Ratio

• Raise the reserve ratio- lowers the money supply by making banks hold more $$

• Lower the reserve ratio- changes the amount of excess reserves and the multiplier---allows banks to loan more money

Changing the Discount Rate

• If the Fed lowers this rate, banks are able to borrow more and increase their loans to the public and vice versa

Asset Demand for Money

• The amount of money people hold as a store of value

• People like to hold money since it is the most liquid asset

Transaction Demand for Money

• The amount of money people want to hold to use as a medium of exchange to make purchases

• People hold cash to buys goods/services

• Varies directly with nominal GDP

Interest Rate

• The payment made for the use of money

Money Market GraphR

ate

of

Inte

res

t, I

pe

rce

nt

10

7.5

5

2.5

050 100 150 200 250 300

Amount of MoneyDemanded and Supplied

(Billions of Dollars)

Dm

Sm

Bond Prices and Interest Rates

• When interest rate fall, existing bond prices rise

• When interest rates rise, existing bond prices fall

• Inverse relationship

Bond Prices

• % interest yield = Amount of interest paid/bond cost

Bond Prices Example

• A $1000 bond pays 5% fixed interest rate and is selling for face value (which pays $50). Now the interest rates go up to 7.5%. The new bonds pay $75 interest. In order to sell the old bond, the sale price must fall to $667

• 50/X = .075• X = 667• The original bond still pays $50 interest