The FED and Monetary Policy

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Fiscal Policy

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Actions taken by Congress to stabilize the economy

Business

ToolsTaxes

Spending

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Business

Monetary PolicyActions taken by The Federal

Reserve to stabilize the economy

Monetary Policy =

Changes inMoney Supply

= Federal Reserve

How the Government Stabilizes the Economy

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How the FED Stabilizes the Economy

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These are the three tools that the FED uses to shift Money Supply

ToolsOpen Market Operations

Discount RateRequired Reserve Ratio

What is Money Supply?All the physical

money in the economy

The FED uses all these tools specifically to

affect the Money Supply

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The Money Market(Supply and Demand for Money)

First, Let’s talk First, Let’s talk about the Demand about the Demand

for moneyfor money

Interest - The price paid for the use of borrowed money. Also, money earned by deposited funds.

Interest Rate - Percentage of interest collected on a debt or investmentSo, if interest rates are high, do you want to So, if interest rates are high, do you want to invest your money, or do you want to keep it invest your money, or do you want to keep it

in your pocket to spend on goods and in your pocket to spend on goods and services?services?

When we talk money, I When we talk money, I mean liquid money, in mean liquid money, in

your pocket or checking your pocket or checking account, that you can account, that you can use to buy goods and use to buy goods and

services.services.

The Demand for MoneyAt any given time, people demand a certain amount of

liquid assets (money) for everyday purchases

The Demand for money shows an inverse relationship between interest rates and the

quantity of money demanded

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At 20% interest rate there is a strong incentive to invest my money in a savings account.

At 2% interest rate there is less incentive to invest, and more incentive to keep and use my money.

low demand for liquid money high demand for liquid money

1. What happens to the quantity demanded of money when interest rates increase?

2. What happens to the quantity demanded when interest rates decrease?

Quantity demanded falls because individuals would prefer to have interest earning assets (investments)

Quantity demanded increases. There is less incentive to convert cash into interest earning assets

Interest rates are affected by the Federal reserve, the money supply, the economy,

and business cycles.

Now let’s talk

Monetary Policy

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When the FED adjusts the money supply to achieve macroeconomic goals

Tools of the FED1. Open Market Operations

2. Discount Rate3. Required Reserve Ratio

The FED uses all these tools The FED uses all these tools specifically to affect the specifically to affect the Money Money

SupplySupply

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DMoney

SMoneyThe FED is a nonpartisan

government office that sets and adjusts the money supply to adjust

the economy

This is called Monetary Policy.

The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED)

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The Supply for Money

20%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

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Video: The FED Today

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The role of the Fed is to “take away the punch bowl just as the party gets going”

Tools of the FED1. Discount Rate

2. Required Reserve Ratio3.Open Market Operations

The FED uses all these tools The FED uses all these tools specifically to affect the specifically to affect the Money Money

SupplySupply

#1 Discount Rate

Discount Rate - The interest rate that the Federal Reserve charges other banks when they need to borrow

money

The FED acts as a lender of last resort when banks and the economy are in financial emergencies.

Example:If Banks of America needs $10 million, they borrow it

from the U.S. Treasury (which the FED controls) but they must pay it back with 3% interest.

To increase the Money supply, the FED should _________ the Discount Rate (Easy Money Policy).

To decrease the Money supply, the FED should _________ the Discount Rate (Tight Money Policy).

Decrease

Increase

#2 The Required Reserve Ratio

Required Reserve Ratio - the fraction of deposits that banks must keep on reserve.

If you make a deposit If you make a deposit at a bank, only some of at a bank, only some of that money has to be that money has to be kept readily available kept readily available in reserve. The bank in reserve. The bank may loan out the rest may loan out the rest

to individuals.to individuals.

The Fed sets the Reserve Ratio, the fraction of people’s money that must be kept available at the

bank.

The excess of that money is loaned out to individuals, put back into the economy, and

often ends up as deposits in other banks, possibly to be loaned out again!

The Money MultiplierExample: Assume the reserve ratio in the US is 10%

You deposit $1000 in the bank The bank must hold $100 (required reserves)The bank lends $900 out to Bob (excess reserves) Bob deposits the $900 in his bankBob’s bank must hold $90. It loans out $810 to JillJill deposits $810 in her bankSO FAR, the initial deposit of $1000 caused the CREATION of another $1710 (Bob’s $900 + Jill’s $810)

Increasing the Required Reserve Ratio lowers the Increasing the Required Reserve Ratio lowers the money supplymoney supply..

Decreasing the Required Reserve Ratio increases the Decreasing the Required Reserve Ratio increases the money supplymoney supply..

#3 Open Market OperationsOpen Market Operations - The buying and

selling of government securities (bonds) to alter the supply of money

Buying Bondsfrom open marketincreases money

supply

More liquid money in the economy

Selling Bondsbrings new investors

decreases money supply

Less liquid money in the economy

Buy Bonds = Increase Money Buy Bonds = Increase Money SupplySupply

Sell Bonds = Decrease Money Sell Bonds = Decrease Money SupplySupply