Monetary Policy Tools Monetary Policy Federal Reserve Act

Monetary Policy Tools

Monetary Policy • Federal Reserve Act of 1913 created the Federal Reserve System – “The Fed” provides the U. S. banking system with the stabilizing influence of a central bank – 1977 amendment: to “promote effectively the goals of maximum employment, stable prices, and moderate longterm interest rates” • The Fed conducts monetary policy – Creates quantity of money that responds to the demands of the economy – Changing short-term interest rates and quantity of money [Note: we will not have a discussion of institutional aspects of money. ]

The Fed • Congress established as an independent organization • Income from investments and banking services • Three components: – The Board of Governors • sets overall direction of the Fed and its policies • 7 members appointed to 14 year terms by the president with the advise and consent of the Senate – The Federal Open Market Committee (FOMC) • conducts monetary policy • 12 members, 7 members from the Board plus 4 rotating district bank presidents and the president of the NY District Bank – The Federal Reserve Banks • regulates and provide a variety of services for banks • 12 regional banks

Open Market Operations • Primary tool to manage money supply – Currency—dollar bills and coins issued by the Federal Reserve System and the Treasury – Deposits at commercial banks and other depository institutions • Buy and sell government securities (Treasury bonds and bills) to commercial banks and general public • Does not issue government securities, can obtain in the open market • Open market operations put currency, Federal Reserve notes, into or out of circulation • Example: When you buy a bond from the Fed for $10, 000, you write a check and take money out of the economy

Reserve Ratio • Used infrequently • Banks hold some fraction of deposits on reserve to meet customers’ cash needs • Banks must meet the Fed’s reserve requirements – Current reserve requirement: about 10% – Banks hold at least $10 for every $100 of deposits • Alter reserve requirement, change money supply – Decrease required reserves increases money in circulation – Increase required reserves decreases money in circulation • some banks sell securities or call in loans • disruptive to customers

Discount Rate • Discount Rate: interest rate at which the Fed loans money to banks • Many short term interest rates tied to it • Discount rate changes move money supply in opposite direction – Increases in discount rate decrease money supply by decreasing borrowing (interest rates rise) – Decreases in discount rate increase money supply by increasing borrowing (interest rates fall) • Changes in discount rates foreshadow the Fed’s policy intentions

Expansionary Monetary Policy • Increase money supply when economy “too slow” – Buy securities (open market operations) – Reduce reserve ratios (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 tied to it fall) • Interest rates fall, spending increases – Plant and equipment (by firms) – New housing – Consumer durables (especially autos) • Increased spending stimulates production, which reduces unemployment and increases GDP, which increases income, which stimulates spending…

Contractionary Monetary Policy • Decrease money supply if economy “too fast” – Sell securities (open market operations) – Increase reserve ratio (not likely) – Raise discount rate • Contractionary monetary policy effective with rapidly increasing GDP and inflation • Decreases investment and slows economic expansion • If economy sluggish, recession will deepen • Cost-push inflation, tight (contractionary) policies have little impact on slowing inflation

Monetary Policy in Action • Many argue price stability is the Fed’s primary goal • If the economy tends toward full employment, monetary policy’s greatest impact is on price level • Tradeoffs can exist between unemployment and inflation – Unemployed means not enough money to spend and the Fed can stimulate spending through expansionary policies – But too much money chasing too few goods increases prices (inflation) • Excessive growth in money supply a root cause of inflation – Friedman argued that given long term impacts of fluctuations in money supply, best is constant increase – 3% per year “the rule”