The FED and Monetary Policy 1 Fiscal Policy

The FED and Monetary Policy 1

Fiscal Policy Actions taken by Congress to stabilize the economy Business Tools Taxes Spending 4

Monetary Policy Actions taken by The Federal Reserve to stabilize the economy Business Monetary Policy = Changes in Money Supply = Federal Reserve 4

How the Government Stabilizes the Economy 14

How the FED Stabilizes the Economy These are three tools that the FED uses to shift Money Supply 15

Tools Open Market Operations Discount Rate Required 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

The Money Market (Supply and Demand for Money) 2

First, Let’s talk about the Demand for money When we talk money, I mean liquid money, in your pocket or checking account, that you can use to buy goods and services. 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 investment So, if interest rates are high, do you want to invest your money, or do you want to keep it in your pocket to spend on goods and services?

The Demand for Money At 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 At 20% interest rate there is a strong incentive to invest my money in a savings account. low demand for liquid money At 2% interest rate there is less incentive to invest, and more incentive to keep and use my money. high demand for liquid money 3

1. What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets (investments) 2. What happens to the quantity demanded when interest rates decrease? 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 When the FED adjusts the money supply to achieve macroeconomic goals 8

Tools of the FED 1. Open Market Operations 2. Discount Rate 3. Required Reserve Ratio The FED uses all these tools specifically to affect the Money Supply

The Supply for Money The U. S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) Interest Rate (ir) 20% The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy 5% This is called Monetary Policy. SMoney 2% DMoney 200 Quantity of Money (billions of dollars) 7

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Video: The FED Today 12

The role of the Fed is to “take away the punch bowl just as the party gets going” 13

Tools of the FED 1. Discount Rate 2. Required Reserve Ratio 3. Open Market Operations The FED uses all these tools specifically to affect the Money Supply

#1 Discount Rate The FED acts as a lender of last resort when banks and the economy are in financial emergencies. Discount Rate - The interest rate that the Federal Reserve charges other banks when they need to borrow money 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 _____ Decrease the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should Increase the Discount Rate (Tight Money Policy). _____

#2 The Required Reserve Ratio - the fraction of deposits that banks must keep on reserve. If you make a deposit at a bank, only some of that money has to be kept readily available in reserve. The bank may loan out the rest 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 Multiplier Example: 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 bank Bob’s bank must hold $90. It loans out $810 to Jill deposits $810 in her bank SO 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 money supply. Decreasing the Required Reserve Ratio increases the money supply.

#3 Open Market Operations - The buying and selling of government securities (bonds) to alter the supply of money Buy Bonds = Increase Money Supply Sell Bonds = Decrease Money Supply Buying Bonds from open market increases money supply Selling Bonds brings new investors decreases money supply More liquid money in the economy Less liquid money in the economy