Unit 4: Money, Banking, and Monetary Policy
How the Government Stabilizes the Economy
How the FED Stabilizes the Economy These are three Shifters of Money Supply
3 Shifters of Money Supply 4
3 Shifters of Money Supply The FED adjusts the money supply by changing any one of the following: 1. Setting Reserve Requirements (Ratios) 2. Lending Money to Banks • Discount Rate 3. Open Market Operations • Buying and selling Bonds The FED is now chaired by Janet Yellen
#1. The Reserve Requirement • Banks don’t just store the money that people deposit back in a vault. They loan out a lot of that money so that they can make a profit from interest. (Otherwise a bank would just be a glorified mattress or safe. ) • They must keep a portion on hand, by law. This portion is the Required Reserve Ratio set by the FED (10% in U. S. ).
#1. The Reserve Requirement • Banks must keep this money on hand for people who want to withdraw some money from their checking accounts. • If everyone wants to withdraw their money at once, this is called a “Bank Run, ” and it’s very bad. The bank would go under and fold because it doesn’t just keep everyone’s money on hand all the time. • Bank runs are contagious because they make people doubt the safety of the banking system.
The Money Multiplier The other 90% not held in Required Reserves is called Excess Reserves. This is the amount banks an loan out to try to earn a profit from interest. Think of the Reserve Ratio as a Bank’s MPS Think of the Excess Reserves as a Bank’s MPC Money Multiplier Spending Multiplier 1 RR 1 MPS =
The Money Multiplier HEADS UP! The FIRST DEPOSIT doesn’t create new money because it was already counted in the money supply (M 1). The NEW money starts with the first loan (or you could think of it as the second deposit). So, if $100 is the initial deposit, and the money multiplier is 10, then it wouldn’t be $100 x 10, it would be $90 x 10 = $900 in M 1 money created FROM the initial deposit. Practice: If the Reserve Requirement is 20%, and someone deposits $500 in their bank, what is the most amount the money supply would increase?
Using The Reserve Requirement 1. If there is a recession, what should the FED do to the reserve requirement? (Explain the steps. ) Decrease the Reserve Ratio 1. Banks hold less money and therefore can loan out more money (excess reserves) 2. This multiplies and leads to an increase in the money supply in circulation 3. Money supply increases, interest rates fall, AD up 2. If there is inflation, what should the FED do to the reserve requirement? (Explain the steps. ) Increase the Reserve Ratio 1. Banks hold more money and have less excess reserves 2. This multiplies and leads to a decrease in the money supply in circulation 3. Money supply decreases, interest rates up, AD down
#2. The Discount Rate is the interest rate that the FED charges commercial banks. Example: • If Bank of America needs $10 million, they borrow it from the U. S. Treasury (which the FED controls) but they must pay it bank with 3% interest. To increase the Money supply, the FED should DECREASE _____ the Discount Rate. To decrease the Money supply, the FED should INCREASE _____ the Discount Rate.
#3. Open Market Operations • Open Market Operations is when the FED buys or sells government bonds (securities, T-bills). • This is the most important and widely used tool of monetary policy When the FED sells bonds to people, they are taking money out of banks’ and people’s hands and giving them IOUs. When the FED buys back bonds, they are taking the IOUs and putting money back in the banks’ and people’s hands.
#3. Open Market Operations To increase the Money supply, the FED should BUY _____ government securities. To decrease the Money supply, the FED should SELL _____ government securities. How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply
Open Market Operations and the Multiplier NOW, when the FED buys back bonds and puts money back into the economy, the NEW money starts with the initial amount spent by the FED because it wasn’t counted as M 1 until the FED injected it. Practice: So, if the Reserve Ratio is 20%, and the FED buys back $500 worth of bonds, then by how much could the M 1 money supply increase?
Practice Don’t forget the Monetary Multiplier!!!! 1. If the reserve requirement is. 5 and the FED sells $10 million of bonds, what will happen to the money supply? 2. If the reserve requirement is. 1 and the FED buys $10 million bonds, what will happen to the money supply? 3. If the FED decreases the reserve requirement from. 50 to. 20 what will happen to the money multiplier?
Federal Funds Rate The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves. (It is usually 1% lower than the discount rate. ) The FED can’t simply tell banks what interest rate to use. Banks decide on their own. The FED uses open market operations to influence the federal funds rate, just like Nominal interest rates are affected in the Money Market.