Monetary Policy

Regulating Money Supply

1. Discount Rate Changes• Interest rate at which Banks borrow directly from the Fed

• It is only used in an “emergency” (currently 0.75%)

• Fed can simply raise or lower discount rate

2. Open Market Operations (to change MS which moves the federal funds rate)

– Process of buying or selling government bonds to change money supply

– Change in MS alters the federal funds rate (currently 0.0%)

– Federal Funds Rate= rate banks borrow directly from each other at

2-Tools of Monetary Policy

GDP

2 Types of Monetary Policy

• LOOSE Monetary Policy– Goal: to increase the money supply– MS ↑ => Short Term Interest rates ↓ => AD ↑ => GDP ↑

• TIGHT Monetary policy– Goal: to decrease the money supply– MS ↓ =>Short Term Interest rates ↑ => AD ↓ => GDP ↓

PriceLevel

RealGDP

AS1AS1

AD1AD1AD1

GDP

The Money Market

MS

MD

InterestRate

Qty $

The Money Market

Demand for money is downward sloping as interest rates ↓ more $ is demanded

Supply of Money is fixed by the Fed

Fed “controls” money supply throughmonetary policy

Model of the federal funds interest rate

Monetary Policy Worksheet

• Graphing both MS & AD/AS

6

• Step #1: Lower the discount rate

• Step #2: Use Open Market Operations to increase money supply--the Fed Buys government bonds

Federal Reserv

e

Government bonds

Money supply ↑

Example: Loose Monetary Policy

Solution: Loose Monetary Policy

Affects AD

Inflation

RealGDP

AD1

Economic Situation GDP growth = -1.0%, Unemployment = 10.0%Little to no inflation

AS1MS2

------------------i2 MD

InterestRate

Qty of $

MS1

---------i1AD2

GDPGDP

↓ Discount Rate Buy Bonds => ↑ MS => ↓ Federal Funds Rate

Lower interest rates =>More Loans taken by Consumers & Business C ↑ + I ↑ => so AD ↑

8

• Step #1: Raise the discount rate

• Step #2: Open Market Operations– to DECREASE

money supply Fed SELLS government bonds

Federal Reserv

e

Government bonds

Money supply ↓

Tight Monetary Policy

Solution: Tight Monetary Policy

Affects AD

Inflation

RealGDP

AD2

Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3.0%

AS1MS1

MD

InterestRate

Qty of $

MS2

---------------i1---------i2 AD1

End Result: Lower GDP & less inflation!

GDPGDP

↑ Discount Rate Sell Bonds ↓MS => ↑Federal Funds Rate

Higher interest rates =>Less Loans taken by Consumers & Business C ↓ + I ↓ => so AD ↓

Stimulus Debates• Economists argue over the benefits versus costs of Loose

Monetary Policy

Benefits Costs/Risks

AD1AD1

Inflation

RealGDP

AS1AS1

Federal Reserve in action 1999 - 2012

LooseMonetary Policy

http://www.gocomics.com/accounts/new?ref=nyt

Bernanke Interview #1 (2009)• http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?ta

g=mncol;lst;1

AD1AD1

Inflation

RealGDP

AS1AS1

Please watch Part I if you were absent Friday 4/18th

Bernanke Interview #2 (2010)

AD1AD1

Inflation

RealGDP

AS1AS1

http://www.youtube.com/watch?v=LxSv2rnBGA8

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