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Economics 14

Lecture 19: Monetary Policy

Federal Reserve
tools of monetary policy
expansionary monetary policy
contractionary monetary policy

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Federal Reserve

Monetary policy involves control of the quantity of money in the economy. The Federal Reserve is responsible for monetary policy in the United States.

Click here for an introduction to the Federal Reserve System from the St. Lous Fed.

organization:

1. District Banks
2. Board of Governors (chairman is Alan Greenspan)
3. Federal Open Market Committee

Tools of Monetary Policy

1. open market operations

Open market operations is the buying and selling of government bonds by the Federal Reserve. When the Federal Reserve buys a government bond from a bank, that bank acquires money which it can lend out. The money supply will increase. An open market purchase puts money into the economy.

2. discount rate

When the Federal Reserve makes a loan to a member bank, the loan is called a discount loan. The interest rate on a discount loan is called the discount rate.

Lowering the discount rate encourages banks to take out more discount loans while raising the rate discourages banks from borrowing from the Fed. Therefore, lowering the discount rate puts money into the economy; raising the discount rate takes money out of the economy.

3. reserve ratio

The reserve ratio is the percentage of deposits banks are required to hold as vault cash and not loan out.. Lowering the reserve ratio allows banks to loan out a greater fraction of deposits and the money supply would increase. Raising the reserve ratio would cause the money supply to shrink.

Expansionary Monetary Policy

To increase the money supply, the Federal Reserve can

• buy government bonds (an open market purchase)
• lower the discount rate
• lower the reserve ratio

Expansionary monetary policy is appropriate when the economy is in a recession and unemployment is a problem.

Changes in the money supply affect the economy through a 3 step process.

1. an increase in the money supply causes interest rates to fall
2. the decrease in interest rates causes consumption and investment spending to rise and so aggregate demand rises
3. the increase in aggregate demand causes real GDP to rise

Contractionary Monetary Policy

To decrease the money supply, the Federal Reserve can

• sell government bonds (an open market sale)
• raise the discount rate
• raise the reserve ratio

Contractionary monetary policy is appropriate when inflation is a problem.

1. a decrease in the money supply causes interest rates to rise
2. the increase in interest rates causes consumption and investment spending to fall and so aggregate demand falls
3. the decrease in aggregate demand causes real GDP to fall

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31