ECON 205 1st Edition Lecture 14 Outline of Last Lecture Continuation of chapter 16 Outline of Current Lecture How does money supple affect inflation and nominal interest rates Quantity theory of money Does the money supply affect real variables like real GDP or the real interest rate How is inflation like a tax Current Lecture Fed s Tools of Monetary Control Fed can change the money supply by changing bank reserves or changing the money multiplier Influence reserves Change reserve ratio Influencing the Reserve Ratio Open Market Operations OMOs purchase and sale of US government bonds by the Fed o If Fed buys a gov bond from a bank it pays by depositing new reserves in that bank s reserve account Increase in reserves leads to the bank making more loans and therefore increasing money supply o To decrease bank reserves and money supply the Fed sells gov bonds On any given day banks with insufficient reserves can borrow from banks with excess reserves o Night loans when shy of reserve requirements at the end of the day Federal Funds Rate the interest rate on these loans FOMC uses OMOs to target the fed funds rate Changes in the fed funds rate causes changes in other rates and have a large impact on the economy Graph F is the quantity of federal funds Demand comes from banks below the reserve requirement Supply comes from banks above the reserve requirement Removes reserves from the banking system decreases the supply of federal funds which leads to the increase of r Rf is the federal funds rate Influencing the Reserve Ratio Fed makes loans to banks increasing their reserves o Traditional method adjusting the discount rate to influence the amount of reserves banks can borrow Discount rate the interest rate on loans the Fed makes to banks o New method Term Auction Facility the Fed chooses the quantity of reserves it will loan then banks bid against each other for these loans The more banks borrow the more reserves they have for funding new loans and increasing the money supply Reserve ratio reserves deposits Fed sets reserve requirements o Reserve requirements regulations on the minimum amount of reserves banks must hold against deposits Decrease reserve requirements will cause a decrease in reserve ration and an increase in money multiplier Problems Controlling the Money Supply If households hold more money as currency banks have fewer reserves make fewer loans and money supply falls If banks hold more reserves than required they make fewer loans and money supply falls Fed can compensate for household and bank behavior by retaining fairly precise control over the money supply Bank Runs and the Money Supply Run on banks when people suspect their banks are in trouble they may run to the bank to withdraw their funds holding more currency and less deposits Banks don t have enough reserves to pay off ALL depositors so many have to close o So even if bank isn t really in trouble the perception of trouble to depositors will create the problem Federal deposit insurance helps prevent bank runs We had bank runs during the Great Depression