Slide 1CHAPTER OUTLINEThe Federal ReserveGoals of Monetary PolicyMeasures of the Amount of Money in the EconomyThe Banking SystemTraditional and Ordinary Tools of Monetary PolicyTools of Monetary Policy: Open Market OperationsTools of Monetary Policy: Targeted Interest RatesTools of Monetary Policy: The Reserve RatioMoney CreationModeling Monetary PolicyExpansionary Monetary PolicyContractionary Monetary PolicyMonetary TransmissionNew Tools of Monetary PolicyCentral Bank IndependenceFed History 1975-1983Fed History 1984-1990Fed History 1990-2003Fed History 2004-2007Fed History 2008-2014Proportion of Bank Reserves Excess & Required ReservesFederal Reserve HoldingsKey Interest RatesThe Inflation/Deflation DebateAggressive Fed Action on the Federal Funds Rate (1999-2012)Inflation TargetingYield Curves in Recent History10-1©2015 McGraw-Hill Education. All Rights Reserved ©2015 McGraw-Hill Education. All Rights Reserved Chapter 10Monetary Policy10-2©2015 McGraw-Hill Education. All Rights Reserved CHAPTER OUTLINE•Goals, Tools and a Model of Monetary Policy•Central Bank Independence•Modern Monetary Policy10-3©2015 McGraw-Hill Education. All Rights Reserved The Federal Reserve•Nicknamed “The Fed”.•Established in 1913 by Congress primarily as the authority for bank regulation.•The power to “coin money” was granted to Congress by Article 1 Section 8 of the US Constitution but this power was delegated to the Federal Reserve.•The power to regulate the amount that exists in the economy was granted to the Federal Reserve in an attempt to avoid the boom and bust periods of the late 1800s.•This power allows the Federal Reserve to alter interest rates without political interference. •There are 12 regional Federal Reserve Banks•Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, St. Louis, Kansas City, Chicago, Dallas, Minneapolis, and San Francisco10-4©2015 McGraw-Hill Education. All Rights Reserved Goals of Monetary Policy•Provide sufficient money to the economy so that it may grow at a sustainable rate.•Dampen the impact of the business cycle.•Control Inflation10-5©2015 McGraw-Hill Education. All Rights Reserved Measures of the Amount of Money in the Economy•Monetary Aggregate: a measure of the quantity of money in the economy•The commonly used ones are •M1 =cash+coin and checking accounts•M2=M1+saving accounts+ small CDs10-6©2015 McGraw-Hill Education. All Rights Reserved The Banking System •When a bank takes a deposit into an account on which a check can be written, it must place a percentage of that deposit on reserve at a Federal Reserve bank. That percentage is called the reserve ratio.10-7©2015 McGraw-Hill Education. All Rights Reserved Traditional and Ordinary Tools of Monetary Policy•Open Market Operations•A relatively fine tool that can be used to make small adjustments. These adjustments can be daily and often occur without much fanfare.•Targeted Interest Rates•A relatively blunt tool that can be used to make large adjustments. In typical years, changes in targeted interest rates a few times per year. •Reserve Ratio•A rather blunt tool that is only used when very large adjustments are in order.10-8©2015 McGraw-Hill Education. All Rights Reserved Tools of Monetary Policy: Open Market Operations•The Fed buys US government debt in order to get cash into the economy.•The Fed sells US government Debt in order to get cash out of the economy.•More money in the economy puts downward pressure on interest rates.10-9©2015 McGraw-Hill Education. All Rights Reserved Tools of Monetary Policy:Targeted Interest Rates•The Fed seeks to influence the Federal Funds Rate (the rate at which banks borrow from one another to meet reserve requirements)•Fed Loans Directly to Banks•Banks with good credit pay the primary credit rate and can borrow unlimited amounts.10-10©2015 McGraw-Hill Education. All Rights Reserved Tools of Monetary Policy: The Reserve Ratio•The Fed directly controls the percentage of deposits that banks must have at their regional Fed bank.10-11©2015 McGraw-Hill Education. All Rights Reserved Money Creation•The banking system can create more “money” than physically exists in the form of coin and cash.•The banking system creates money by a series of loans. •Person 1 makes a $1000 deposit at Bank 1•Bank 1 loans Person 2 $900 who buys something from Person 3 •Person 3 makes a $900 deposit in Bank 2.•Bank 2 loans $810 to Person 4 who buys something from Person 5….. and so on.•In the end there are deposits totaling $10,000 ($1,000+$900+$810+$729+....) that resulted from that initial $1000.10-12©2015 McGraw-Hill Education. All Rights Reserved Modeling Monetary Policy•If the Fed wants to expand the economy it can•buy bonds•decrease the Federal Funds or Discount Rate•lower the reserve ratio.•This increases the supply of loanable funds. This lowers interest rates which increases aggregate demand.•If the Fed wants to contract the economy it can •sell bonds•increase the Federal Funds or Discount Rate•raise the reserve ratio.•This decreases the supply of loanable funds. This raises interest rates which decreases aggregate demand.10-13©2015 McGraw-Hill Education. All Rights Reserved Expansionary Monetary PolicyRGDPInterest Rates Price LevelLoanable FundsSASAD1DrS’r’AD210-14©2015 McGraw-Hill Education. All Rights Reserved Contractionary Monetary PolicyLoanable Funds Interest rate Price LevelRGDPSASAD1DrAD2S’r’10-15©2015 McGraw-Hill Education. All Rights Reserved Monetary Transmission•The Monetary Transmission Mechanism is the means by which changes in the interest rate impact the overall economy through changes in business investment and consumer spending.•The Fed can impact the interest rate with monetary policy.•The Fed cannot count on interest rates changing business investment and consumer spending.•When the Monetary Transmission Mechanism fails, you have a liquidity trap.10-16©2015 McGraw-Hill Education. All Rights Reserved New Tools of Monetary Policy•Purchases of Commercial Paper, short term debt of corporations.•Purchases of longer term Federal Treasuries•Purchases of mortgage backed securities.10-17©2015 McGraw-Hill Education. All Rights Reserved Central Bank Independence•Countries with Central Banks (the general name for institutions like the US Federal Reserve) that are more independent of political control have higher rates of