ECON 1113 1st Edition Lecture 16 Outline of Last Lecture I The Monetary Sector A The Nature of Money B The Functions of Money C The Quantity Equation of Money D The Quantity Theory of Money Outline of Current Lecture I Case Study Double Digit Inflation and the Recession of 1982 II How the Federal Reserve System the Fed Controls the Money Supply MS A Institutional Background B Three Tools of Monetary Policy changes in MS to influence macroeconomic conditions Current Lecture I II Case Study Double Digit Inflation and the Recession of 1982 A The Quantity Theory of Money 1 M S V P Q B 1979 1981 a peace time 1 M S V P Q 13 0 10 3 2 Unprecedented inflation during peace 3 To combat inflation the Fed reduced the rate of growth of MS thus M S decreased C 1981 1982 1 M S V P Q 7 0 9 2 2 A negative percentage change in real output Q signifies a recession 3 When supply decreases ceteris paribus the price increases a When money supply MS decreased ceteris paribus the price increased which raises interest rates i Higher interest rates decreased the output Q in interest sensitive industries like housing and automobile sectors ii Unemployment levels rise as well How the Federal Reserve System the Fed Controls the Money Supply MS A Institutional Background about the Fed 1 A central bank which controls MS not profit seeking These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute a Not a commercial bank which is a profit seeking firm that can change MS through loans 2 Comprised of 12 district banks located throughout the US that all operate as one unit under the direction of the board of governors a The board of governors has 7 members appointed by the president and confirmed by the Senate b Janet Yellen is the current chairman of the board of governors B Three Tools of Monetary Policy changes in MS to influence macroeconomic conditions 1 Legal Reserve Requirements a The percentage currently 5 of a commercial bank s deposits that must legally be placed in reserves in the form of vault cash or reserve deposits with the District Fed Bank 2 Discount Rate a The rate of interest the District Fed charges commercial banks within the district for loans b Primarily a signal to the financial community about the future direction of interest rates 3 Open Market Options a The Fed central bank buying or selling securities primarily US government bonds on the open market b Federal Open Market Committee FOMC buys and sells securities 4 Monetary Policies to Combat Inflation a Overall Fed objective decrease M S i Raising legal reserve requirement a percentage placing more money in reserves and so that it becomes less available to the public ii Increasing discount rate making it more expensive for commercial banks to borrow money thus more expensive for their customers to borrow money implying less money loaned to the public iii The Fed operating through FOMC sells securities in the open market b Since 2009 the Fed has tried to increase employment in interest sensitive industries especially housing by increasing MS thus decreasing interest rates i How could the Fed increase MS Lowering legal reserve requirement a percentage placing less money in reserves and so that it becomes more available to the public Decreasing discount rate making it less expensive for commercial banks to borrow money thus less expensive for their customers to borrow money implying more money loaned to the public The Fed operating through FOMC buys securities in the open market 1 Quantitative Easing QE the Fed buying securities on the open market in huge quantities c Recently the European Central bank embarked on quantitative easing by buying bonds and securities like Greek government bonds
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