ECON 1113 1st Edition Lecture 16 Outline of Last Lecture I. The Monetary SectorA. The Nature of MoneyB. The Functions of MoneyC. The Quantity Equation of MoneyD. The Quantity Theory of MoneyOutline of Current Lecture I. Case Study: Double Digit Inflation and the Recession of 1982II. How the Federal Reserve System (the Fed) Controls the Money Supply (MS)A. Institutional BackgroundB. Three Tools of Monetary Policy (changes in MS to influence macroeconomic conditions)Current LectureI. Case Study: Double Digit Inflation and the Recession of 1982A. The Quantity Theory of Money1.% ∆ MS+% ∆V =% ∆ P+ % ∆QB. 1979-1981: a peace time1.% ∆ MS+% ∆V =% ∆ P+ % ∆Q  13% + 0% = 10% + 3%2. Unprecedented inflation during peace3. To combat inflation, the Fed reduced the rate of growth of MS, thus% ∆ MS decreasedC. 1981-19821.% ∆ MS+% ∆V =% ∆ P+ % ∆Q  7% + 0% = 9% + -2%2. A negative percentage change in real output (Q) signifies a recession3. When supply decreases, ceteris paribus, the price increasesa. When money supply (MS) decreased, ceteris paribus, the “price” increased, which raises interest ratesi. Higher interest rates decreased the output (Q) in “interest sensitive” industries, like housing and automobile sectorsii. Unemployment levels rise as wellII. How the Federal Reserve System (the Fed) Controls the Money Supply (MS)A. Institutional Background about the Fed1. 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 loans2. Comprised of 12 district banks located throughout the US that all operate as one unit under the direction of the board of governorsa. The board of governors has 7 members appointed by the president and confirmed by the Senateb. Janet Yellen is the current chairman of the board of governorsB. Three Tools of Monetary Policy (changes in MS to influence macroeconomic conditions)1. Legal Reserve Requirementsa. The percentage (currently 5%) of a commercial bank’s deposits that must legally be placed in reserves in the form of vault/cash orreserve deposits with the District Fed Bank2. Discount Ratea. The rate of interest the District Fed charges commercial banks within the district for loansb. Primarily a signal to the financial community about the future direction of interest rates3. Open Market Optionsa. The Fed (central bank) buying or selling securities, primarily US government bonds, on the open marketb. Federal Open Market Committee (FOMC): buys and sells securities4. Monetary Policies to Combat Inflationa. Overall Fed objective: decrease % ∆ MSi. Raising legal reserve requirement (a percentage), placing more money in reserves and so that it becomes less available to the publicii. 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 publiciii. The Fed, operating through FOMC, sells securities in the open marketb. Since 2009, the Fed has tried to increase employment in “interest sensitive” industries, especially housing, by increasing MS, thus decreasing interest ratesi. 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 expensivefor 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 securitiesin the open market1. Quantitative Easing (QE): the Fed buying securities on the open market in huge quantitiesc. Recently, the European Central bank embarked on quantitative easing by buying bonds and securities (like Greek government