ECON 201 1st Edition Lecture 35Outline of Last Lecture I. Effects of a Shift in SRASa. Definition of stagflationII. Accommodating an Adverse Shift in SRASIII. John Maynard KeynesIV. Monetary Policya. Definition of monetary policyb. Definition of central bankV. The Federal Reserve and Its Structurea. Definition of the federal reserveb. Definition of board of governorsc. Definition of Federal Open Market Committee (FOMC)VI. Circular Flow of Bankinga. Definition of circular flow of bankingOutline of Current Lecture I. Monetary Policy Toolsa. Definition of open-market operations (OMOs)b. Definition of discount-ratec. Definition of federal funds rated. Definition of reserve requirement regulationsII. Expansionary and Contractionary Monetary Policya. Definition of expansionary monetary policyb. Definition of contractionary monetary policyIII. Problems Controlling the Money SupplyIV. A New ResponseV. The Velocity of Moneya. Definition of velocity of moneyCurrent LectureI. Monetary Policy ToolsThese 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.There are three tools that the federal reserve uses to regulate monetary policy: open-market operations, discount rate, and reserve requirement regulations.i. Open-Market Operations (OMOs) are the purchase and sale of U.S. government bonds by the federal reserve. The federal reserve makes loans to banks and increasestheir reserves. An example of this occurred during the depression era; during the depression, the government needed money and sold bonds. More money came in, but it dried up the monetary supply.ii. The federal reserve also adjusts the discount rate, which is the interest rate on loans;this is the traditional method they use to regulate monetary policy. The federal funds rate is the interest rate banks charge each other for loans; this rate is “set” by the federal reserve. When the federal reserve changes the discount rate, banks change their prime interest rates and the family of rates follows. It is a chain, and it isa big decision for the federal reserve to change the discount rate. iii. The federal reserve sets the reserve requirement regulations, which are the minimum amount of reserves banks must hold against deposits. It is rarely used because it has such a huge effect on the economy. Since October of 2008, the federalreserve has actually paid interest on reserves.All three tools create excess reserves for the banks, which allows them to create money throughmaking loans. II. Expansionary and Contractionary Monetary PolicyExpansionary monetary policy increases the money supply while contractionary monetary policy decreases the money supply. Expansionary monetary policy increases the money supply, investment, consumption, aggregate demand, prices, and real GDP; it decreases the reserve requirements. Contractionary monetary policy decreases the money supply, investment, consumption, aggregate demand, prices, and real GDP; it increases the reserve requirements. These effects are shown in the diagrams below. The effects of expansionary monetary policy area standard recession response. Expansionary Monetary Policy: M ↑ →r ↓ → I ↑ → C ↑→ Ag ↑→ P ↑→ real GDP ↑Contractionary Monetary Policy: M ↓ →r ↑ → I ↓ → C ↓→ Ag ↓ → P ↓→ real GDP ↓III. Problems Controlling the Money SupplyIf households hold more of their money as currency and if banks hold more reserves than they are required to do, fewer loans will be made and it will lower the money supply. The federal reserve compensates for household and bank behavior to retain “fairly” precise control over themoney supply. It is important to mention that this system lives on the confidence of the people; without their confidence, bank runs occur. During 1929-1933, bank runs and closings caused themoney supply to fall 28%. Since then, federal deposit insurance has helped prevent bank runs inthe U.S. It is also possible to have a run on a country, when currency falls in that country. Some economists even claim that the 2008-2009 recession was not a recession but a depression, because it didn’t react to standard recession responses.IV. A New ResponseQuantitative easing is a new response (since November of 2008) that the federal reserve uses to purchase more government securities and “toxic” assets. It is a “hefty” tool and very different, but is not often used because of its power in the market. V. The Velocity of MoneyVelocity of money is the number of transactions in which the average dollar is used. The formula is shown below; P is price level, Y is real GDP, M is money supply, and V is velocity. The product of P and Y is nominal GDP. When more money is printed, prices increase. V =P×