Interest Rates and Monetary Policy - Demand and Supply of money o Money demand- the amount of money demanded by individuals, businesses, etc.o Money Supply- the amount of money In circulation o Price of Money- the opportunity cost of holding money- interest rates We will assume one interest rate - The demand for moneyo Transaction demand: Money used as a medium of exchange Determined by nominal GDP Not affected by the interest rate o Asset Demand: Money people want to hold as a store of value As the opportunity cost of holding money increases people hold less money The interest rate is the is the opportunity cost of moneyo Total Money Demand= Asset + Transaction o- Supply of Moneyo The Federal Reserve and Banking System Central Bank: An institution that oversees the banking system and regulates the money supply Monetary Policy: The setting of the money supply by policymakers in the central bank The Federal Reserve (Fed): The central bank of the United Stateso- Market for Moneyo- Monetary Policy o FOMCo Dual Mandate Control: unemployment and inflation- Keep unemployment low- Keep inflation low Conflicting mandates- When there is more money, business are able to take out loans and expand production – leads to higher inflation - When there is less money, it is difficult for businesses and individuals to take out loans, but lower inflation o Tools of Monetary Policy Open Market Operations: the purchase and sale of U.S. government bonds by the Fed To increase the money supply, the Fed BUYS government bonds, paying with new dollars- Which are deposited in banks, increasing reserves, - Which banks use to make loans, causing the money supply to expand To reduce the money supply, the Fed SELLS government bonds, taking dollars out of circulation, decreasing the money supply Reserve Requirements (RR): affect how much money banks can use to make loans To increase the money supply, Fed REDUCES RR- Banks can make more loans from each dollar of reserves- Which increases the money multiplier and the money supply To reduce the money supply, the Fed RAISES RR and the process works in reverse The Discount Rate: the interest rate on loans the Fed makes to banks When banks are running low on reserves, they may borrow reserves from the Fed To increase the money supply, the Red can - Lower the discount rate- Encouraging banks to borrow more reserves from the Fed To reduce the money supply the Fed can- Raise the discount rate Term Auction Facility- Introduced in December 2007 - Banks bid for the right to borrow reserves - Twice a month the Fed auctions off the right to borrow reserves for 28 and 84 day periods- Allows the red to guarantee that the amount of reserves it wishes to lend will be borrowed- They can sell more reserves at a lower price to increase the money supply Open market operations are the most important and most often used Reserve ratio were last changed in 1992 Discount rate was a passive tool- Banks can also lend to other banks at Federal Funds Rate: Targeted with the discount rate- Fed is the “lender of last resort”- helping failing
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