MONETARY POLICY – A central bank’s changing of the money supply to influence interest rates and assist the economy in achieving price stability, full employment and economic growth.
CONSOLIDATED BALANCE SHEET OF THE FEDERAL RESERVE BANK
- Assets – anything of monetary value owned by a firm or individual.
The two main assets of the Federal Reserve Banks are:
· Securities – They consist largely of Treasury bills, Treasury rates and Treasury bonds issued by the U.S. government to finance past budget deficits. These are part of the public debt – the money borrowed by the Federal government.
· Loans to Commercial Banks – They are assets to the Fed because they are claims against the commercial banks. Through borrowing in this way, commercial banks can increases their reserves.
- Liabilities – A debt with a monetary value; an amount owed by the firm or an individual.
3 items on the liability side of the Fed’s consolidated balance sheet:
· Reserves of Commercial Banks – They are assets on the books of the commercial banks, which still own them even though they are deposited at the Federal Reserve Banks.
· Treasury Deposits – To the Treasury these deposits are assets, to the Federal Banks they are liabilities. Treasury creates and replenishes theses deposits by depositing tax receipts and money borrowed from the public or from the commercial banks through the sale of bonds.
· Federal Reserve Notes Outstanding – When this money is circulating outside the Federal Reserve Banks, it constitutes claims against the asset of the Federal Reserve Banks. The Fed thus treats this notes as a liability.
TOOLS OF MONETARY POLICY
- Open-Market Operations – consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the general bank.
· Buying Securities
From Commercial Banks
a) Commercial banks give up part of their holdings of securities to the Federal Reserve Banks
b) The Federal Reserve Banks, in paying for those securities, increase the reserve of the commercial banks by the amount of purchase
From the Public
a) Gristly gives up securities to the Federal Reserve Banks and gets in payment a check drawn by the Federal Reserve Banks on themselves
b) Gristly promptly deposits the check in its account with the Wahoo bank
c) The Wahoo bank sends this check against the Federal Reserve Banks to a Federal Reserve Bank for collection
· Selling Securities
To Commercial Banks
a) The Federal Reserve Banks give up securities that the commercial banks acquire
b) The commercial banks pay for those securities by drawing checks against their deposits – that is, against their reserves – in Federal Reserve Banks
To the Public
a) The Federal Reserve Banks sell government bonds to Gristly, which pays with a check drawn on the Wahoo bank
b) The Federal Reserve Banks clear this check against the Wahoo bank by reducing Wahoo’s reserves
c) The Wahoo bank returns check to Gristly, reducing Gristly’s checkable deposit accordingly
- The Reserve Ratio – ability to lend
· Raising the reserve ratio
· Lowering the reserve ratio
Reserve ratio affects the money-creating ability of the banking system in two ways:
· It changes the amount of excess reserves
· It changes the size of the monetary multiplier
- The Discount Rate – The interest rate that the Federal Reserve Banks change on the loans they make to commercial banks and thrift institutions.
- Easy Money and Tight Money
· Easy money policy/ Expansionary monetary policy – Federal Reserve System actions to increase the money supply to lower interest rates and expand real GDP.
-Buy securities
-Lower the reserve ratio
-Lower the discount rate
· Tight money policy/ Restrictive money policy – Federal Reserve System actions that contracts, or restrict the growth of the nation’s money supply for the purpose of reducing or eliminating inflation.
-Sell securities
-Increase the reserve ratio
-Raise the discount rate
- Relative Importance
Of the three instruments of monetary control, buying and selling securities in the open market is the most important.
MONETARY POLICY, REAL GDP AND THE PRICE LEVEL
- Cause-Effect Chain
-Money market – demand curve for money and the supply curve of money are brought together.
-Equilibrium interest rate – is the rate at which the amount of money demanded and the amount supplied are equal.
-Investment – this curve shows the relationship between the interest rate –the cost of borrowing to invest – and the amount of investment spending.
-Equilibrium GDP – shows the impact of our three interest rates and corresponding levels of investment spending on aggregate demand.
- Effects of an Easy Money Policy – the economy must be experiencing substantial and unemployment.
- Effects of a Tight Money Policy – the higher interest rate will discourage investment, lowering aggregate demand and restraining demand-pull inflation.
MONETARY POLICY IN ACTION
It has two key advantages:
· Speed and flexibility
· Isolation and political pressure
- Focus on the Federal Funds Rate – it is the interest rate that banks charge one another to overnight loans of reserves hold at the Federal Reserve Banks.
- Problems and Complications
· Lags – monetary policy is hindered by a recognition lag and operation lag
· Changes in velocity
Velocity of money – the number of times per year the average dollar is spent on goods and services.
· Cyclical Asymmetry
- “Artful Management” or “Inflation Targeting”?
Inflation Targeting – the annual statement of a target, say 1 to 2 percent, for the economy over some period, say 2 years.
- Monetary Policy and the International Economy
- · Net Export Effect – the idea that the impact of a change in monetary policy or fiscal policy will be strengthened or weakened by the consequent change in exports.
- Macro Stability and the Trade Balance
The easy money policy, which is appropriate for the alleviation of unemployment and sugglish growth, is compatible with the goal of correcting a balance-of-trade deficit.
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