Monetary Policy

The Federal Reserve and Monetary Policy

How the Fed addresses its Dual Mandate

Keep inflation at 2%
Room for growth
Predictable

​​Price Stability

Unemployment rate between 3,5%-4.5%
(Frictional Employment)
Encourages Job Growth

Full Employment

Money Creation

Banks create money by making loans
More loans creates more money in the system
More money creates more demand

​Fractional Banking

Money is deposited in a bank
Banks loan out available money
New loans allow more spending and others to deposit money
Banks use new deposits to make more loans
New loans allow more spending and so on and so on

Using bank deposits to make loans allows the creation of money

Fractional Banking

Monetary Policy

​Controlling the economy by controlling money supply

The Fed wants more money circulating when the economy is slow and wants less money circulating when the economy is over-heated

Easy money
Lower interest rates
Higher money supply
Increase spending

Expansionary Policy

Tight money
Higher interest rates
Lower money supply
Slow spending

Contractionary Policy

Monetary Policy

• Interest rates are the price of money

• Lower interest rates make borrowing cheaper

• Higher interest rates make borrowing more expensive

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The Fed controls the money supply by influencing interest rates

Match

Match the following economic conditions with the Fed's response

• High Inflation

• High Unemployment

• Low unemployment and high inflation

• High unemployment and low inflation

Lower the money supply

Raise the money supply

Tighten the money supply to slow prices

Easy money to lower the cost to borrow

• Lower the money supply

• Raise the money supply

• Tighten the money supply to slow prices

• Easy money to lower the cost to borrow

Monetary Policy Tools

Monetary Policy Tools

Reserve Requirements

This is the percentage of bank deposits that the Fed requires banks to keep on deposit and CANNOT use to make loans

Minimum amount member banks must keep on deposit at a bank
Lower minimum gives banks more money to lend
Higher minimum gives banks less money to lend

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​Reserve Requirement

Multiple Choice

What is the reserve requirement?

• The amount of money banks owe the government

• The amount of money banks have to hold

• The amount of money banks can borrow

• The amount of money banks can invest

Reorder

How the Fed slows inflation with the Reserve Requirement (RR)

• Prices begin to rise from increased demand

• Fed increases RR

• Banks have less money to lend

• Borrowing is more expensive

• Demand begins to fall

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Reorder

How the Fed helps lower unemployment with the Reserve Requirement (RR)

• Decreased demand for products lowers sales

• Businesses lay off workers

• Fed lowers RR

• More money means lower interest rates

• People begin to buy more

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Monetary Policy Tools

Discount Rate

Interest rate the Fed charges to commercial banks to borrow money

Interest rate the Fed charges member banks to borrow money
Higher rates increase costs (Less borrowing)
Lower rates decrease costs
(More borrowing)

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Discount Rate

Multiple Choice

What is the "discount rate"

• Interest rate the Fed charges commercial banks

• The rate of inflation

• The rate of return on investments

• The rate of exchange between two currencies

Reorder

How the Discount Rate can help lower inflation

• Increase Discount Rate

• Member banks reluctant to borrow from Fed

• Banks have less money for loans

• Consumer intrest rates rise on loans

• Less demand, buying slows, inflation slows

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How the Discount Rate can help lower high unemployment

• High unemployment

• Fed lowers discount rate

• Member banks willing to borrow from Fed

• Banks have more money for loans and interest rates fall

• More businesses willing to borrow money and expand business and jobs

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Fed removes money from banks and decreases the money supply

Fed sells securities

Fed adds money into the banks and increases the money supply
Buy Bonds - Bigger money supply

Fed buys securities

Monetary Policy Tools: Open Market Operations (Gov't securities and bonds)

The Federal Open Market Committee (FOMC)

This is the body that sets the guide for where the Fed would like interest rates that help move the economy through controlling the money supply
This is monetary policy

Guided by the Federal Open Market Committee (FOMC)

The FOMC sets a target for interest rates through the Federal Funds Rate
The Federal Funds Rate is the interest member banks pay to borrow money overnight from other banks
Higher rates make borrowing more expensive
Lower rates make borrowing less expensive
This sets a base for other interest rates

Reorder

How the Fed can use open market securities to control inflation

• High prices from high demand

• Fed sells securities

• Banks give money to Fed in exchange for securities

• Banks have less money for loans and interest rates rise

• Higher interest rates slow demand and prices slow

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How the Fed can use open market operations to lower unemployment

• Unemployment high from low demand

• Fed buys securities and puts more money into banks

• Banks have more money for loans and interest rates fall

• Lower interest rates lower costs of borrowing and people borrow more money

• Increased demand for goods increase hiring for workers

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Monetary Policy Tools

Interest on Excess Reserves (IROB)

Fed pays interest to member banks on their reserves
(Think of this like interest on a checking account)
A higher interest rate encourages banks to keep their money in reserve
A lower interest rate encourages banks to make more loans

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​Investment Options for Member Banks to Earn Interest

Earn interest from the Fed - IORB
Interest on Reserve Balance

​​Deposit at the Fed

Earn interest on loans to other banks - FFR
Federal Funds Rate

Loan to Another Bank

Earn interest rate paid by the government

Invest in Treasuries

​Options for Banks to Invest their Deposits

The Fed 's Role

The Fed can conduct monetary policy by guiding interest rates and giving banks options to make money on excess reserves

Now, banks can decide to loan money and make interest on loans or invest and earn interest on those investments