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Describe Monetary Policy And Its Goals – Monetary Policy Monetary policy is the intentional change in the money supply for the purpose of influencing interest rates and therefore total spending in the economy.
Presentation on theme: “Monetary Policy Monetary policy is the deliberate change in the money supply for the purpose of affecting interest rates and thus total spending in the economy.”— Presentation transcript:
Describe Monetary Policy And Its Goals
1 Monetary Policy Monetary policy is the deliberate change in the money supply for the purpose of influencing interest rates and therefore total expenditure in the economy. The goals of monetary policy are to ensure price stability, full employment and economic growth.
Money And Inflation, Feducation
The federal reserve has three (3) tools it uses (depending on what is deemed necessary at the time) to influence the banking system’s ability to create money. These are: 1. Open Market Operations 2. Reserve Rate Change 3. Discount Rate
3 Open Market Operations The federal reserve’s open market operations involve the purchase or sale of government securities to commercial banks or the public. This is the MOST IMPORTANT tool for influencing the money supply.
The Fed will do this to increase reserves in the banking system. Here’s how it works: If the Fed buys government securities (bonds) held by banks, the following happens: A. Banks sell bonds to the Fed, reducing their assets by that amount. B. The Fed then pays the banks for their bonds by increasing the interest rate. assets as RESERVEs by the same amount C. This will increase the ability of banks to lend, increasing the money supply, lowering interest rates as the money supply increases, thus increasing C and Ig. The fed funds rate will fall. This is the target the Fed is aiming for.
5 Buying bonds part II If the Fed buys government bonds from the public (you or me) the following happens: A. we sell the bonds to the feds and receive a check from the Fed for that amount B. We deposit this check at our local bank C. The resulting bank’s withdrawable deposit increases, which increases its reserves. D. This results in an increase in lending, which increases the money supply, lowering interest rates, which increases C and Ig. The fed funds rate will fall, and that’s the target the Fed is aiming for.
Circular Flow Model
6 Buying bonds part III A note: When the Fed buys bonds from a bank, all of the money the bank receives will be transferred to reserves. The bank does not need to make a provision for this money since it is not a withdrawable deposit. When individuals deposit Fed money into the bank in exchange for bonds, the bank must keep a percentage of it as a reserve. This means that the money creation potential is slightly less in the second scenario. In practice, this does not affect the expansionary nature of the policy. In both cases, bank reserves increase.
7 Bond Sale The Fed’s bond sale is a contractionary monetary policy. The aim is to reduce bank reserves and prevent growth in the money supply.
8 Selling bonds to banks When the Fed sells bonds to banks, the following occurs: A. The Fed sells bonds and receives a check from the bank for its cash reserves. B. Bank reserves are reduced by this amount. C. This will reduce the bank’s (banking system) ability to lend, reduce the money supply, increase interest rates, and lower C and Ig. The Fed funding rate will increase, this is the Fed’s goal.
If the Fed sells bonds to the public, the following occurs: A. individuals or companies buy the bonds and write checks to the Fed. B. Checks reduce banks’ withdrawable deposits, reducing excess reserves in the process. C. This reduces the ability of banks (the banking system) to lend, reduces the money supply, raises interest rates, and reduces C and Ig. The purpose of the policy change is to increase the federal funds rate.
Interest Rate Parity (irp) Definition, Formula, And Example
The answer is the price of bonds and the interest rate of bonds. As we can see, bond prices and interest rates are inversely related. So when the Fed buys bonds, demand for them increases, the price rises and the interest rate falls. This encourages banks and the public to sell bonds to the FED.
11 Why…? On the other hand, when the Fed sells bonds in the open market, the additional supply of bonds lowers the price and increases the interest rate, making them more attractive to potential buyers. THE MAIN PURPOSE of the FED is not to enrich bond buyers or sellers, but to CHANGE THE FED FUNDS RATE as a means of changing the money supply.
The Fed can also manipulate banks’ reserve requirement ratio to affect the amount of money banks MUST hold. This will affect the total amount of excess or loanable funds in the system
Suppose the federal reserve increases the reserve ratio from 20% to 30%. If the bank has $100,000 in deposits, it will keep $20,000 in reserves below the old rate. But under the new regulation, he will have to keep $30,000, which will significantly reduce the amount he can lend.
Comparison Of Policy Goals, Governance Mechanisms And Accountability…
A. Banks would lend less B. Banks would withdraw old loans Generally, the effect would be the same as for selling securities. Increasing the reserve would constitute contractionary monetary policy. It will reduce banks’ excess reserves, reduce lending, reduce the money supply, increase interest rates, and reduce C and Ig.
Let’s assume the Fed reduces banks’ reserve requirement ratio from 20% to 10%. If the bank had $100,000 in deposits, it would have to keep $20,000 below the old rate, but only $10,000 below the reduced rate. ratio. This will significantly increase the amount it can lend.
Changes the amount of excess reserves banks can lend to Changes the size of the money multiplier Note that the Money Multiplier is 1/Required Reserve Ratio (required reserve ratio) This tool is not used very often due to its power and dramatic effects. .
17 Discount Rate The Fed is a central bank. This is why it is known as the lender of last resort. This means that if a bank experiences an unexpected cash shortage, it can borrow those funds from the Federal Reserve. The Fed will charge interest to the bank. This rate is called DISCOUNT rate.
International Monetary Fund
Since this borrowed money does not need to be kept in reserve, all of this money will be ready to be lent to the bank. This increases bank reserves, lowers interest rates, increases the money supply, and hence C and Ig. Because the Fed sets the discount rate, it can and does use it to encourage banks to borrow or to discourage banks from borrowing. This will affect banks’ ability to provide loans. So this can be either expansionary or contractive depending on the situation.
19 Easy Money Easy money is an expression of expansionary Monetary Policy Easy Money consists of using 3 tools: BUY SECURITIES (BONDS): This allows banks to increase reserves REDUCES THE RESERVE RATE: This allows banks to increase excess reserves. DISCOUNT RATE: This allows banks to increase their reserves with $ from the Fed
20 PURPOSE The aim of the EASY monetary policy is to make bank loans cheaper by reducing interest rates and to make them more available by increasing the money supply, increasing output, AD and employment.
21 TIGHT MONEY Tight money is an expression of contractionary Monetary Policy Using Tight Money 3 tools consists of the following: SELL SECURITIES: Decreases bank reserves RAISE THE RESERVE RATE: Decreases bank reserves RAISE THE DISCOUNT RATE: This hinders the ability of banks to borrow. you have extra money to lend
Open Market Operations: Explained With Examples
22 PURPOSE The purpose of TIGHT MONETARY POLICY is to reduce bank reserves, reduce the ability of banks to lend, reduce the money supply, increase interest rates, reduce or stabilize the price level, reduce production, reduce employment and reduce AD.
Selling and Buying Bonds in the Open Market IS MOST IMPORTANT. It is flexible in that small or large amounts of bonds can be bought and sold. This is very subtle and less noticeable to the public. The Fed also has a huge amount of bonds to sell and a lot of money to buy.
24 Relative Importance Changing Reserve Requirements Perhaps the main reason why the Fed uses this tool cautiously is that it can seriously affect bank earnings. Reserves do not earn interest, and not having money to lend or having too much money but not being able to lend is essentially the same thing for a bank, so the Fed rarely uses this approach.
The discount rate is often raised or lowered by the Fed, but it has little effect this way because banks rarely hold more than a few percentage points of reserves. The truth is that most of the borrowing by banks from the Fed is a result of banks wanting to buy bonds in open market operations. Discount rate is more of an announcement
Monetary Policy Definition, Types, Instruments, And Objectives
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