CH 14: Monetary policy

Instruments of monetary policy

1. Open market operations 2. Discount policy 3. Required reserve ratio Overall it is a difficult job because they can't influence it directly. They indirectly influence for companies to create more jobs, GDP growth and inflation

Required reserve ratio conclusion

1. Whenever banks gain reserves, they make new loans and the money supply expands 2. Whenever bank lose reserves they reduce their loans and the money supply contracts

Monetary policy

Actions the central bank takes to manage the money supply and interest rates to pursue it's economic objectives

Quantitative Easing (QE)

An unconventional monetary policy in which a CB purchases government securities or other securities from the market in order to lower interest rates and increase the money supply

FED uses federal funds rate

As a monetary policy target: control this interest rate through open market operations Believes that changes in this rate will affect economic variables that are related to its monetary policy goals

How instruments of monetary policy work

Short-term interets rate -> GDP growth -> objective stable prices

Interest rate on financial asset

high interest rate -> high opportunity cost -> quantity of money demanded will be low Low interest rate -> low opportunity cost -> quantity of money demanded will be high

Monetary policy targets

-CB tries to maintain price stability and promote economic growth but they can't affect either of these economic variables directly -The fed uses variables, called monetary policy targets that they can affect directly that in turn affect variables that are closely related to the CB policy goals such as real GDP -Monetary policy targets are usually short-term interest rate

Reasons for Aggregate expenditure will be high

-Population grows and incomes rises -> C will increase -Economy grow -> firms expand capacity -> new firms established -> Increase I -Expanding population and economy require increased government services -> G will increase

Discount policy

Changing the discount rate Discount loans: loans a central bank makes to banks (the amount of money banks borrow from the central banks) Discount rate: the interest rate a central bank charges on discount loans

Loanable funds model

Concerned with the long-term real rate of interest

Money market model

Concerned with the short-term nominal rate of interest

The quantity theory of money

Connecting money and prices: the quantity equation M * V = P * Y M= Money supply P= price level Y= real GDP V= velocity of money (the number of time on average money switches hands within a year)

Price level as a variable that causes money demand to shift

Increase in price level -> increases the quantity of money demanded -> money demand curve to the right Decrease in price level -> decreases the quantity of money demanded -> money demand curve to the left

GDP as a variable that causes money demand to shift

Increase real GDP -> increase in buying and selling of goods and services -> increases demand for money -> quantity of money households and firms want to hold increases -> shift money demand curve to the right Decrease real GDP -> decrease in buying and selling of goods and services -> decrease demand for money -> quantity of money households and firms want to hold decreases -> shift money demand curve to the left

Money supply (MS)

Is a vertical line Increase in MS -> households buy short-term financial assets or deposit the money into an account -> banks offer lower interest rate on deposits -> opportunity cost of holding money falls -> movement down the MD curve Decrease in MS -> households will sell short-term financial assets and withdraw funds and other interest-paying bank accounts -> bank offer higher interest rate -> increase opportunity cost of holding money -> movement up the MD curve

Two main monetary policy targets

Money supply and interest rate

Two most important variables that causes money demand to shift

Real GDP and price level

The goals of monetary policy

The FED and other CB's have set 4 monetary policy goals that are intended to promote a well-functioning economy 1. Price stability 2. High employment 3. Economic growth 4. Stability of financial markets and institutions

Expansionary monetary policy (loose/easy policy)

The FED policy of decreasing interest rates to increase real GDP 1. FOMC orders an expansionary policy 2. The money supply increases and interest rates fall 3. C, I and NX all increase 4. AD curve shift to the right 5. Real GDP and the price level rise

Contractionary monetary policy (tight policy)

The FED policy of increasing interest rates to reduce inflation 1. FOMC orders an contractionary policy 2. The money supply decreases and interest rates rise 3. C, I and NX all decrease 4. AD curve shift to the left 5. Real GDP and the price level fall Does NOT cause the price level to fall but it causes the price level to rise by less than it would have without the policy

Open market operations

The buying and selling of government bonds by central banks/ the FED (to and from the public)

Federal funds rate

The interest rate banks charge on each other for overnight loans -Rate it determined by the demand and supply for reserves

What does FED use as its monetary targets?

The money supply or the interest rate

RRR (required reserve ratio)

When a central bank reduces the required reserve ratio, it converts required reserves into excess reserves

Equilibrium in the money market

When the MD curve crosses the MS curve

Money market

brings together the demand and supply for money