Chapter 12: Monetary Policy

Monetary policy is more flexible and less political than fiscal policy. In monetary policy, the Fed can act more quickly than Congress and the President because it doesn't have to go through the lengthy political process of passing legislation. If the need is great enough, the top decision makers at Fed can raise or lower interest rates with just a telephone conference. In monetary policy the Fed can also take action in baby steps. It can cut or raise a little bit at a time and see how the economy reacts before it goes further. When the economy recovers from a downturn, the Fed can take back a monetary stimulus more easily than Congress can take back a tax cut or added spending.

Compare and contrast monetary policy and fiscal policy.

The Federal Reserve System was founded by Congress in 1913 in response to a financial panic that occurred in 1907. The financial panic wiped out several big banks and sent the stock market plummeting by nearly 50%. The Federal Reserve was set as a system. At the head of the Federal Reserve System is the Federal Reserve board, which consists of seven-person board of Governors. Congress also created 12 regional Federal Reserve Banks around the country, in part to gain support of Western and Southern politicians. The U.S. President appoints the members of its Board of Governors, including the chair. However, the Fed funds its own operations, so it doesn't need budget allocations from Congress and members of the Board of Governors serve 14 year terms which end in different years, so a single President can't replace the whole board. The chair of the board of governors, who holds most of the power is appointed for a four-year renewable term.

Describe the history and structure of the Federal Reserve System.

The Federal Reserve can use direct lending to fight a financial crisis by lending vulnerable financial institutions as much as money as they need- money that is backed by the full faith and credit of the federal government.

Discuss how the Federal Reserve can use direct lending to fight a financial crisis.

Changing the Fed funds rate can affect the economy because a decrease in the Fed funds rate boosts spending and GDP, whereas an increase in the Fed funds rate diminishes spending and GDP. Example: Most car buyers finance their purchases either by borrowing money for their new vehicles or by taking out leases. The monthly payments vary according to the prices of the cars, the length of the loans or leases, and the interest rates. The higher the interest rate, the lower the payment. Figure 12.4: The Effect of Lower Rates on Market for Cars: As the interest rates on car loans fall, people buy more at a given price. The demand curve shifts to the right, and the equilibrium quantity in the market rises.

Explain how changing the Fed funds rate can affect the economy.

The fed funds rate is set by a vote(votes on MP) Federal Open Market Committee(FOMC) based on conditions in the economy. The FOMC consists of all seven members of the Board of Governors and the presidents of five of the twelve Reserve banks on a rotating basis. The FOMC meets eight times a year to discuss the economy and set the direction for monetary policy.

Federal Open Market Committee?

Increase in GDP.= Monetary Policy= Decrease in interest rates.= Decrease in Cost of borrowing= Raise loans.= C goes up, RI goes up, and NI goes up. Fed controls interest rates through changing the amount of money in economy.

Fighting a Recession?

1. Controlling Inflation.= The inflation rate stays in the neighborhood of 2%. 2. Smoothing out the business cycle.= Recessions are short and mild, and the unemployment rate stays relatively low. 3. Ensuring Financial Stability.= Most borrowers are able to get access to loans relatively easily with little fear that financial institutions will go out of business. The Main Monetary Policy Tools: 1. Control over short-term interest rates. 2. Quantitive Easing. 3. Direct lending to banks and other financial institutions. 4. Changes in the reserve requirement and other financial regulations.

Identify the major goals of monetary policy, and list the policy tools used by the Federal Reserve.

The Fed buys + sells U.S. government bonds. The Fed's most-used policy tool is its ability to control short-term interest rates. Fed buying + selling bonds.= Change in money= Change in interest rates= Change in GDP. ( Controlling inflation or control recession). The rate the Fed controls is the federal funds rate.= Interest rate charged on bank to bank loans.

1. Open Market Operations?

Quantitive easing is similar to open market operations, however it is designed to influence long-term interest rates such as mortgage rates, rather than short-term rates. QE= Fed digitally print money to purchase assets that influence long-term rates. It is a relatively new policy tool first used during the Great Recession of 2008.

2. Quantitive Easing?

During a financial crisis, the Fed can lend vulnerable financial institutions as much cash as much cash they need. Discount loans= Loans from the Fed to the banks.

3. Direct Lending?

The Fed plays a key role in regulating the financial institutions(banks). Through regulations, the Fed can exert control over the economy. Reserve requirements(R) require banks to keep a portion of their deposits either in cash in their vaults or on reserve with the Fed. R= 10%= banks must keep 10% of deposits at Fed. R= For regulation of banks. R= Can also be used to conduct monetary policy. Change in R= Change in money in economy.

4. Reserve Requirements?

1. The top goal of the Federal Reserve is to keep inflation under control. Prior Chairmen of the Fed have argued that a low and stable inflation is the best way to achieve strong economic growth. The question is how low should inflation be? The current target rate in the neighborhood of 2%. How? They do it through controlling interest rates. Fight inflation: Lower GDP= GDP= C+RI+NI+PI+G+NX. They enact monetary policy to raise interest rates.= Increase in Cost of borrowing= Decrease in loans/usage in credits.= consumption goes down, residential investment goes down, non-residential investment goes down.= GDP falls.

Goal 1: Controlling Inflation?

2. The Federal Reserve also has the goal of fighting recessions. Taking action when the economy slows and unemployment rises. Cutting interest rates to boost the economy. Lower interest rates will stimulate purchases of goods that require financing, such as autos and homes. GDP= C+RI+NI+PI+G+NX.

Goal 2: Smoothing Out the Business Cycle?

3. The third goal of the Federal Reserve is to serve as the lender of last resort in the event of a financial crisis. Financial markets are subject to occasional bouts of panic and fear. If this happens, the Fed will calm things down by making sure that bank and Wall Street firms have the money they need to function. Discount loans= Loans from Fed to banks. Discount rate= Interest rate charged on discount loans.

Goal 3: Ensuring Financial Stability?

1. Medium of exchange.= You can use money to buy goods & services and accept money in exchange for the goods and services you provide. 2. Store of value.= You can hold onto money to use later. So when you put your money into a bank, you expect that you will be able to take it out sometime in the future and that it will still be able to buy goods and services. 3. Standard of value.= It lets you make comparisons between different goods and services. Example: If two houses sell for the same amount of money then at that moment they are equally valuable. If you are willing to pay more for one car than another, then at that moment, the first car is more valuable to you.

List three uses of money.

Money consists of currency(paper bills and coins) plus funds in checking and savings accounts. Money= Currency + Deposits. Maintaining stability and public trust in the value of a currency is paramount for a well-functioning economy. Government issued currency has several advantages: Everyone knows which bill is valid. It is easier for policymakers to guide and control the economy. Helps government maintain trust in it's money.

Money Defined?

Tools to conduct MP in order to reach goals. There are four main tools of monetary policy: What Feds currently use. 1. Control over short-term interest rates through open market operations.= Change in interest rates. 2. Quantitive easing to bring down long-term interest rates. 3. Direct lending to banks and other financial institutions in times of crisis.= Discount loans. 4. Changes in the reserve requirement and other financial regulations. Short-term interest rates= Interest rates on short-term loans. Long-term interest rates= Interest rates on long-term loans.

Policy Tools?

Monetary policy has certain advantages over fiscal policy: Monetary policy is more flexible and less political than fiscal policy.(Fed is independent). Monetary policy can be conducted in small steps(raising or lowering rates a little bit at a time). If the economy recovers the Fed can cancel economic stimulus more easily than Congress can rescind a tax cut or spending increase. Monetary policy is reversible. However, fiscal policy is not reversible.

Practice of Monetary Policy?

The Federal Reserve(Fed) is the country's central bank. It was created by Congress in 1913 in response to the financial panic of 1907. The Federal Reserve has the power to issue currency, conduct monetary policy(set interest rates), regulate banks, and lend directly to banks(bank for banks).

The Federal Reserve?

The original goal of the Federal Reserve was to maintain the stability of the financial system.(Raise lender of last resort). The Humphrey-Hawkins Act in 1978 specified a broader set of goals. The main goals of the Fed today are controlling inflation, smoothing out the business cycle, and ensuring financial stability. Table 12.1: The Three Goals of Monetary Policy: 1. Controlling Inflation: The inflation rate stays in the neighborhood of 2%. 2. Smoothing out the business cycle: Recessions are short and mild and the unemployment rate stays relatively low.= Conduct Monetary Policy to ensure these goals. 3. Ensuring Financial Stability: Most borrowers are able to get access to loans relatively easily with little fear that financial institutions will go out of business.

The Goals of Monetary Policy?

It is headed by the Federal Reserve board.= Washington D.C.. They consist of the chair of the board (the person at the highest level of the Fed), and 6 governors(not governors of the state) governors at the Federal Reserve. Jerome Powell is the current chair of the Federal Reserve. It is a system of banks: 12 district banks that are located throughout the country. The Federal Reserve was designed to have considerable independence in making policy decisions. The Fed doesn't need presidential or congressional approval for monetary policy decisions. To keep politics out.

The Structure of the Federal Reserve?

Money is an asset that serves three purposes: 1. First, it is a medium of exchange. Use money in trade. 2. Second, money is a store value. We use money to store wealth(we can save money to use in future purchases). 3. Finally, money is a standard of value. We use money to compare value of G+S.

The Uses of Money?