Economic chapter 15 Monetary Policy, GDP, and the Price Level

Order for Open Market Operations

1. Federal Reserve Board of Governors 2. FOMC 3. Federal Reserve Bank of New York 4. "Primary Dealers" 24 Very Large International Banks & Financial Institutions

A - Administrative Rates

An interest rate set by a central bank to help it manage market-demand interest rates 1.Discount Rate 2.Interest Rate on Reserve Balances (IORB) 3.Overnight Reserve Repo Rate (ON RRP)

Open Market Operations (OMO)

-Buying and Selling of Government Securities (Treasury Bills, Treasury Notes and Treasury Bonds)

Restrictive (Tight) Monetary Policy

-Economy Experiencing Rising Inflation -Fed Sells Government Securities (OMO) (Treasury Bills, Treasury Notes, Treasury Bonds) -Decrease the Money Supply -Increase Federal Funds Rate -Increase Other Interest Rates

Expansionary (Easy) Monetary Policy

-Economy Experiencing a Recession -Fed Purchases Government Securities (OMO) (Treasury Bills, Treasury Notes, Treasury Bonds) -Increase the Money Supply -Decrease Federal Funds Rate -Decrease in Other Interest Rates

•Monetary Policy Advantages over Fiscal Policy

-Monetary Policy Lags/Impact (3 Months to 1 Year) -Fiscal Policy Lags/Impact (1 Year to 3 Years) -Speed (3 Months to 1 Year) and Flexibility Only requires the Approval of the seven (7) members of the Board of Governors. -Isolation from Political Pressure (14-year Terms) - Monetary policy is more "subtle" (less publicity). Fiscal policy which requires Presidential and Congressional Approval, and followed closely by the Media.

Quantitative Tightening (QT) - Inflation

a central bank pre-announces that it will sell a fixed quantity of long-term bonds so as to raise long-term/interest rates

If velocity and money go up

economy is getting better if not the economy is not getting better

When a economy is experiencing inflation the Fed will

increase interest rates for banks

Monetary Policy tools- Interest On Reserve Balances (IORB)

•If the Fed wants Banks to Decrease Loans, the Fed will Increase the (IORB) Interest Rate On Reserve Balances. •If the Fed wants Banks to Increase Loans, the Fed will Decrease the (IORB) Interest On Reserve Balances

"The BIG Picture"

•Monetary Policy and the Overall Affect on Real GDP, Unemployment, and Price Level •"Cause-Effect Chain" - Money Market determines interest rates - Business Investments are based on the interest rate - Investment Changes affect and Aggregate Demand (AD) - Overall Affect on Real GDP, Unemployment, and Price Level •Expansionary Monetary Policy (Easy Policy) •Restrictive Monetary Policy (Tight Policy) •Neutral Monetary (No Change in Policy)

The Fed's "Dual Mandate" Inflation and Unemployment

•Suggests how the Federal Reserve will adjust the nominal interest rate as it pursues the "Dual Mandate". •Based on the idea that if forced to make a choice between inflation being too high and unemployment being too high, the Federal Reserve will "err" on the side of inflation being too high, and focus on reducing unemployment.

Important about OMO

It is the most important tool the fed uses to influence the Money Supply

Velocity of Money = V

Nominal GDP = $300 Billion/ Dt = $100 Billion Velocity of Money V = 3

Economy Experiencing a "Recession"

The Fed "Pushes (P-P)" Money "INTO" the Economy (Buying Bonds to decrease an interest rate)

Economy Experiencing "Inflation"

The Fed "Soaks (S-S)" Money "OUT" of the Economy (Selling Bonds to Increase an Interest Rate)

Interest On Reserve Balances (IORB)- Ample Reserves

The Fed increases the money supply.

Interest On Reserve Balances (IORB)- limited reserves

The Fed limits the Money Supply

Who controls interest rates in our country?

The Feds through FOMC (Federal Open Market Committee)

Is FFR important

YES, It is the most important because every other rate is based off this one

Open Market Operations- Recession

"Purchase-Push" Purchase-Securities from Dealers Pushes- Money Into the Economy

Open Market Operations- Inflation

"Sell-Soak" Sells- securities to dealers Soaks- Money out of the economy

•If the Fed wants Banks to Increase Loans, the Fed will Decrease the (IORB) Interest On Reserve Balances

(Commercial Banks are "Discouraged" to keep their Reserves at the Fed, given lower interest rate, and will be Encouraged to make additional loans.)

•If the Fed wants Banks to Decrease Loans, the Fed will Increase the (IORB) Interest Rate On Reserve Balances.

(Commercial Banks are Encouraged keep their Reserves at the Fed, earn a higher interest rate, and will be "Discouraged" to make additional loans.)

OMO - Open Market Operations (OMO)

1.Expansionary Policy (Easy Monetary Policy Economy Experiencing a Recession) 2.Contractionary Policy (Tight Monetary Policy Economy Experiencing Inflation) 3.Neutral Policy (No Change Economy at the NRU)

F - Forward Guidance

1.Optimistic Forward Guidance 2.Pessimistic Forward Guidance

The First Bank of the United States

1791-1811 Alexander Hamiliton's grand experiment in central banking began in 1791 to assist a post-Revolutionary War economy and ended 20 years later

The Second Bank of the United States

1816-1841 The nation made its second attempt at creating a central bank in 1816 following an economic downturn. But unlike its predecessor the institution's charter was not renewed.

Price stability

2 percent

Maximum sustainability employment

4.1 percent

Monetary Policy Tools "A - F - OMO"

A - Administrative Rates F - Forward Guidance OMO - Open Market Operations (OMO)

The Federal Funds Rate is the interest rate that the Fed "Targets".

Based on the direction of the overall economy, the Federal Reserve (The Fed) determines the appropriate Federal Funds Rate to encourage individuals and businesses to borrow money (by lowering interests rates), or discourage borrowing money (by increasing interest rates).

What if the Fed did NOT set the Administrative Rates?

Interest Rates would be Negative- Below Zero

Quantitative Easing (QE) - Recession

Central bank pre-announces/ purchasing long-term bonds so as to lower long-term interest rates

Monetary Policy

Change in the money supply to influence interest rates by the Federal Reserve to achieve economic growth, full employment, and price stability.

What happens when Fed sells securities?

Commercial bank Reserves Decrease, the Fed "Soaks (S-S)" Money "OUT" of the Economy

What happens when Fed Purchases securities?

Commercial bank Reserves Increase, the Fed "Pushes (P-P)" Money "INTO" the Economy

Remember the sequence for administrative interest rates.

D-I-F- Ohhh 1. Discount Rate 2.IORB rate 3.FFR 4.ON RRP rate

When an economy is experiencing and recession the Fed will

Decrease interest rates

Interest Rates (Nov. 2023)

Discount Rate = 5.5% IORB = 5.4% FFR = 5.33% ON RRP = 5.3%

Optimistic Forward Guidance

Fed's forward guidance is optimistic is optimistic or positive about the economy's prospects/more likely to want to borrow and lend/money will increase

Pessimistic Forward Guidance

Fed's forward guidance is pessimistic or negative about the economy's prospects/ fewer loans will be demanded/ reducing overall size of the money supply

All interest rates in the economy begin with______?

Federal Funds Rate

•Problems of Monetary Policy Timing (3 Months - 1 Year) R - A - O

R - Recognition Lag (Where are we in the economy?) A - Administrative Lag (What policy should we apply?) O - Operational Lag (How long before it actually impacts the economy?) •Future Policy Reversals (Remember the initial policy may NOT impact the economy for 1 year) •Political Business Cycles (During Election Years, the Fed should NOT be influenced by politicians

The Dual Mandate Bullseye Chart

TARGETS INFLATION = 2% UNEMPLOYMENT (NRU) = 3.5%. to 4.1% As of November 2023 INFLATION = 3.2% UNEMPLOYMENT = 3.9%

Federal Funds Rate (FFR - Target Rate)

The "Effective Federal Funds Rate (EFFR)" is the actual interest rate banks charge each other to borrow money overnight (just 12 hours).

Who does the Fed SELL bonds to?

The commercial bank which SOAKS money out of the economy

Who does the Fed PURCHASES bonds from?

The commercial banks which PUSHES money out

Federal funds market

The financial market in which banks and other financial firms negotiate overnight loans of currency ("Federal Funds") held on deposit at one of the twelve Federal Reserve banks.

Definition of Velocity

The number of times per year that the average dollar in the Money Supply is spent for final goods and services. Nominal Gross Domestic Product (GDP) divided by the Money Supply.