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The Federal Reserve and Monetary Policy

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The Fed controls the amount of money in circulation in the United States by using three tools: ... There is, however, a limit to how much money we want to hold. ... – PowerPoint PPT presentation

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Title: The Federal Reserve and Monetary Policy


1
The Federal Reserve and Monetary Policy
2
The Federal Reserve System
  • The central bank of the US is the Federal Reserve
    System, usually called the Fed.
  • The Bank for Banks.
  • Twelve Districts.

3
The Structure of the Fed
4
The Feds Policy Tools
  • The Fed controls the amount of money in
    circulation in the United States by using three
    tools
  • 1. Required reserve ratios (or Reserve
    Requirement)
  • 2. Discount rate
  • 3. Open market operations

5
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6
The Feds Balance Sheet, December 1998(page 335)
Assets Liabilities (billions of dollars) (billi
ons of dollars)
  • Gold and foreign exchange 65 Federal Reserve
    notes 481
  • U.S. government securities 463 Banks
    deposits 27
  • Loans to banks 0 Other liabilities (net) 20
  • Total assets 528 Total liabilities (net) 528

7
Monetary Base
  • The monetary base is total currency in
    circulation plus banks reserve deposits at the
    Fed.

8
The Money Multiplier
  • The money multiplier is the amount by which a
    change in the monetary base will change in the
    quantity of money.
  • M mm B

9
The Impact of Currency
  • An increase in currency held outside banks is
    called a currency drain.

10
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11
The Demand for Money
  • There is no limit to the amount of income we
    would like to receive.
  • There is, however, a limit to how much money we
    want to hold.
  • The amount of money we hold is a stock of
    purchasing power.

12
Motive to hold Money
  • Precautionary demand
  • Transaction demand
  • Speculative demand

13
The Influences onMoney Holding
  • The quantity of money people choose to hold
    depends on four main factors
  • 1. The price level
  • 2. The interest rate
  • 3. Real GDP
  • 4. Financial innovation

14
The Demand for Money Curve
Effect of an increase in the interest rate
6
Interest rate (percent per year)
5
Effect of a decrease in the interest rate
4
MD
2.9
3.0
3.1
Real money (trillions of 1992 dollars)
15
Changes in the Demand Curve for Real Money
Effect of increase in real GDP
6
Interest rate (percent per year)
5
MD2
4
Effect of decrease in real GDP or financial inno
vation
MD0
MD1
2.9
3.0
3.1
Real money (trillions of 1992 dollars)
16
The Demand for Moneyin the United states
17
The Demand for Moneyin the United states
18
Money Market Equilibrium
MS
6
Excess supply of money. People buy bonds and i
nterest
rate falls
Interest rate (percent per year)
5
4
Excess demand for money. People sell bonds and
interest
rate rises.
MD
2.9
3.0
3.1
Real money (trillions of 1992 dollars)
19
Shifts in money supply and ? in interest rate.
MS0
6
Interest rate (percent per year)
5
4
MD
2.9
3.0
3.2
2.8
3.1
Real money (trillions of 1992 dollars)
20
Monetary Policy
  • How does it work?

21
From an open market operation to an impact on AD.
  • 1. The FED Buys a bond.
  • 2. Bond prices go up and interest rates go
    down.
  • 3. This increases reserves and the money supply.

22
Direct Effect
  • People spend the money on securities or on goods
    and services.
  • This increases I or C.

23
Indirect Effect
  • The lower interest rates makes credit cheaper.
    Increase in I.
  • It lowers the price of the dollar on the foreign
    exchange market. Increase in X.

24
The Ripple Effects of Monetary Policy
25
Monetary Policy
  • Does it work?
  • Most short-term interest rates move together.
  • Short-term interest rates moved in the opposite
    direction from M2 until 1990.

26
Money and Interest Rates
27
Cause and Effect
  • M2 and interest rates usually move in opposite
    directions .
  • This does not tell us which is the cause and
    which is the effect.
  • Do the Feds own actions cause interest rates to
    change?

28
How long will it take?
  • The lags may be up to a year an a half.
  • Does this make Monetary Policy effective?

29
What effect does the anticipation of a policy
change have?
30
Profiting by Predicting the Fed
  • Some open market operations are designed to
    change interest rates.
  • Predicting Interest Rates
  • The effect of anticipation

31
The History of the FED
  • Paul Volckers Fed
  • Alan Greenspans Fed
  • The Fed Tries for a Soft Landing

32
Interest Rates andReal GDP Growth
33
Did you learn?
  • What is the FED and what is the FOMC?
  • What is the base and how is it controlled?
  • How the interest rate changes the demand for
    money?
  • How the short-run interest rates are determined
    in the "money market."
  • How monetary policy "works" and how effective is
    it?
  • What were the goals of the Volker FED, and what
    are the goals of Greenspan FED?
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