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What is Monetary Policy?• The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals. – Goals of Monetary Policy • Price stability • High employment • Stability of financial markets and institutions • Economic growth
Price Stability• Rising prices erode the value of money as a medium of exchange and a store of value.• Increase in inflation rate results in a rise in prices.• Decrease in inflation rate results in a decrease in prices.• Keeping the inflation rate stable helps keep prices stable.
High Employment• Unemployed workers contribute to reducing GDP below its potential level.• Unemployment causes financial distress and decreases self-esteem of workers who lack jobs. – Lack of job results in less spending/more saving which decreases demand and causes inflation and prices to rise.
Stability of Financial Markets and Institutions• The Fed promotes this so that an efficient flow of funds from savers to borrowers will occur. – Resources are lost when they are not efficient in matching savers and borrowers. – Firms with the potential to produce valuable goods and services cannot obtain the financing they need. – Savers waste resources looking for satisfactory investments.
Economic Growth• Stable growth allows households and firms to plan accurately and encourages the long-run investment needed to sustain growth. – Provide incentives for saving for larger pool of investment funds – Provide direct incentives for business investment
Monetary Policy Targets• The Fed cannot effect unemployment and inflation rates directly.• The Fed uses variables that it can affect directly and that affect variables like real GDP, employment, and price level.• Two main targets: – Money supply – Interest rate
Money Supply and Interest Rate Lower interest rates lead to increased spending!
Choosing a Monetary Policy Target• The fed can either choose money supply or interest rate. – Typically focus on interest rate• There are many kinds of interest rates. – The Fed targets federal funds rate. • The interest rate banks charge each other for loans. – Determined by the supply of reserves relative to the demand for them. • The Fed can increase/decrease supply of bank reserves through open market operations and set a target for the federal funds rate.
• Expansionary Monetary Policy – The Federal Reserve’s increasing the money supply and decreasing interest rates to increase real GDP. – Used during a recession when unemployment is a problem. – To increase the money supply, the Federal Reserve can: • buy government bonds (an open market purchase) • lower the discount rate • lower the reserve requirement
Too Low for Zero?• If the Fed must reduce the federal funds rate to nearly zero then Quantitative Easing is tried. – The buying financial assets from commercial banks and other private institutions with newly created money in order to inject a pre- determined quantity of money into the economy. – Although more money is floating around, there is still a fixed amount of goods for sale. This will eventually lead to higher prices or inflation.
• Contractionary Monetary Policy – The Federal Reserve’s adjusting the money supply to increase the interest rates to reduce inflation. – Used when inflation is the problem. – To decrease the money supply, the Federal Reserve can: • sell government bonds (an open market sale) • raise the discount rate • raise the reserve requirement
Inflation Targeting• Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.
Can the Fed Eliminate Recessions?• The best the Fed can do is to keep recessions shorter and milder then they would be otherwise. – Offsetting the effects of the business cycle – Timing is essential • If the Fed too early or late in recognizing a recession and implementing a policy then it could destabilize the economy.