Monetary Policy and the Fed

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Financial Markets and the Economy
"Give me control of a nation's money and I care
not who makes it's laws"
-Mayer Amschel Rothschild

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In this module, we’ll continue to
explore monetary policy
In the previous module, we learned
that the Fed can manipulate the money
supply to manage the economy.
We now discuss that tool – Monetary Policy –
in more detail.
We’ll learn that the Fed has historically had
three tools at its disposal, though it primarily
only uses one (until very recently).
And we will explore how monetary policy can
be used in practice.

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First – a quick review of
the AD-AS Model
We’ve learned that the AD-AS model
compares Prices and Real GDP.
We know that under ideal
circumstances – when all resources
are used – an economy can produced
its potential Real GDP.
LRAS
At that point, we see that economy’s
Long Run Aggregate Supply curve
(LRAS). Let’s suppose that amount is
$200 billion.
$200b
Put a different way, we can say this: if
this economy is at its natural rate of
unemployment (5%), it will produce
$200 billion in goods and services.

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First – a quick review of the AD-
AS Model
We know its actual experience may be
different.
It will actually operate at the
intersection of the Aggregate Demand
(AD) curve and the Short Run
Aggregate Supply (SRAS) curve.
LRAS
Perhaps those curves appear as
follows.
$200b
If so, then macroeconomic equilibrium
assure us that the economy will tend to
this point.
AD1
SRAS1
At this point, prices will be P1 and Real
GDP will be $150b.
P1
$150b

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This scenario illustrates a recession!
LRAS
$200b
AD1
SRAS1
P1
$150b
Here we see the economy is capable
of producing $200 billion in goods and
services – if it uses all its resources.
But it is instead only producing $150
billion in goods and services.
In that case, Real GDP is low and
unemployment is high – these are the
hallmarks of a recession.
But what can be done?!
“Recessionary Gap”

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The Fed can use monetary policy to
correct for these imbalances
Open Market
Operations
(OMO) where
they purchase
and sell
government
bonds.
Reserve
Requirements –
set by the Board of
Governors – it is
the share of each
deposit that banks
must hold.
Discount Rate -
It is the interest
rate at which
banks may
borrow money
from the Federal
Reserve.
Let’s explore each of these in detail…
The Fed has historically had three tools at its disposal.

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Tool #1: Open Market Operations (OMO)
This is the Fed’s primary policy tool.
This involves the purchase and sale of
U.S. treasury bonds.
The fed buys (or sells) millions of dollars in bonds
daily to “manage” the U.S. money supply.

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How might Open Market
Operations unfold?
Suppose the Fed
identifies that a
recessionary gap is
occurring.
The Fed could respond
by buying bonds, thereby
injecting money into the
economy.
Lower interest rates
encourages investment
and lowers the dollar value.
Economic indicators serve to
inform that judgment. You
are not the only ones paying
attention to those 
This is called Expansionary
monetary policy – it
increases the money supply
and causes interest rates to
fall.
Lower interest rates cause
investment to increase. The
weaker dollar causes net
exports to increase. Both push
AD higher.

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Closing the “Recessionary Gap”
Having completed Open Market
Operations to expand the money
supply, AD is now at an intersection
with SRAS on top of the LRAS.
In theory, unemployment returns to
the natural rate (5%).
The recessionary gap has been
‘closed’.
But what about inflationary gaps?

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This scenario illustrates inflation!
LRAS
$250b
AD1
SRAS1
P3
$200b
Here we see the economy is capable
of producing $200 billion in goods and
services – if it uses all its resources.
But it is instead producing $250 billion
in goods and services.
In that case, Real GDP is high and
unemployment is low– this economy
may be overheating.
But what can be done?!
“inflationary Gap”

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How might Open Market Operations be
used to combat inflation?
Suppose the Fed identifies
that an inflationary gap is
occurring.
The Fed SELLS Bonds,
thereby removing money
from the economy.
Higher interest rates
discourages investment and
increases the dollar value.
High rates of output require
lo levels of unemployment.
Workers demand raises in
this environment and higher
costs are passed on to
consumers.
This is called contractionary
monetary policy – it
decreases the money supply
and causes interest rates to
rise.
Higher interest rates cause
investment to decrease. The
stronger dollar causes net
exports to fall. Both pull the AD
leftward.

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Can we see historic observations of the
Fed’s behavior? You bet we can!
The supply of money
was increased to
accelerate the economy
in the early 1990s in
response to the 1991
recession.
Once reasonable RGDP growth was
realized, the money supply was
reduced to ensure that inflation did
not occur. The idea is to provide
enough money to manage growth
without inflation!
In response to the 9/11
attacks, the money supply
was quickly and drastically
increased to help absorb the
shock that the attacks might
have had on the economy.
Once it was realized that the
economic impact of 9/11
would not be as big as first
thought, the money supply
was quickly contained to
avoid inflation.
It is easy to see how concerned the
Fed was during the Financial
Crisis…look how rapidly they
expanded the money supply!

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Policy goals can be
conflicting in some cases
LRAS
$150b
AD1
SRAS1
P2
$200b
Ideally, the Fed seeks full employment
and stable prices. Sometimes it must
choose between the two.
Take this case for example. Imagine
that the economy is operating at its
potential. GDP is at $200 billion and
the unemployment rate is 5%.
Then something happens…Oil prices
skyrocket and the SRAS curve shifts
left in response.
SRAS2
P3
This nasty combination is called
stagflation. Here we see that Real
GDP has fallen but prices are rising.
So what should be done?

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A possible response to
stagflation
LRAS
$150b
AD1
SRAS1
P2
$200b
If facing stagflation, as is pictured here,
the Fed will observe a recessionary
gap that is accompanied by high
unemployment.
It could address that by buying bonds
(expansionary monetary policy) which
would return the economy to full
employment.
But that increases price even further.
SRAS2
P3
A policy reaction like that may risk
allowing the economy to slip into
hyperinflation.
AD2
P4
Note the recessionary gap

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The response to stagflation
LRAS
$150b
AD1
SRAS1
P2
$200b
Here again, the Fed sees stagflation.
With it, the Fed will also observe
relatively higher prices, which will be
concerning.
It could address that by selling bonds
(Contractionary monetary policy) which
would stabilize prices.
But that would reduce Real GDP even
further driving unemployment higher.
SRAS2
P3
This policy may take a moderate
recession and make it more severe.
Note the increase in prices
AD2
$120b

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What is the correct
response to stagflation?
Technically, there is not a good answer.
The Fed must choose between its
priority of full employment and stable
prices.
This happened to the U.S. in the late
1970s and the early 1980s.
The Fed Chairman then (Paul Volker)
chose to fight inflation first.
He reduced the money supply thereby
pushing interest rates significantly
higher.
Paul Volker, a 6’6”” man, vowed to
“break the back” of inflation.

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LRAS
AD1
SRAS1
AD2
You give it a try…be the Fed Chairman!
Imagine that you are Chairman of the Fed
and you preside over the hypothetical
economy as depicted by this AD-AS Model..
The following year, you observe this change.
Which of the following do you most likely
conclude?
There is a
recessionary gap
There is an
inflationary gap
Unemployment is
rising
Prices are falling
(deflation)
AD has shifted to the right. In this economy, an inflationary gap has
developed, which would concern the Fed.

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LRAS
AD1
SRAS1
AD2
conclude?
The Fed should
buy bonds
The Fed should
sell bonds
The Fed should do
nothing.
All the above.
AD has shifted to the right leaving this economy at its potential. No
Monetary Policy action is necessary.

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LRAS
AD1
SRAS1
conclude?
Prices have fallen
(deflation)
Real GDP has
increased
The unemployment
rate is falling.
All the above.
SRAS has shifted to the right…perhaps oil prices fell or workers are more
productive. This lowers prices and increases Real GDP.
SRAS2

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LRAS
AD1
SRAS1
conclude?
Prices have
increased (inflation)
Real GDP has
increased
The unemployment
rate is falling.
This economy is in
recession.
AD has shifted left by what appears to be a drastic amount. Real GDP has fallen a lot
and unemployment is likely on the rise. That is a recession!
AD2

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Tool #2: The Required Reserve Ratio
While Open Market Operations is the most
commonly used monetary policy tool, there
are others.
The second covered here involves the
required reserve ratio.
Recall that when you make a deposit at a
bank, that bank is required to hold some of
that money in reserve.
That insures the bank’s health and helps prevent
bank runs. But the ratio that is required to be
held has big implications on the amount of
money created by the banking system.

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Tool #2: Required Reserve Ratio
Note that with a
required reserve ratio
of 40%, a $10 million
initial deposit creates
$15 million in money.
Lowering the required
reserve ratio
increases money
creation. With a 3%
reserve requirement,
$323 million is created
by an initial $10
million deposit.
If that is true, then the required reserve
ratio can be used to influence the
money supply!

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Using the Required Reserve Ratio to
manage the economy
The Required Reserve Ratio is set by the
Federal Reserve's Board of Governors.
In theory, if that body wanted to expand the
money supply – thereby stimulating economic
activity, it could lower the reserve ratio.
A lower RRR would mean that more money
is created though the money creation
process.
A greater money supply should lower interest
rates and induce investment and exports.

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The Reserve requirement is not typically
used as a policy tool (in the U.S.)
However, history has shown us that changing the Required
Reserve Ratio has a jarring affect on the economy.
Imagine if you are a banker and you
agree to loan me money next week for a
new plant.
I hire architects and construction workers
to get started.
Then, the Required Reserve Ratio is
changed and you have to cancel my
loan.
Then, the Required Reserve Ratio is
changed and you have to cancel my
loan.
These jarring impacts are tough on an
economy so the Fed generally does not
alter the required reserve ratio.
In fact, it has not been changed in
decades….
…though some are arguing that if banks
had higher reserves, they would have
been better prepared to handle the
financial crisis.

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Tool #3: The discount rate
$
Borrowing money from the Fed is more expensive and usually
indicates that a bank is in “trouble”. For these reasons banks
avoid putting themselves in this position.
The interest rate that banks charge each
other is called the “Federal Funds Rate”.
*The actual rate varies depending on how much a bank has on
deposit. Assume the required reserve ratio is 10%.
Member banks are required to have
10% of deposits in an account with a
Federal Reserve Bank.*
If a bank appears to be unable to meet
that requirement, it may borrow from
another bank to get the funds.
If other banks are unable or unwilling to extend
them credit, they can borrow from their regional
Federal Reserve Bank.

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How the Fed uses the discount
rate as a monetary policy tool
• Increasing the discount rate will discourage banks from
borrowing from the Fed (called “borrowing from the
discount window”)
• This will discourage banks from being aggressive about
making loans for fear that they will not be able to meet
their required reserve ratio
• This works in reverse too. Lowering the discount rate
might encourage banks to be more aggressive and make
more loans. An increases in loans expands the money
supply!
Fewer loans means
less money is created!
%
The discount rate is not an effective monetary policy
tool and is only typically used to signal changes in
future open market operations

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Which direction should we go…Easy
or tight money?
• Easy Money
– Purchase bonds in
Open Market
Operations
– Lower the required
reserve ratio
– Lower the discount
rate
• Tight Money
– Sell bonds in Open
Market Operations
– Raise the reserve
ratio
– Raise the discount
rate
This is the Fed’s Primary monetary policy tool. The
others are rarely used or used only for symbolic
reasons

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Monetary policy has some pros and
cons. The pros:
• Monetary policy is not politically sensitive
• The Federal Reserve is isolated from political pressure,
particularly with 14 year terms
• Monetary policy impacts the economy
quickly
• It can take 6 months or a year (or more) for other tools used
by our government to impact the economy

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Disadvantages of monetary policy
• In some cases, easy money won’t spur
increases in AD
– Just because a central bank increases money supply (thereby
reducing interest rates) does not mean banks will loan more
money
• For example: Japan instituted a “zero interest rate policy in August
2000
• Rates that banks loan each other money was zero
• Despite this, AD did not increase (enough) and deflation remained
• 6 years later, rates were raised to 0.25%
This dilemma is referred to as “pushing on
a string”. Even with very low interest rates,
if economic conditions are bad, people
might still not borrow money!

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New tools are being developed
In response to financial crisis, the Fed has created
some new tools.
One is called a Term Auction Facility where banks
borrow money from the fed for a short period of time –
from two weeks to three months.
Loan amounts and the interest rate banks are willing
to pay are submitted in secret.
And the Fed makes loans to the banks with the
highest bids until the have reach a loan limit (for
example $20 billion in loans).
This plan ensured that the Fed would be able to inject
a set amount of money in the economy – in a time
when banks may be nervous to make loans!

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In Summary
The Federal Reserve is responsible to
ensure we have economic growth
without high inflation.
The Fed uses monetary policy to
manage the economy
It has several tools to do this, though Open
Market Operations is its primary tool.
By increasing the money supply,
economic growth can be stimulated.
By decreasing the money supply, inflation
can be contained.
$

Monetary Policy and the Fed

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