Monetary Policy
What is the FED and what does it
have to do with me?

Fiscal Policy (from last class)
• How the president and Congress controls the
economy
– Expansionary Policies: to increase economic growth
– Contractionary Policies: to slow economic growth
• PROBLEM: Government cannot be relied on to
make good decisions regarding the economy!

Monetary Policy
• Def.: How the Federal Reserve influences
the supply of money and brings the nation
out of either a recession or inflationary
period.

The Federal Reserve
• Def.: A national system of banks that
influence and control the economy and the
money supply.
• Called “The Fed”
• What banks are parts of the Fed?
• All nationally-chartered and most state
chartered banks are required to join.

Federal Reserve Board of
Governors
• Def. Seven members, including a
chairman, appointed by the President.
• These governors as well as five presidents
of the Federal Reserve Banks form the
Federal Open Market Committee.
• This committee establishes our national
monetary policy.

Appointed, not elected
• The Board of Governors is appointed by
the President so that they can make
unpopular decisions about the economy
without having to worry about being re-
elected.

So, what does the Federal Reserve
Do?
1. Federal Government’s Banker
Maintains a checking account for the treasury
and processes payments such as tax
refunds.
2. Government Securities Auctions
Sells, transfers and redeems government bonds
3. Issues Currency (paper money)

So, what does the Federal Reserve
Do? (cont.)
4. Check Clearing
Transfers money from one account to another
when checks are written
5. Supervises Lending Practices
Monitors bank reserves throughout the country
6. Lender of Last Resort
In case of economic emergency, banks can
borrow funds from the Fed

So, how does Monetary Policy
Work?
• By adjusting the supply of money in the
nation, the Fed can speed up the economy
or slow it down.

To get out of a recession, the Fed
encourages people to spend by
increasing the money supply.
To stop inflation, the Fed
discourages people from spending
by decreasing the money supply.

How does the Fed do this?
• Three tools of the Fed:
–Reserve Requirement
–Discount Rate
–Open-Market Operations

Reserve Requirement
• Def.: The percentage of all deposits that a
bank must keep in their vaults.
• Ex. I have $100,000 in deposits and the
reserve Requirement is 10%. How much
must I keep in my vault? How much can I
lend out?

• Vault: $10,000 Loans: $90,000
What if the Reserve Requirement goes up to
20%?
• Vault: $20,000 Loans: $80,000
What if the Reserve Requirement goes
down to 5%?
• Vault: $5,000 Loans: $95,000

How does this affect the money
supply?
Reserve Requirement Money Supply
Reserve Requirement Money Supply

The Discount Rate
• Def. At times the Fed lends money to
banks. By either lowering or raising the
interest rate they charge the banks, they
can influence the interest rate that banks
charge their customers.

Discount rate is 2%, the banks charge 3%
• The Fed decides to raise the rate:
Discount rate is 3%, the banks charge 4%
Higher interest, less people get loans
• The Fed decides to lower the rate
Discount rate is 1%, the banks charge 2%
Lower interest, more people get loans

How does this affect the money
supply?
• Discount Rate Money Supply
• Discount Rate Money Supply

Open Market Operations
• Def.: When the government buys and sells
bonds.
• Selling bonds takes money out of
circulation
• Buying bonds puts money back into
circulation

How does this affect the money
supply?
Selling Bonds Money Supply
Buying Bonds Money Supply

Monetary Policy During a
Recession
• Goal:
Increase Money Supply
• Decrease the Reserve Requirement
• Decrease the Discount Rate
• Buy Bonds
• Called Easy Money Policy

Monetary Policy during a period of
Inflation
• Goal:
Decrease spending and the money supply
• Increase the Reserve Requirement
• Increase the Discount Rate
• Sell Bonds
• Called Tight Money Policy