PSCI 150 : INTRODUCTION TO ECONOMICS Bachelor of Political Science, KIRKHS, IIUM

1. PSCI 1500:
Introduction to Economics
Monetary Policy

2. MONETARY POLICY
 Monetary Policy
Changing the money supply to influence the levels of
output, employment, and/or prices in the economy.
i. Easy Money Policy (expansionary)
Policy by the Federal Reserve to increase excess
reserves of depository institutions in an effort to
increase spending and reduce unemployment.
ii. Tight Money Policy (restrictive)
Policy by the Federal Reserve to reduce excess
reserves of depository institutions in an effort to
reduce spending and inflationary pressure.

3. MONETARY POLICY
 MONETARY POLICY TOOLS
Federal Reserve has three major tools to
change excess reserves (ER) in the financial
depository institutions system:
1. Reserve Requirement
2. Discount Rate (Interest Rate)
3. Federal Funds Market/OMO

4. MONETARY POLICY
Monetary Policy Tools
1. Reserve Requirement
i. Easy Money Policy
 Decreases in the reserve requirement would
increase excess reserves and encourage borrowing;
appropriate to stimulate the economy. Appropriate to
fight recession or unemployment
ii. Tight Money Policy
 Increases in the reserve requirement would
decrease excess reserves and discourage
borrowing; appropriate to fight demand-pull inflation.

5. 2. Discount Rate
• Refers to the interest rate that a Federal Reserve
Bank charges a financial institution for borrowing
of reserves.
• Financial depository institutions borrow reserves
to increase it’s reserve accounts, the cost of
this borrowing is called Discount Rate.
Easy Money Policy
• Decrease in discount rate will encourage reserve
borrowings
Tight Money Policy
• Increase in discount rate will discourage reserve
borrowings
MONETARY POLICY

6. 3. Open Market Operations (OMO)
• The most often used tool for changing the excess
reserve, can be achieved quickly since it’s
operations is being carried on every business day
• Buying and selling of securities, primarily
government securities, by the Federal Reserve.
• Open Market Committee - determines the general
policy on OMO.
• Excess reserves can be altered slightly or greatly
depending on whether the government securities are
bought in small or large quantities
i. Easy Money Policy - buy securities in the OMO
ii. Tight Money Policy - sell securities in the OMO
MONETARY POLICY

7. Tools & Policy Objectives
1. Expanding the economy requires:
• Buying securities from banks and dealers on the
open market, and/or
• Lowering the reserve requirement, and/or
• Lowering the discount rate
2. Fighting demand-pull inflation requires:
• Selling securities to banks and dealers on the open
market, and/or
• Increasing the reserve requirement, and/or
• Increasing the discount rate
MONETARY POLICY

8. Government Fiscal Deficits & Monetary Policy
Crowding Out
Occurs when borrowing by the government
increases the interest rate and reduces
households and businesses borrowings
Government borrowing to finance deficit budget
give upward pressure on interest rate and causes
the households and business to borrow less.
FISCAL & MONETARY POLICY

9. Fiscal Deficits & Monetary Policy (Cont’d)
Monetizing the Debt
To offset the crowding out effect via preventing the
rise of interest rate; prevent government borrowing
through the increase in excess reserve (reduce
reserve requirement ratio) by amount equal to
increase in demand for borrowing.
Increasing the money supply to accommodate the
government borrowing and reduce upward pressure
on the interest rate.
FISCAL & MONETARY POLICY

10. Effect of Government Borrowing and Monetizing the Debt on
the Interest Rate and Loan Making
CROWDING OUT & MONETIZING THE DEBT
FISCAL & MONETARY POLICY

11. ADVANTAGES & DISADVANTAGES OF
MONETARY POLICY
Advantages:
• Quickly implemented as compared to fiscal policy
• Largely removed from politics
Disadvantages:
• Loan-making link - Someone must be willing to borrow
and a bank must be willing to lend. The Fed cannot
force the loan-making process.
• Inflation - As the money supply is tightened, interest
rates increase, and businesses that borrow at high
rate may raise prices on their products to compensate.

12. Evaluate on the use of the monetary policy tools.
Government Securities - open market operations (OMO)
buying government securities in OMO from banks or the public
will increase the excess reserves and expand the money supply
while selling them decrease the excess reserves of the banks
and shrink the money supply.
Reserve Ratio (RR)
raising the RR will decrease while lowering RR will increases
the excess reserves.
Interest Rate/Discount Rate (DR)
raising the DR discourages banks from borrowing while
lowering DR encourages the borrowing of reserves from the
central bank.
TEST YOUR UNDERSTANDING

13. Describe how changes in the policy tool leads to
expansionary and restrictive fiscal policies.
With an expansionary fiscal policy, to expand to
promote aggregate spending, borrowing and
growth - lower taxes, increase government
expenditure and or transfer payments - will
increase the level of spending.
With a restrictive fiscal policy, the vice versa!
TEST YOUR UNDERSTANDING