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Principles of economics openstax chapter28

Principles of Economics
Chapter 28 Monetary Policy and Bank Regulation
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Federal Reserve System (FED)

Some of the most influential decisions regarding monetary policy are made at the FED
behind these doors.


Federal Reserve System (FED)

The FED is the central bank of the United States established in 1913 to regulate the private banking
system and the supply of money

Unique Features of the FED

• Decentralization: 12 districts across country
• Independent of the US government
• Decision-maker about amount of money in circulation and short-term interest rates

• Semi-public institution
• Policy goal: to sustain economic growth with zero inflation


The Federal Reserve System


The Federal Reserve System

Janet Yellen, Chair
UC, Berkeley Professor of
Economics

Stanley Fischer, Vice Chair
MIT, Professor of Economics


Functions of the FED
Clearing interbank payments
Regulating the banking system
Assisting banks in difficult financial times
Managing the nation’s foreign exchange rates and foreign exchange reserves


Functions of the FED

Control of mergers between banks
Examination of banks to ensure that they are financially sound
Setting the short-term interest rate
Lender of last resort


Monetary Policy
Monetary Policy: FED’s action of managing the money supply and the
interest rate
Expansionary or Easy Monetary Policy: Drop the interest rate to boost
planned investment and consumption, thus increasing the GDP
Contractionary or Tight Monetary Policy: Raise the interest rate to reduce
planned investment and consumption, thus curbing inflation



Monetary Policy

The FED uses three instruments to manage the money supply and
interest rates:

Reserve Requirement
Discount Window
Open Market Operations


Reserve Requirement
Reserve Requirement is the percentage of deposits that banks must hold at
their accounts in the FED.
If the FED wants to increase the money supply, it lowers the Reserve
Requirement. As a result, banks would hold less Required Reserve and keep
more Excess Reserve. To lend the additional Excess Reserve, banks will drop
the rate of interest on business and consumer loans.


Discount Window

Banks can borrow from the FED. The interest rate they pay on loans from the
FED is the Discount Rate.

If the FED wants to increase the money supply, it would lower the discount rate,
which encourages banks to borrow more from the FED. To lend these additional
reserves, banks will drop the interest rate on business and consumer loans.


Open Market Operations

Open Market Operations: The FED’s purchase and sale of government bonds to
member banks.
The FED held over $2.4 trillion of US government bonds as of February 4, 2015.
To increase the money supply, the FED buys more government bonds from
member banks. Banks receiving additional reserves from the FED will lower the
interest rate to lend them to households and business.


Expansionary Monetary Policy

To increase the money supply and reduce the interest rate, the FED
could

• Lower the Reserve Requirement
• Lower the Discount Rate
• Buy government securities from member banks


Contractionary Monetary Policy

To decrease the money supply and increase the interest rate, the FED
could

• Raise the Reserve Requirement
• Raise the Discount Rate
• Sell government securities from member banks


Monetary Policy
The original equilibrium occurs at E0.
An expansionary monetary policy will shift the supply of loanable funds to the right
from the original supply curve (S0) to the new supply curve (S1) and to a new
equilibrium of E1, reducing the interest rate from 8% to 6%.
A contractionary monetary policy will shift the supply of loanable funds to the left from
the original supply curve (S0) to the new supply (S2), and raise the interest rate from
8% to 10%.


Monetary Policy


Monetary Policy

a.

The economy is in recession. An expansionary monetary policy will reduce interest rate and
increase investment and AD, moving the economy toward the potential GDP with a relatively small
rise in the price level.

b.

The economy is producing above the potential GDP, experiencing rapid inflation. A contractionary
monetary policy will increase the rate of interest, depressing investment and dropping AD. The
economy will move to an new equilibrium with smaller GDP and lower price level.


Monetary Policy


Monetary Policy

In expansionary monetary policy the central bank causes the supply of money to increase, which
lowers the interest rate, stimulating additional borrowing for investment and consumption, and
raising the AD. The result is a higher price level and and a larger GDP.

In contractionary monetary policy, the central bank causes the supply of money and credit to
decrease, which raises the interest rate, discouraging borrowing for investment and consumption,
and dropping the AD. The result is a lower price level and a smaller GDP.


Monetary Policy


Monetary Policy

Through the episodes shown here, the Federal Reserve typically reacted to higher inflation with a
contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with
an expansionary monetary policy and a lower interest rate.


Velocity of money

Velocity is the nominal GDP divided by the money supply for a given year. Different measures of velocity can
be calculated by using different measures of the money supply. Velocity, as calculated by using M1, has
lacked a steady trend since the 1980s, instead bouncing up and down.


Monetary policy: long-run effect

With a vertical AS, monetary policy is ineffective in the long-run. An expansionary policy shifting the
AD will have no effect of GDP, but causes the price level to rise.



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