Chapter 15 - Monetary Policy

What is money?

Anything that is generally accepted as payment for goods and services or in the settlement of debt.

What are the 3 functions of money?

1. Medium of exchange

2. Store of value

3. Unit of Account

What does it mean that money is a medium of exchange?

You can use it to purchase goods and services.

• It’s more efficient than the barter system

What does it mean that money is a store of value?

It retains a certain amount of purchasing power over time.

• Most convenient way to hold onto wealth over time

What does it mean that money is a unit of account?

It is a standard unit of comparison

• Allows for more informed decisions

What are the characteristics of good money?

• Stability of value - wide acceptance

• Convenience - more convenient than the gold standard

What is fiat money?

Money that has no value apart from its use as money.

• Money is really based upon trust

What is commodity-backed money?

Paper currency that can be exchanged for a commodity

• Ex: $1 = 1/20 oz gold

What is an advantage of a fiat system?

The government has the ability to manage the money supply.

What is a central bank NOT?

• A commercial bank

• The government’s financial arm

  • That is the Treasury Department

What type of policy does the Treasury Department conduct?

Fiscal

What type of policy do central banks conduct?

Monetary

What is the dual mandate of the Fed?

1. Price stability

   • Maintain stable money supply while keeping prices constant over time

2. Maximum sustainable employment

What does it mean when the Fed is called a Lender of Last Resort?

It financially supports banks that no longer have other available means of borrowing.

What is the central bank?

A government institution that is charged with:

• Achieving macroeconomic stability

• Achieving financial stability

• Regulating commercial banks

What is a district bank?

A joint venture between the private sector and the government sector

What are the activities of district banks?

• Manage check clearing

• Hold reserves

• Manage currency in circulation

• Make discount loans

• Collect data and engage in research

How is the Fed organized?

12 regional banks headed by Board of Governors

What is the Federal Market Open Committee responsible for?

Setting monetary policy

What is the Board of Governors?

7 members

• Appointed by President and confirmed by Senate for 14-year terms

• Experts in finance, banking, and monetary policy

Who makes up the FOMC?

• The Board of Governors

• 5/12 of the Presidents of District Banks

  • The President of the New York regional bank is always a member

What makes the Fed independent?

It does not need the permission of the President or Congress to make and implement changes.

• Is also financially independent

How does the Fed primarily influence the economy?

By changing interest rates

What is expansionary monetary policy?

Actions that increase the money supply in order to increase aggregate demand

When would the Fed want to use expansionary monetary policy?

When economy is in a recession and when there’s a concern about unemployment

How does expansionary monetary policy impact the following: Interest rates, money supply, component(s) of aggregate demand, aggregate demand, prices, real GDP, and employment?

• Interest rate - Decreases

• Money supply - Increases

• Investment and consumption - Increase

• Aggregate Demand - Increases

• Prices - Increase

• Real GDP - Increases

• Employment - Increases

What is contractionary monetary policy?

Actions that reduce the money supply in order to decrease aggregate demand

When would the Fed want to use contractionary monetary policy?

When economy is in a boom and when inflation is high

How does contractionary monetary policy impact the following: Interest rates, money supply, component(s) of aggregate demand, aggregate demand, prices, real GDP, and employment?

• Interest rate - Increases

• Money supply - Decreases

• Investment and consumption - Decrease

• Aggregate Demand - Decreases

• Prices - Decrease

• Real GDP - Decreases

• Employment - Decreases

What are reserve balance accounts?

The accounts in which banks hold cash at the Fed

What are federal funds transactions?

The transfer of funds from one bank’s reserve account to another bank’s reserve account.

What is the federal funds rate (FFR)?

The interest rate banks charge each other to borrow.

How would the Fed alter the FFR during expansionary monetary policy?

Lowers target for FFR

How would the Fed alter the FFR during contractionary monetary policy?

Increases target for FFR

How does the Fed influence the federal funds rate?

• Expansionary policy - decreases it

• Contractionary policy - increases it

What are the monetary policy tools?

1. Interest Rate on Reserve Balances (IORB)

2. Overnight Reserve Repurchasing Facility Offering Rate (ON RRP)

3. Discount Rate

4. Open Market Operations

5. Reserve Requirement Ratio (RRR)

What is the IORB?

The interest rate that banks earn from the Fed on the funds they deposit in their reserve balance accounts

How would the Fed alter the IORB during expansionary monetary policy?

Decrease IORB

How would the Fed alter the IORB during contractionary monetary policy?

Increase IORB

What is the ON RRP?

The interest rate at which different market participants swap treasuries for cash to cover short-term cash needs

• For financial institutions that aren’t eligible to receive IORB

• Should be a floor on the FFR

• Currently = 5.30%

How would the Fed alter the ON RRP during expansionary monetary policy?

Decrease ON RRP

How would the Fed alter the ON RRP during contractionary monetary policy?

Increase ON RRP

What is the discount rate?

The interest rate the Fed charges banks to borrow

• Should be a ceiling on the FFR

• Currently = 5.50%

How would the Fed alter the discount rate during expansionary monetary policy?

Decrease discount rate

How would the Fed alter the discount rate during contractionary monetary policy?

Increase discount rate

What are open market operations?

The Fed’s buying and selling of U.S. government bonds in the secondary market

How would the Fed alter open market operations during expansionary monetary policy?

Fed should buy bonds from banks

• Banks have more money to lend

How would the Fed alter open market operations during contractionary monetary policy?

Fed should sell bonds to banks

• Banks have less money to lend

What is the RRR?

The percent of a deposit banks are required to hold

How would the Fed alter the RRR during expansionary monetary policy?

Decrease RRR

How would the Fed alter the RRR during contractionary monetary policy?

Increase RRR

What are some advantages of monetary policy?

• Speed and flexibility

• Isolated from political pressure

  • Doesn’t make decisions based on who will get votes

What are some disadvantages of monetary policy?

• Fed can’t control behavior of banks, businesses, and households

• Lower bound on interest rates

  • When interest rates are close to zero, or even negative, central banks may run out of room to stimulate the economy in times of recession or deflation.