Monetary Policy

What is Monetary Policy?

The term "monetary policy" refers to what the Federal Reserve, the nation's central bank, does to influence the amount of money and credit in the U.S. economy.

What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy.

Fiscal Policy Vs. Monetary Policy

Central banks are often insulated from domestic political pressures and so are better able to impose economic restraint.

• Central banks can change policy relatively quickly in response to new economic conditions.

• Legislative process too slow to respond to rapidly changing economic conditions.

• National legislatures have a disposition toward stimulus and find it politically easier to run deficits rather than surpluses.

Three functions of money in an economy:

- Medium of Exchange. 
- Unit of Account. 
- Store of Value.

Medium of Exchange

An item that buyers give to sellers when they want to purchase goods and services.

Unit of Account

The yardstick people use to post prices and record debts.

Store of Value

An item that people can use to transfer purchasing power from the present to the future.

Money Stock ( Money Supply)

amount of money in circulation in the economy]

M1: consists of currency and traveler's checks plus checking deposits owned by individuals and businesses.

M2includes M1 plus savings deposits, time deposits, money market mutual funds, and other deposits.

M3 consists of M2 plus large scale time deposits and term deposits.

Monetary Base

The sum of currency in circulation plus reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve).

Money Identity Equation

M x V = P x Q = nominal GDP

M

Money Suppy

V

Velocity of Money

P

Price Level

Q

Quantity of Output

Money Multiplier

The amount of money the banking system generates with each dollar of reserves.

Money Multiplier= 1/reserve ratio

Central Bank

is an institution designed to oversee the banking system and regulate the quantity of money in the economy.

Other major central banks around the world include the Bank of England, the Bank of Japan, and the European Central Bank (ECB).

The Federal Reserve is...

the central bank in the U.S.

US Federal Reserve System

different banks across the US based on geo location

Most Important: New York

US Federal Reserve Chair

Janet Yellen
Professor of Economics, UC Berkeley

Open Market Operations

Fed 1st tool of monetary control

The purchase and sale of U.S. government bonds by the Fed.

This is the tool the Fed uses most often.

Selling Government Bond

Fed 1st tool of monetary control

When the Fed sells bonds, it pulls liquidity out of the economy and therefore reduces the money supply.

Buying Government Bonds

Fed 1st tool of monetary control

When the Fed buys bonds, it injects money into the economy and there increases the money supply.

Reserve Requirement

Feds 2nd Tool of Monetary Control

Regulations on the minimum amount of reserves that banks must hold against deposits.

An increase in the reserve requirement means...

that banks must hold more reserves, and therefore, can loan out less of each dollar that is deposited.

A decrease in reserve requirements means...

that banks hold less reserves, and therefore, can loan out more of each dollar that is deposited.

Reserve Ratio

Feds 2nd Tool of Monetary Control

The portion (expressed as a percent) of depositors' balances banks must have on hand as cash.

Discount Rate

Feds 3rd Tool of Monetary Control

The interest rate the Federal Reserve sets and offers to member banks and thrifts that need to borrow money from the Fed "discount window".

A lower discount rate...

encourages banks to borrow from Fed, increases quantity of reserves, and increases the money supply.

A higher discount rate...

discourages banks from borrowing from the Fed, decreases quantity of reserves, and decreases the money supply.

Federal (Fed) Funds Rate

The interest rate banks charge one another for overnight use of excess reserves. Put simply, banks can avoid borrowing directly from the Federal Reserve (via the discount window) by borrowing from one another instead.

This rate is interest rate the Fed adjusts most often.

Prime Rate

The interest rate offered by commercial banks to its most valued corporate customers. But in reality, it just serves as a benchmark for lending rates.

Variable interest rates of credit cards, business loans, home loans, auto loans and other types of loans will:

Increase discount/fed funds rate, Increase prime rate, and Increase Cost of Borrowing

Decrease discount rate/fed funds rate, Decrease prime rate, Decrease Cost of Borrowing

Monetary Control

increase or lower the money supply

Increase or lower the discount rate and reserve requirement it will increase or lower the money supply

Increase Money Supply

Interest Rate Falls 
Exchange Rate Depreciates
Price Level Rises (Inflation)

Decrease Money Supply

Interest Rate Rises 
Exchange Rate Appreciates
Price Level Falls (Deflation)