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Chapter 14

Monetary Policy

Economics, 7th Edition

Boyes/Melvin

Copyright © Houghton Mifflin Company. All rights reserved. 14 | 2

The Federal Reserve System

• The Federal Reserve System (“the Fed”)serves as the central bank for the United States.

• A central bank:– accepts deposits from and makes loans to

commercial banks, and regulates banks

– acts as banker for the federal government.

– controls the money supply.


Structure of the

Federal Reserve System

The primary elements in the Federal

Reserve System are:

1. The Board of Governors

2. The Regional Federal Reserve District

Banks (FRBs)

3. The Federal Open Market Committee


The Federal Reserve Banks

• 12 District banks

• Nine directors

• The directors appoint the district

president who is approved by the

Board of Governors


The Board of Governors

• Seven members, appointed by the President

and confirmed by the Senate

• Serve 14-year term

• Terms are staggered so that one comes vacant

every two years

• President appoints a member as Chairman to

serve a four-year term


Federal Open Market

Committee (FOMC)

• Meets approximately every six weeks to

review the economy

• Made up of 12 voting members:

• 7 members of the Board of Governors

• 5 of the FRB presidents (rotate annually)


Functions of the Fed (1)

The Fed’s Banking Services:

– supplies currency

– holds the reserves

– processes and routes checks

– makes loans to banks

– supervises and regulate banks

– the banker for the U.S. government


Functions of the Fed (2)

Controlling the Money Supply

– The Fed managing the nation’s money supply. This

helps keep interest rates less volatile.

– The Fed also changes the money supply to

achieve policy goals set by the FOMC.


Policy Goals of the Fed

• Ultimate Goal of Monetary Policy:– Economic growth with stable prices. This means

greater output (GDP) and a low, steady rate of inflation.

• Intermediate Targets:– The Fed establishes target growth rates for the

money supply, which affects GDP and the level of prices.


Velocity of Money

• The velocity of money is the average

number of times per year that a dollar

is spent on final goods and services.

• Wheresgeorge.com


Velocity


Equation of Exchange

• The equation of exchange is an equation that

relates the quantity of money to nominal GDP.

– M = money supply

– V = velocity of money

– P = price level

– Q = real GDP

– MV = PQ


Quantity Theory of Money

• The Quantity Theory of Money with constant

velocity, changes in the quantity of money

change nominal GDP proportionately.


Operating Procedures

• FOMC Directive: Federal Reserve Bank of NY is directed to implement monetary Policy for a six-week period via buying or selling government bonds.

– The federal funds rate (“fed funds rate”) is the interest rate that banks charge when they lend excess reserves to each other.

– The buying and selling of government bonds by the

fed to achieve policy objectives are called “openmarket operations (OMO)”.


FOMC Statements

• The FOMC holds eight regularly scheduled

meetings per year.

• http://www.federalreserve.gov/newsevents/pres

s/monetary/20100127a.htm

http://www.federalreserve.gov/newsevents/press/monetary/20100127a.htm

http://www.federalreserve.gov/newsevents/press/monetary/20100127a.htm



The Fed’s Policy Tools

The three main policy tools are:

1) Reserve Requirements (increase to

constrict money supply, decrease to expand

money supply)

2) Discount rate

3) Open market operations


Discount Rate

• The discount rate is the rate of interest a Fed

District Bank charges a bank in its district when

such a bank borrows from the Fed.

Raise discount rate to constrict money supply.

Lower discount rate in expand money supply.

• Federal Funds Rate: interest rate that banks

charge each other. Fed doesn’t control but does

target.


Open Market Operations

• Open Market Operations (OMOs): the buying and selling of government bonds by the Fed

• If the FOMC wants to increase the money supply, it directs the FRB-NY to buy bonds, injecting new reserves into the banks of the bond sellers.

• To decrease money supply, sell bonds.


Money demand is a

negative function of

the rate of interest.

The interest rate is

the opportunity cost

of holding money.

Those who hold

money must forgo

receiving interest.

The higher the

interest rate the lower

the quantity of money

demanded.

Money Demand


The effect of a change inincome on money demand

Transactions demand

increases with

income. As nominal

income increases, the

volume of

transactions increase,

requiring additional

demand for money.


Money Supply

The money supply

is controlled by the

Fed, and therefore

is not a function of

interest rates. As a

result the money

supply function is

vertical.


Money Market Equilibrium


Money Supply vs. Interest Rates

Money

Interest

Rates

Fed Increases

Money Supply

M2M1

r2

r1Interest

Rates

Fall

Md


How Money Supply

Changes affect GDP

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