Monetary Policy

Conducted by the FED; comprised of 3 tools

Reserve Requirement

• Small % of deposit in bank, rest is loaned out (Fractional Reserve Banking)
• Inc. in MS -> Inc. in amt of $ held in bank deposits
• Recession - Dec. RR -> More ER; More loans; MS up, interest rates down; AD up (Easy)
• Inflation - Inc. RR -> Less ER; Less loans; MS down, interest rates up; AD down (Tight)

Discount Rate

• Interest rate FED charges to banks
• MS up needs decrease in Dis. Rate (Easy)
• MS down needs increase in Dis. Rate (Tight)

Open Market Op

• FED buys/sells bonds (securities)
• MS up needs buy bonds (easy)
• MS down needs sell bonds (tight)

Easy monetary policy: Buy Bonds; Decrease Dis. R & RR

Loans increase; AD up; GDP up; MS up; Interest rates down

Tight monetary policy: Sell Bonds; Increase Dis. R & RR

Loans decrease; AD down; GDP down; MS down; Interest rates up

• Fed Fund Rate - FDIC banks loan each other overnight funds (Opposite of Dis. Rate)
• Prime Rate - Interest rate banks give to most credit worthy customers 

Countercyclical Policies: Keynesian Fiscal Policy vs. Monetary Policy

In the early 21st century, here in the USA, an efficient, "full employment" economy will probably have:

• Annual unemployment rate 4%
• Annual inflation rate 4%

If the economy goes into a recession:

• The real GDP drops for at least 6 months
• Unemployment rate increases to 6% or more
• Inflation rate decreases to 2% or less

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the recession, then:

• The policy will try to improve C or G (parts of AD)
• Congress will decrease federal taxes
• Congress will increase job and spending programs
• The federal budget will probably create a deficit
• Due to changes in Money Demand, interest rates will increase (Crowding out might occur, but Keynesians don't care)

If the Federal Reserve employs Monetary Policy options to slow/stop the recession, then: 

• The policy will target improvement in Ig (part of AD)
• The Fed will target a lower Fed Fund Rate
• The Fed can lower the discount rate
• The Fed can buy bonds (Open Market Operations)
• The Fed can (theoretically) lower the reserve requirement, but probably won't because it is too complex for the banks.
• These Fed policies will lower the interest rates through changes in the Money Supply
• These options should increase Ig

If the economy suffers from too much demand-pull inflation or cost-push inflation, then:

• The unemployment rate will go to 4% or less 
• The inflation rate will probably go to 4% or more

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the inflation problems, then: 

• The policy will try to decrease C or G (parts ofAD)
• Congress will increase federal taxes
• Congress will decrease job and spending programs
• The federal budget will probably create a surplus
• Due to changes in Money Demand, interest rates will decrease

If the Federal Reserve employs Monetary Policy options to slow/stop the inflation problems, then:

• The policy will target decreases in Ig (part of AD)
• The Fed will target a higher Fed Fund Rate
• The Fed can increase the discount rate
• The Fed can sell bonds (Open Market Operations)
• The Fed can (theoretically) raise the reserve requirement, but probably won't because it is too complex for banks
• These Fed policies will raise the interest rates through changes in the Money Supply
• These options should decrease Ig