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Monetary Policy and the Federal Reserve
Wednesday, April 13, 2016

The Federal Reserve

1:09 PM

• Stabilizing policies are government policies that are meant to influence planned
aggregate expenditure, with the goal of eliminating output gaps
○ Monetary policy, which can be changed quickly by a decision of the
Federal Reserve's Federal Open Market Committee, is more flexible and
responsive
○ Fiscal policy can only be changed by Congress
• The Federal Reserve is the central bank of the United States
○ Responsible for monetary policy
○ Oversight and regulation of financial markets
• 12 regional Federal Reserve banks each with a Federal Reserve district
• Board of Governors: the leadership of the Fed, consisting of seven governors
appointed by the president to staggered 14-year terms
• Federal Open Market Committee (FOMC): the committee that makes decisions
concerning monetary policy
• Banking Panic: a situation in which news or rumors of the imminent bankruptcy
of one or more banks leads bank depositors to rush to withdraw their funds
○ Happen due to fractional-reserve banking, where bank reserves are less
than deposits
○ Banks do not have enough cash on hand to pay off depositors if they were
all to withdraw at one time
○ Greatly reduces nation's money supply
• The Fed can make loans to banks so that during a panic, banks can borrow cash
from the Fed to pay off depositors
• Each extra dollar of bank reserves translates into several dollars of money
supply
○ Each dollar can "support" several dollars in bank deposits
○ Public's withdrawals from banks, which increased currency held by the
public but reduced reserves by an equal amount, led to a net decrease in
the total money supply
§ Currency + deposits
• Bank deposits = Bank reserves/desired reserve to deposit ratio
• Deposit Insurance: a system under which the government guarantees that
depositors will not lose any money even if their bank goes bankrupt
○ Eliminates the incentive for people to withdraw their deposits when

the total money supply
§ Currency + deposits
• Bank deposits = Bank reserves/desired reserve to deposit ratio
• Deposit Insurance: a system under which the government guarantees that
depositors will not lose any money even if their bank goes bankrupt
○ Eliminates the incentive for people to withdraw their deposits when
rumors circulate that the bank is in financial trouble
○ May also lead to reckless behavior

Monetary Policy and Economic Fluctuations

• Planned aggregate expenditure is affected by the level of the real interest rate
○ Lower interest rate encourages higher planned spending
○ Higher real interest rate reduces spending
○ By adjusting the nominal interest rate, the Fed can move planned
spending in the desired direction
§ Does so through its control of the money supply
• R = i - pi
○ R = real interest rate
○ I = nominal interest rate
○ Pi = rate of inflation
• Federal Funds Rate: the interest rate that commercial banks charge each other
for very short-term loans
○ Not an official government interest rate
○ The Fed has expressed its policies in terms of the federal funds rate
• A higher interest increases the reward for saving --> less spending
○ Also discourages firms from buying capital
• At any given level of output, both consumption spending and planned
investment spending decline when the real interest rate increases
○ A fall in the real interest rate stimulates consumption and investment by
reducing financing costs
• Short-run equilibrium output is the level of output that equals planned
aggregate spending
• Decrease in real interest rate --> increase in planned consumption and
investment --> increase in PAE --> increase in output
• Increase in real interest rate --> decrease in planned consumption and
investment --> decrease in PAE --> decrease in output
○ In a recessionary gap, real output < potential output and planned
spending is too low
§ Fed will reduce the interest rate to stimulate consumption and
investment spending
○ In an expansionary gap, output is too high
§ Fed will raise the interest rate which reduces consumption and
planned investment
• Only focuses on the general economy because it is very difficult to identify asset

investment spending
○ In an expansionary gap, output is too high
§ Fed will raise the interest rate which reduces consumption and
planned investment
• Only focuses on the general economy because it is very difficult to identify asset
bubbles

The Federal Reserve and Interest Rates

• Any value of the money supply chosen by the Fed implies a specific setting for
the nominal interest rate, and vice versa
• The nominal interest rate is effectively the "price" of holding money (or its
opportunity cost)
• Money is the set of assets, such as cash and checking accounts, that are usable
in transactions
○ Also a store of value, like stocks, bonds, or real estate (financial assets)
• Portfolio Allocation Decision: the decision about the forms in which to hold
one's wealth
• People generally prefer to hold assets that they expect to pay a high return and
do not carry too much risk
• Diversification is when one owns a variety of different assets
• Demand for Money: the amount of wealth an individual or firm chooses to hold
in the form of money
○ An individual should increase his or her money holdings only so long as
the extra benefit of doing so exceeds the extra cost
○ The principal benefit of holding money is its usefulness in carrying out
transactions
○ Principal cost is the opportunity cost, since cash pays zero interest
§ In order to hold an extra dollar of wealth in the form of money, a
person must reduce by one dollar the amount of wealth held in the
form of higher-yielding assets, such as bonds or stocks
§ Opportunity cost of holding money is measured by the interest rate
that could have been earned if the person had chosen to hold
interest-bearing assets instead of money
§ The higher the nominal interest rate, the higher the opportunity
cost of holding money
• Real income or output (Y) affects the benefit of holding money
○ An increase in aggregate real income or output, such as real GDP, raises
the quantity of goods that people want to buy and sell
○ To accommodate the increase in transactions, people need to hold more
money
• The price level (P) affects the benefit of holding money
○ The higher the price of a good, the more dollars are needed to make a
given set of transactions
• Money Demand Curve: a curve that shows the relationship between the
aggregate quantity of money demanded (M) and the nominal interest rate (i)

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money
The price level (P) affects the benefit of holding money
○ The higher the price of a good, the more dollars are needed to make a
given set of transactions
Money Demand Curve: a curve that shows the relationship between the
aggregate quantity of money demanded (M) and the nominal interest rate (i)
○ Slopes downward
○ An increase in the nominal interest rate increases the opportunity cost of
holding money, which reduces the quantity of money demanded
○ Any change (other than i) that makes people want to hold more money
will shift the money demand curve to the rights
○ Any change (other than i) that makes people want to hold less money will
shift the money demand curve to the left
The supply of money is controlled by the Federal Reserve
The Fed uses open-market operations
○ To increase money supply, can use newly created money to buy
government bonds from the public (open-market purchase), which puts
new money into circulation
Money supply curve is a vertical line that intercepts the horizontal axis at the
quantity of money chosen by the Fed (M)
Prices of existing bonds are inversely related to the current interest rate
○ Higher interest rates --> lower bond prices

How the Fed Controls the Nominal Interest Rate

• The Fed can control the money supply in three ways: open-market operations,
discount window lending, and directly affecting bank reserves
• To reduce money supply, the Fed can sell government bonds to the public in
exchange for money
○ Cause interest rate to rise
• The cash or assets held by a commercial bank for the purpose of meeting
depositor withdrawals are called its reserves
○ Desired amount of reserves = deposits*desired reserve to deposit ratio
• Discount Window Lending: the lending of reserves by the Federal Reserve to
commercial banks
• Discount Rate (or Primary Credit Rate): the interest rate that the Fed charges
commercial banks to borrow reserves
○ Federal Funds Rate is different -- it is the interest rate banks charge each
other for short term loans
• Reserve Requirements: set by the Fed, the minimum values of the ratio of bank
reserves to bank deposits that banks are allowed to maintain
○ Reserve to Deposit Ratio = total reserves/total deposits
○ A decline in reserve-deposit ratio would cause money supply to rise
• Fed can also decrease money supply by increasing the interest rate paid on
reserves

reserves to bank deposits that banks are allowed to maintain
○ Reserve to Deposit Ratio = total reserves/total deposits
○ A decline in reserve-deposit ratio would cause money supply to rise
• Fed can also decrease money supply by increasing the interest rate paid on
reserves
○ Increases the reserve-deposit ratio since banks will want to hold more
○ Causes money supply to decrease and raises nominal interest rates
• Quantitative Easing (QE): an expansionary monetary policy in which a central
bank buys long-term financial assets from private financial institutions
○ Lowers the yield or return of those assets while increasing the money
supply
○ Aims to lower long-term interest rates



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