1. Monetary Policy
The Basics

2. What is Monetary Policy?
• The actions the Federal Reserve takes to
manage the money supply and interest rates
to pursue macroeconomic policy goals.
– Goals of Monetary Policy
• Price stability
• High employment
• Stability of financial markets and institutions
• Economic growth

3. Price Stability
• Rising prices erode the value of money as a
medium of exchange and a store of value.
• Increase in inflation rate results in a rise in
prices.
• Decrease in inflation rate results in a decrease
in prices.
• Keeping the inflation rate stable helps keep
prices stable.

4. High Employment
• Unemployed workers contribute to reducing
GDP below its potential level.
• Unemployment causes financial distress and
decreases self-esteem of workers who lack
jobs.
– Lack of job results in less spending/more saving
which decreases demand and causes inflation and
prices to rise.

5. Stability of Financial Markets and
Institutions
• The Fed promotes this so that an efficient
flow of funds from savers to borrowers will
occur.
– Resources are lost when they are not efficient in
matching savers and borrowers.
– Firms with the potential to produce valuable
goods and services cannot obtain the financing
they need.
– Savers waste resources looking for satisfactory
investments.

6. Economic Growth
• Stable growth allows households and firms to
plan accurately and encourages the long-run
investment needed to sustain growth.
– Provide incentives for saving for larger pool of
investment funds
– Provide direct incentives for business investment

7. Monetary Policy Targets
• The Fed cannot effect unemployment and
inflation rates directly.
• The Fed uses variables that it can affect
directly and that affect variables like real GDP,
employment, and price level.
• Two main targets:
– Money supply
– Interest rate

8. Money Supply and Interest Rate
Lower interest rates lead to increased spending!

9. Choosing a Monetary Policy Target
• The fed can either choose money supply or
interest rate.
– Typically focus on interest rate
• There are many kinds of interest rates.
– The Fed targets federal funds rate.
• The interest rate banks charge each other for loans.
– Determined by the supply of reserves relative to the demand
for them.
• The Fed can increase/decrease supply of bank reserves
through open market operations and set a target for
the federal funds rate.

10. • Expansionary Monetary Policy
– The Federal Reserve’s increasing the money
supply and decreasing interest rates to increase
real GDP.
– Used during a recession when unemployment is a
problem.
– To increase the money supply, the Federal Reserve
can:
• buy government bonds (an open market purchase)
• lower the discount rate
• lower the reserve requirement

11. Too Low for Zero?
• If the Fed must reduce the federal funds rate to
nearly zero then Quantitative Easing is tried.
– The buying financial assets from commercial
banks and other private institutions with newly
created money in order to inject a pre-
determined quantity of money into the economy.
– Although more money is floating around, there is still
a fixed amount of goods for sale. This will eventually
lead to higher prices or inflation.

13. • Contractionary Monetary Policy
– The Federal Reserve’s adjusting the money supply
to increase the interest rates to reduce inflation.
– Used when inflation is the problem.
– To decrease the money supply, the Federal
Reserve can:
• sell government bonds (an open market sale)
• raise the discount rate
• raise the reserve requirement

15. Inflation Targeting
• Conducting monetary policy so as to commit
the central bank to achieving a publicly
announced level of inflation.

16. Can the Fed Eliminate Recessions?
• The best the Fed can do is to keep recessions
shorter and milder then they would be
otherwise.
– Offsetting the effects of the business cycle
– Timing is essential
• If the Fed too early or late in recognizing a recession
and implementing a policy then it could destabilize the
economy.