I. Monetary policy
      A. Monetary policy is the regulation of the money supply to affect interest rates and economic activity.
      B. It is part of, but not the focal point of Keynesian economics.
      C. Objective is noninflationary full employment.
      D. One goal is to change economic activity by affecting interest rates and investment.
          1. The Federal Reserve determines the reserve requirement which may affect the money supply which may 
              affect interest rates.
              a. Reserve requirement is the amount of demand deposits that must be kept in cash with the Federal Reserve
                  or in the bank.
              b. Often expressed as a percent called the reserve ratio.
              c. Excess reserve can be loaned as demand deposits.
              d. Excess reserves determine the potential money supply (M1).
              e. A change in the money supply changes interest rates which may change investment causing a change in AD
                  which changes economic activity.
                  1) Increasing investment will increase economic activity.
                      a) The Federal Reserve increases the money supply which may lower interest rates. 
                      b) Low interest rates increase investment which increases AD which causes an increase in Real GDP.
                 2)  Decreasing investment will decrease economic activity.
                      a) The Federal Reserve decreases the money supply which may increase interest rates. 
                      b) High interest rates decrease investment which decreases AD which causes a decrease in Real GDP.
         2. Dollar values on this page are representative of amounts prevalent during the late 1990's (billions of dollars).

E. Affecting the non-investment components of aggregate demand
          1. Lower interest rates also increase C, G, and X_N
              a. Consumption increases as credit purchases become cheaper.
              b. Refinancing existing debt at lower interest rates by individuals, businesses, and governments frees funds for spending.
              c. Lower interest rates also decrease the international value of the dollar as investors buy (demand) other currencies to
                  earn more interest. The lower dollar increases X_N as U.S. goods are less expensive and foreign goods more expensive.
          2. Higher interest rates have an opposite affect

 II. Types of monetary policy
      A. Quantitative controls affect the money supply.
           1. Required Reserve Ratio
               a. Lowering the reserve ratio creates excess reserves which banks may loan as newly created money. This is expansionary.
               b. Raising the reserve ratio eliminates excess reserve so banks can not renew loans removing money and causing
                   a contraction.
           2. Open-market operations
               a. Buying and selling of U.S. government bonds by the Federal Reserve from banks or in the open market to change
                   excess reserves thus affecting the supply of M1 and interest rates is the primary tool.
               b. Buying bonds is expansionary.
                   1) When buying from banks, the Federal Reserve pays with reserves providing excess reserves banks can loan as
                       demand deposits.
                   2) When buying in the open market, increased demand from the Federal Reserve pushes up prices sellers receive,
                        lowering the effective interest sellers pay.
               c. Selling bonds contracts the economy.
               d. Federal Open Market Committee  minutes make interesting reading.
           3. Discount rate
               a. This is the rate charged by the Federal Reserve for loans to member banks.
               b. It strongly affects the prime interest rate paid by a bank's best customers.
                   1) Lower the rate to expand economy as interest rates decrease.
                   2) Raise the rate to contract economy as interest rates increase.
                   3) Another important interest rate is the federal funds rate which is the rate at which banks loan funds to each other.
      B. Other controls affect the actions of market participants.
          1. Moral suasion or jawboning  
              a. This social pressure by influential people to encourage specific people to act in the public interest.
              b. It is used to influence public opinion and political attitudes.
              c. An example is when the Chairman of Board of Governors makes his Semiannual Report to Congress on the economy and monetary policy.
          2. Margin requirements, the down payment required on stocks which is now 50%, is seldom changed.
          3. Consumer credit controls, on items such as credit cards, work so well it is seldom used.

III. Effectiveness of monetary policy
      A. Strengths
          1. Speedy and flexible
          2. Somewhat isolated from political pressure
          3. Hard money, restrictive policy by the Federal Reserve, has worked well recently. 
     B. Weaknesses
          1. Easy money has not worked well.
              a. In the early 1900's, it didn't stop a recession. 
              b. Low profit expectations by business and fears over possible employment loss by workers make
                  lower interest rates ineffective.
              c. Interest rate cuts in 2001 were not able to stop a recession.
          2. Bank deregulation has made commercial banks a less important supplier of investment funds thus 
             diminishing the effectiveness of monetary policy.
          3. Changes in the velocity of money may negate some of the effects of monetary policy.
      C. Monetary Policy, by James Tobin: The Concise Encyclopedia of Economics

IV.  Test your knowledge of monetary and fiscal policy with Economic Policy Tools by Dennis Kaufman of the University of Wisconsin-Parkside

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