Test Review III: Controlling Total Economic Activity
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II. Monetary Policy
A. The Demand for Money is Dm= Dt + Da
1. Transaction Dt results because people hold money, often in a money market account, to use as a medium of exchange.
2. Asset Demand, Da results because people accumulate money, often held in an investment account, to buy assets.
B. Monetary policy is the regulation of the money supply to affect interest rates, economic activity, with the objective of noninflationary full employment.
1. It is part of, but not the focal point of Keynesian economics.
2.Affecting interest rates and to change investment thus affecting economic activity is one goal of the Fed.
a. Controlling reserve requirement may affect the money supply which may affect interest rates
1. Reserve requirement is the amount of demand deposits that must be kept in cash with the Federal Reserve or in the bank.
2. Often expressed as a percent called the reserve ratio.
3. Excess reserve can be loaned as demand deposits.
4. Excess reserves determine the potential money supply (M1).
b. Changes interest rates change investment causing a change in AD which changes economic activity.
1) Increasing the money supply may lower interest rates. increasing investment which increases AD which causes an increase in Real GDP.
2) Decreasing the money supply may increase interest rates lowering investment which increses AD which causes an increase in Real GDP.
c. Dollar values on this page are representative of amounts prevalent during the late 1990's (billions of dollars).
C. Types of monetary policy
1. Quantitative controls affect the money supply.
a. Required Reserve Ratio
1. Lowering the reserve ratio creates excess reserves which banks may loan as newly created money. This is expansionary.
2. Raising the reserve ratio eliminates excess reserve so banks can not renew loans removing money and causing a contraction.
b. Open-market operations
1. Buying and selling of U.S. government bonds by the Fed from banks or in the open market to change excess reserves affecting M1 supply and interest rates is the primary tool.
2. Buying bonds is expansionary.
a) When buying from banks, the Federal Reserve pays with reserves providing excess reserves banks can loan as demand deposits.
b) When buying in the open market, increased demand from the Federal Reserve pushes up prices sellers receive, lowering the effective interest sellers pay.
3. Selling bonds contracts the economy.
4. Review of Valuing bonds
a) Suppose you buy a twenty year, $10,000 bond paying 5% per year at face value of $10,000. Face value is called par value.
1) A few years go by and you need money and one choice is to sell the bond.
2) If interest rates on this type bond have gone down, people will be very anxious to buy, demand, will be high pushing price up and your will receive more than $10,000.
3) If rate shave gone down, no one will give you $10,000, demand will be low, so if you need the money, you will sell for less, below par.
4) You can hold for twenty years and get par and get the money some where else.
b) Therefore, interest rates and bond values (prices) go in the opposite direction, if interest rates down, old bond price up because they are at the old higher rate.
c) This is called the interest rate risk for bonds. Other risks have to do with issuer default and monetary inflation.
5. It is the most powerful of the four tools.
C. Discount rate
1. This is the rate charged by the Federal Reserve for loans to member banks.
2. It strongly affects the prime interest rate paid by a bank's best customers.
a) Lower the rate to expand economy as interest rates decrease.
b) Raise the rate to contract economy as interest rates increase.
c) Another important interest rate is the federal funds rate which is the rate at which banks loan funds to each other.
D. Term Auction Facility
1. Initiated in 2007, it allows banks to add to their reserves at low rates.
2. Done to increase bank liquidity which was low because of a loss in reserve caused by a housing crisis.
2. Other controls affect the actions of market participants.
A. Moral suasion or jawboning is social pressure by influential people to encourage specific people to act in the public interest.
B. Margin requirements, the down payment required on stocks which is now 50%, is seldom changed.
C. Consumer credit controls, on items such as credit cards, work so well it is seldom used.
D. The Federal Funds Rate is the overnight rate banks with excess fed reserve charge each banks short of fed reserve to keep the system in balance.
1. Most controllable interest rate 2. Targeted by monetary policy 3. Controlling reserves, controls this rate. 4. Allows some control over short-term rates.
D. Effectiveness of monetary policy
1. Strengths a. Speedy, flexible b. Somewhat isolated from political pressure c. Hard money, restrictive policy by the Federal Reserve, has worked well recently.
2. Weaknesses a. Easy money has not worked well because low business profit expectations , fears over employment loss by workers make low interest rates ineffective.
b. Bank deregulation has made commercial banks a less important supplier of investment funds thus diminishing the effectiveness of monetary policy.
c. Changes in the velocity of money may negate some of the effects of monetary policy.
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