MONETARY POLICY

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Monetary Policy:

Monetary Policy Deliberate changes in the money supply to change the interest rate and employment level in the economy.

Objectives of Monetary Policy:

Objectives of Monetary P olicy Achieve full-employment level Stable or low inflationary rate Economic growth

Tools of Monetary Policy:

Tools of Monetary P olicy Open Market Operations (OMO) Reserve Ratio (RR) Discount Rate (DR)

Open market operations:

Open market operations FED’s open market operations consist of buying of govt. Bonds from or selling to commercial banks and general public

Open Market Operations (OMO):

Open Market Operations (OMO) Buying security Bank gives up securities FED pays bank Banks have increased reserves

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Open Market Operations (OMO) Selling Security FED gives up securities Bank pays for securities Banks have decreased reserves

Reserve ratio:

Reserve ratio The fraction of deposits that banks hold as reserve to the FED.

Reserve Ratio (RR):

Reserve Ratio (RR) Raising the Reserve Ratio Banks must hold more reserves Banks decrease lending Money supply decreases Lowering the Reserve Ratio Banks may hold less reserves Banks increase lending Money supply increases

Discount Rate (DR):

Discount Rate (DR) The interest rate charged to banks for borrowing short-term funds directly from the Federal Bank High discount rate Low discount rate

Types of Monetary Policy:

Types of M onetary P olicy Expansionary monetary policy: Contractionary monetary policy:

Expansionary monetary policy: :

Expansionary monetary policy: Expansionary policy increases the total supply of money in the economy Buy Securities Decrease Reserve Ratio Lower Discount Rate

Expansionary Monetary Policy:

Expansionary Monetary P olicy Problem: Unemployment &Recession FED buys bonds, lowers RR or lowers DR Excess Reserves increase Federal Fund Rate Falls Money Supply rises Interest Rate falls Investment spending increases Aggregate Demand increases RGDP rises

Contractionary monetary policy: :

Contractionary monetary policy : Contractionary policy decreases the total money supply in the economy Sell Securities Increase Reserve Ratio Raise Discount Rate

Contractionary Monetary Policy:

Contractionary Monetary P olicy Problem: inflation FED sells bonds, raises RR or raises DR Excess Reserves falls Federal Fund Rate increases Money Supply falls Interest Rate rises Investment spending decreases Aggregate Demand decreases RGDP falls

Monetary Policy and Equilibrium GDP:

Monetary Policy and Equilibrium GDP (a). Quantity of money demanded and supplied Dm MS1 MS2 MS3 10 8 6 125 150 175 Rate of Interest ( i ) 10 8 6 (b). Investment demanded (I) 15 20 25 Rate of Interest ( i )

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(c). Real domestic output, GDP AS AD 1 (I=$15) P 1 AD 3 (I=$25) P 2 Price level AD 2 (I=$20) P 3

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