Money, Banking, and Monetary Policy ❮ 153The chain of events for expansionary and contractionary monetary policy is as follows.• Unemployment is too high →↑MS, ↓i%, ↑I, ↑AD, ↑real GDP, ↓unemployment
• Inflation is too high →↓MS, ↑i%, ↓I, ↓AD, ↓real GDP, ↓price levelTIPOpen Market Operations
Just like individuals and firms, the Federal Reserve, through the Federal Open Market
Committee (FOMC), can buy and sell securities on the open market. Such an open
market operation (OMO) typically involves the buying (or selling) of Treasury
bonds from (or to) commercial banks and the general public. Of the three tools of
monetary policy, conducting OMOs is by far the approach most frequently taken by
the Fed.
Buying Securities. Commercial banks hold Treasury bonds as an asset rather than excess
cash reserves. If the Fed offers to buy some of those securities, the banks would receive
excess cash reserves and the Fed would get the bonds. When banks have excess reserves,
the money creation process begins. The money supply increases and the interest rate falls.
• When the Fed buys securities, the money supply expands. If it helps to remember, use
this: “Buying Bonds = Bigger Bucks” (a larger money supply).
Selling Securities. Commercial banks might be in the market to buy Treasury bonds as
an asset rather than excess cash reserves. If the Fed offers to sell some of their securities,
the banks would get the bonds and their excess cash reserves would fall. When banks have
fewer excess reserves, the money destruction process begins. The money supply decreases
and the interest rate rises.
• When the Fed sells securities, the money supply contracts. If it helps to remember, use
this: “Selling Bonds = “Smaller Bucks” (a smaller money supply).The Federal Funds Rate
The discussion of OMOs seems to indicate that the buying and selling of securities is
the main policy tool. If the FOMC wants to lower the interest rate, it buys bonds. If the
FOMC wants to increase the interest rate, it sells bonds. In reality, the federal funds rate
is set as a target interest rate and the FOMC then proceeds to engage in OMOs to hit that
target rate. The federal funds rate is the interest rate that banks charge other banks for
short-term loans. One bank might need to borrow funds from other banks, primarily to
cover an unexpected dip in reserves. The important thing to remember is that our analysis
of monetary policy is the same whether we talk about changes in the money supply or
changes in the target federal funds interest rate.Changing the Discount Rate
There are times when commercial banks need a short-term loan from the Fed. When they
borrow from the Fed, they pay an interest rate called the discount rate. When the Fed
lowers the discount rate, it makes it more affordable for commercial banks to increase
excess reserves by borrowing from the Fed. The entire amount of the loan goes into excess
reserves and can be borrowed by customers of the bank, increasing the money supply. As
a practical matter, the Fed tends to change the discount rate in lockstep with the federal
funds target rate.KEY IDEA“This is a
great way to
remember this!”
—AP Teacher