Equilibrium
Increase
Decrease
This lesson is divided in three parts:
The government may manipulate the economy by changing the price of money. What is the price of money? It is what you normally call the interest rate. For example, you may have a car loan, a mortgage or a credit card. The interest you pay in those loans is nothing else but the price of money the bank is letting you use! Monetary Policy is run by the Federal Reserve System. (Fed)
In terms of economic growth the Fed may help the economy grow by simply lowering interest rates. For example if you get a 3 year car loan of $10,000 at 12% your payment is $332/month. If the Fed lowers interest rates and the car loan is now at 8%, your payment is only $313/month. That is a $19/month amount of savings, enough for a night at the movies including pop-corn :).
Let's say the Fed lowers interest rates and the spending by all consumers increases, then the graph below shows the increase in GDP generated by this change in monetary policy.
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Equilibrium Increase Decrease |
The graph above depicts Price Level on the vertical axis and GDP on the horizontal axis. A direct relationship for the total amount of production and an inverse relationship for total spending.
The common tools of monetary policy are three:
discount rate - rate of interest charged to banks. For the economy to grow the Fed will decrease this number, the opposite is true when the Fed wants the economy to slow down.
required reserve - amount of reserves banks have to maintain. The Fed will raise this number when the economy is growing too fast. (And vice versa)
Open Market Operations - buying or selling of government bonds. The Fed will sell bonds when the economy is growing too fast and vice versa.
If you were the chairman of the Fed and you believed the economy was growing too fast, what would you do with your three tools? Write your recommendations on a piece of paper and go to lesson three.
In order to slow down the economy the Fed should:
raise discount rates
raise required reserves
sell bonds in the market
These actions would reduce the money supply, therefore the economy should slow down. Of course if the economy was growing too slowly then all these policies should be reversed.
Worksheet
1. If the Fed lowers the discount rate, what do you expect will happen to inflation? Why? Explain the role of the banking system.
2. Explain the "spread", where banks make money by lending you your own money at much higher rates!
3. If the required reserve is 15% and new money in the amount of $500,000 comes into the banking system, explain how much money the first bank may lend. How much will the entire banking system lend? Why? Explain how the fractional reserve system operates.
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