Lecture 19
MONEY SUPPLY AND THE CENTRAL BANK

Objectives
- To keep inflation in check
- To promote economic growth
- Question: Are these goals at odds with each other?
Conducting monetary policy
- Change money supply (equivalently, interest rates)
Independence of the central bank
- Is it okay that the Chair of the Fed is not an elected official?

How does the Fed do it?

(NOTE: Since the Global Financial Crisis of 2007-09, the Fed has radically revamped the conduct of its monetary policy - see #5 below.)

To increase money supply, the Fed will inject reserves into the banking system
To decrease money supply, the Fed will soak up reserves from the banking system

Method 1: Open-market operations

Buy govt securities from commercial banks OR Sell govt securities to commercial banks
Suppose the Fed buys Treasury bonds from Citibank
- Citibank's holdings of govt. securities will fall ...
  ... and its reserves will rise (why?)
- Citibank will lend out its reserves ...
  ... causing M1 to increase
If the Fed sells govt. securities to the commercial banks, money supply will [ increase / decrease ].

Method 2: Changes in Interest on Reserve Balances (IORB)

The IORB rate, or interest on reserve balances rate, is the rate of interest that is paid by the Federal Reserve on balances maintained by or on behalf of eligible institutions in master accounts at Federal Reserve Banks. The IORB rate is set by the Board of Governors, and it is an important tool of monetary policy. Source: Federal Reserve Board - Interest on Reserve Balances (IORB) Frequently Asked Questions
In order to increase money supply, the Fed will [ raise / lower ] the IORB rate. Explain how this works.

Method 3: Changes in the discount rate

What is the discount rate?
If the Fed wants to increase money supply, it will [ increase / decrease ] the discount rate. Explain how this works.

The FOMC conducts monetary policy by setting the target range for the federal funds rate
The primary tool for adjusting the federal funds rate is the interest paid on reserve balances (IORB)
- By changing the interest paid on reserve balances (IORB) that banks hold in their accounts at a Federal Reserve Bank, the Fed can engineer an increase or decrease in the federal funds rate
The discount rate serves as a ceiling (upper bound) for the federal funds rate
Open market operations--the buying and selling of government securities by the Federal Reserve--are used to ensure that reserves remain ample.

Figure 1 provides an illustration of the transmission of monetary policy.

Monetary policy works by spurring or restraining growth of overall demand for goods and services in the economy.
When overall demand slows relative to the economy's capacity to produce goods and services, unemployment tends to rise and inflation tends to decline.
- The FOMC can help stabilize the economy in the face of these developments by stimulating overall demand through an easing of monetary policy that lowers interest rates.
Conversely, when overall demand for goods and services is too strong, unemployment can fall to unsustainably low levels and inflation can rise.
- In such a situation, the Fed can guide economic activity back to more sustainable levels and keep inflation in check by tightening monetary policy to raise interest rates.
The process by which the FOMC eases and tightens monetary policy to achieve its goals is summarized as follows.