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Get this right: THE FED DOES NOT SET
INTEREST RATES. I know you will read in the news that the
"Fed has increased interest rates". But the Fed does NOT
change interest rates. Banks set their own interest rates,
BUT the Fed can cause banks to raise or lower their
rates.
Also, the Fed does not change the
money supply (MS). As we learned in the previous lesson
(15a) banks create money and therefore banks change the
money supply, NOT THE FED. But you may ask, didn't we say in
lesson 12c that the Fed changes the MS? Yes we did, but we
didn't say how they do it. We will do that here.
We will learn that the Fed has three
tools to control the MS: open market operations (OMO), the
discount rate (DR), and the required reserve ratio (RR). The
Fed uses these three tools to change the excess reserves
(ER) of banks. And, as we learned in the previous lesson
(15a) if banks have more ER they can make more loans and
increase the money supply (MS) and if banks have fewer ER
they make less loans and decrease the MS.
Finally, as we learned in lesson 12c,
when the MS changes this causes interest rates to change.
When interest rates change then this causes Investment (I)
to change (and also consumption [C]). When
Investment (I) changes it causes aggregate demand (AD) to
change. When AD changes it causes a change in the price
level (PL) and real domestic output (RDO). When the PL
changes it causes a change in inflation (IN) and when RDO
changes it causes a change in unemployment (UE) and economic
growth (EG).
To understand how monetary policy
(MP) works you need to get the CAUSE and EFFECT order
correct. What CAUSES what? The " "
symbol below means CAUSES. Notice that is an arrow pointing
only in one direction meaning that what comes before CAUSES
what comes after. For example: not studying
lower grades.
Memorize the following. Practice
writing it until you get it correct.
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