Tools of the monetary policy, inflation and interest rate

Money Market, since slide 43

Tools of monetary policy

1) Discount rate: rate of interest the FED charges on loans to banks

By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply

2) Open Market Operations: FED’s purchases and sales of government bonds

By purchasing bonds and paying the sellers, the FED increases the money supply

Expansionary Monetary Policy

Increase the money supply by any one or combination of the above tools

Reduce the interest rate to encourage investment

Increase employment & income

Inflation is an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or service.

The inflation rate is the percentage rate of change of a price index over time.

Here is a great illustration of the power of inflation:

In 1970, the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage in manufacturing was $3.36 per hour. In 2008, the Times cost $1.50, the price of a home was $183,300, and the average wage was $19.85 per hour.

Prices, expressed in money terms, permit comparison of values between different goods

Must retain its value—the value of money varies inversely with the price level (inflation)

If money breaks down as a store of value (hyperinflation), economy resorts to barter (прибегает к бартеру)

Inflation—Persistent rise of prices

Hyperinflation—Prices rising at a fast and furious pace

Deflation—Falling prices, usually during severe recessions or depressions

Inflation reduces the real purchasing power of the currency—can buy fewer goods/services with the same nominal amount of money

Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending.

Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output)

If inflation is 10% and you get a 7% raise, what has happened to your money income? real income? Your money income has increased by 7% but your real income has decreased by 3%

What is the percent increase from $30,000 to $32,000?Take the difference and divide by the original number $2,000/$30,000 = 6.7%. Inflation is 5%, are you better or worse off? You are better off,because your real income has increased by 1.7% :-)

How does inflation change society?

It breeds uncertainty, diminishes buying power, erodes (разрушать) real savings, causes unemployment, alters social traditions, and confuses the price mechanism