Mar 17 2008

Little used monetary policy tool called into battle!

More Bold Moves from the Fed: Business Week online ediction

Here we are, the night before our test on Monetary Policy, and good ol’ Mr. Bernanke throws me a perfect blogworthy bit of news!

The Federal Reserve announced a series of steps Mar. 16 to help provide relief to a spreading credit crisis that threatens to plunge the economy into recession: The central bank approved a cut to its lending rate to financial institutions, from 3.5% to 3.25%, and created another lending facility for big investment banks to secure short-term loans.

Global financial markets appeared to react with alarm on Sunday evening. In overseas trading, the euro made new highs vs. the dollar, U.S. Treasury futures fell, and gold futures posted new record highs at $1,009.50 per ounce.

Discussion Questions:

  1. Describe briefly what the article means by “a spreading credit-crisis”. How does less lending threaten to “plunge the economy into recession”?
  2. Which tool of monetary policy does the term in bold refer to? Why would financial institutions ever need to borrow from the Fed?
  3. Why did the euro reach “new highs vs. the dollar” on news of the US lowering interest rates? Why did gold shoot to its highest price in history on the news?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

28 responses so far

28 Responses to “Little used monetary policy tool called into battle!”

  1. calvinluon 18 Mar 2008 at 1:56 am

    with a lower discount rate, banks can borrow from the fed much easier, thus expanding the excess reserve. As a result, the banks have more incentive to loan, which causes the interest rate to drop. the increase in loans causes the increase in investment and consumption, boosting its GDP and lowering its unemployment rate.

  2. jacqueszhangon 17 Mar 2008 at 10:07 pm

    The spreading credit-criss, I suppose, is the shortage of loan-able credit in the American economy. It threatens to plunge the economy into recession because with less available loans, there is less investment and purchase of expensive American goods.

    This example refers to the decrease of the interest rate charged by the banks. Because there is less interest on the loans, consumers will be more likely to consume, which increases spending and money supply.

  3. Nicole Wongon 17 Mar 2008 at 10:58 pm

    As the Fed lends less, it the supply of money in commercial banks decreases, seeing as excess reserves shrink and checkable deposits decrease as well. This means that banks can make fewer loans to the public and investment and consumption decreases. The American public is already not spending enough money in their economy, which is why economists are now panicked.

    The term referred to is the discount rate. Financial institutions would need to borrow from the Fed if they are short of meeting their reserve requirements. Instead of paying for their technically illegal act, commercial banks borrow money from the Fed, which is why the Fed is the "banker's bank".

    The value of the euro increased relative to the dollar because the value of money in the States is now decreasing. With GDP decreasing, price level is decreasing and the euro is becoming "stronger". The price of gold has also risen sharply because the value of the dollar has decreased. More dollars are now needed to satisfy the value of gold.

  4. kevinyehon 17 Mar 2008 at 11:20 pm

    Wow that's pretty interesting just as we were talking about how little used this method is. The reason we mentioned was that it has such a huge impact on the economy by just a small rate cut. I guess the Fed sees that the US is in such a huge recession now that it needs some major help and stimulation.

  5. Sharon Lion 17 Mar 2008 at 11:28 pm

    Less loans to banks means less money available to people to spend. This lowers consumption and investment which overall lowers GDP and slows down the economy into a recession. This monetary policy tool is the discount rate. in this case, the discount rate is raised so the money supply decreases by discouraging banks from borrowing from the FED.

  6. Jack Loon 18 Mar 2008 at 12:08 am

    When the Fed cuts interest rates, it will allow the commercial banks to loan out more money. With more excess reservers available to banks to loan out, interest rates will naturally be lower. And in turn, there will be more investment and private consumption.

  7. Jack Loon 18 Mar 2008 at 12:11 am

    Oops I kind of read the sentence wrong. And I have no idea what I said above. WHAT I REALLY MEANT TO SAY WAS that when the Fed lowers its interest rate, the discount window widens. This offers more incentive for financial institutions to borrow from the Fed. Which means that banks will be more bold in lending out money because they know that they can borrow from the Fed at the end of the day if they absoloutely have to.

  8. Jessica Ngon 18 Mar 2008 at 12:28 am

    This decrease in discount rate, a rare monetary policy tool, shows that borrowing reserves from the Fed will be easier, thus expanding excess reserves of the commercial banks. This pushes for more lending from the banks for investment purposes, which in turn increases the aggregate demand. With the aggregate demand increasing, this will hopefully decrease the unemployment and increase GDP, getting the U.S. out of their current recession.

  9. Charlie.Gaoon 18 Mar 2008 at 12:59 am

    I like how monetary policy is very quick and changes can be implemented in a shorter period of time than fiscal policy. This will make changes in the economy much faster in regulating economy back to full employment.

  10. Michael Dailyon 18 Mar 2008 at 1:21 am

    This spreading credit crisis means that the banks can not loan as much credit to consumers in the U.S. Therefore, GDP decreases because of less consumer and investment spending. The Fed's lending rate to financial institutions is called the discount rate. And because of the decrease in the value of the dollar, both the euro and gold have risen in value.

  11. Margaret Liuon 18 Mar 2008 at 8:38 am

    When the discount rate is lowered, banks feel more comfortable loaning out money and sometimes do so past their required reserves if they can get a higher interest from the borrower than they have to pay to the fed. With more loans going out, investment increases causing consumption to increase.

  12. alicesuon 18 Mar 2008 at 1:53 am

    Less lending threatens to plunge the U.S. economy into recession because as banks loan less, people spend less, decreasing aggregate demand and reducing GDP. The monetary policy referred to here is that of changing the discount rate; financial institutions would need to borrow from the Fed if their reserves were not enough to meet the required reserve ratio. The value of gold and the euro reached new highs in comparison to the dollar as interest rates decreased because interest rates are a measure of the "price of money", or its value/worth. Thus as interest rates fall, the U.S. dollar's value also falls.

  13. Cassy Changon 18 Mar 2008 at 5:21 pm

    less loan means congestion of money flow. instead of stimulating economy during recession, less loans would worsen the problem. fed institutions must borrow money to fulfil the reserve requirement. gold's value increase because money's value is more volatile, so people choose to hold gold instead of paper money.

  14. Chris Seahon 18 Mar 2008 at 7:16 pm

    Gold, a commodity, had its value skyrocket amid global market concerns because as a single commodity it will retain more of its value as opposed to paper money, which fluctuates frequently. Gold would be very appealing if world markets are struggling (which they are).

  15. Howard Jingon 18 Mar 2008 at 8:19 pm

    If interest rates lower, the value of the dollar will drop because consumers will have less money to invest with. On the other hand, the euro and gold, which are relatively more stable, will start increasing in value compared to the dollar as people begin to turn to the euro as a substitute

  16. serenatuon 18 Mar 2008 at 8:30 pm

    The Feds use the discount rate to regulate the other banks' borrowing. With a decreased discount rate, this will have the other banks more incentives to borrow from the Feds, therefore now the banks will have more excess reserves to lend for investments.

  17. serenatuon 18 Mar 2008 at 8:36 pm

    The Feds use the discount rate to regulate other banks' borrowing of money. With a lower discount rate, it will give other banks more incentives to borrow money from the Feds; the excess reserves in the banks allow more lending for business investments, therefore will increase consumptions.

  18. Jinny Kwonon 18 Mar 2008 at 9:21 pm

    What a coincidence! I just posted my AP Econ in the News about the same topic! Well obviously, the monetary tool that the article is referring to is the discount rate. As the Fed decreases the discount rate, it becomes more easier for commercial banks to borrow money from the Fed and increase the money supply in the economy. This, in effect, will decrease the interest rates as money supply increases, making it easier for firms and businesses to borrow money for investment, which would ultimately lead to a rightward shift of aggregate demand, increasing the level of real output. And by doing this, the Fed will succeed in fighting a recession that is imminent in US economy.

  19. Drew Venkatramanon 18 Mar 2008 at 10:25 pm

    So I'm pretty sure that this is a clever move. The bank now can lend out more money, which therefore allows for public banks to lend more, and therefore raises the Consumer spending and AD. This creation of money therefore will hopefully save the economy, and it only comes from a few decimal points. amazing!

  20. Hansen Guon 19 Mar 2008 at 12:02 am

    A decrease in increase rates increases demand for money which increases the money supply. The Euro is higher versus the dollar as the value of the dollar, with a larger money supply, has depreciated.

  21. julie.linon 19 Mar 2008 at 12:18 am

    "a spreading credit crisis" means that the banks are short on loans to consumers compared to credits. decrease in consumer and incestment spending causes GDP to decrease too. The Fed’s lending rate to financial institutions is the discount rate. euro and gold increase because of the decrease in US dollar.

  22. kevinmaon 19 Mar 2008 at 12:32 am

    Yea i agree with the point that decrease in interest rates will increase the demand for money. This will increase investments and will push the aggregate demand out. The monetary tool used here is discount rate. Gold has reached its peak of value to the US dollar so far because the US dollar is depreciating.

  23. Jessicaon 19 Mar 2008 at 12:33 am

    Less lending means that there is less money in circulation. The discount rate is decreased. The Fed is the bankers bank because it does for the banks what the banks do for the public. Banks would need to borrow money in order to meet their reserve requirements. As the money supply increases, the value of the US dollar depreciates because it is relatively less scarce.

  24. jenniferchoion 19 Mar 2008 at 7:32 am

    By such changes, it becomes more easier for banks to borrow money from the Fed and increase the money supply in the economy. Ultimately this will lead to a rightward shift of AD curve. As the result there will be increased output level.

  25. Dana Y.on 20 Mar 2008 at 12:13 am

    The value of gold and the euro reached new highs in comparison to the dollar as interest rates decreased because interest rates are a measure of the “price of money”, or its value/worth. Thus as interest rates fall, the U.S. dollar’s value also falls.

    As aggregate demand shrinked due to less lending and thus less spending, the fed lowered the discount rates to increase money in circulation. This in turn lowered interest rates and soon the required reserve ratio will be met. U.S. dollar depreciated while the value of gold and Euros appreciated as more dollars are required to buy the same amount of gold.

  26. Jonathan Lauon 20 Mar 2008 at 8:31 pm

    Nice, perfect example of the discount rate. The rate is being rasied so the money supply decreases because banks are now more discouraged from borrowing money from the Federal Bank. Because there are less loans to banks, consumption is reduced and GDP decreases, which slows down recession.

  27. kevinhuangon 20 Mar 2008 at 10:49 pm

    If there is less lending, that means there is less money flow, which means people are spending less, which means aggregate demand has shifted in, which means GDP goes down; therefore, less lending has caused a plunge into recession. With a lowered interest rate, there would be increased loaning from banks because it would be cheaper to borrow and thus spending would increase, saving the US from its receession. The value of gold is rising because the value of the USD is decreasing. It means that more USD is required for gold. Because the value of the dollar is decreasing, GDP and the price level are also decreasing and as a result, the Euro seems to be "stronger."

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