Discount loans Loans the Federal Reserve makes to banks.

Discount rate The interest rate the Federal Reserve charges on discount loans. The United States is divided into 12 Federal Reserve districts, each of which has a Federal Reserve bank. The real power within the Federal Reserve System, however, lies in Washington, DC, with the Board of Governors. Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic objectives. To manage the money supply, the Fed uses three monetary policy tools: 1. Open market operations 2. Discount policy 3. Reserve requirements Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States. Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. Discount Policy By lowering the discount rate, the Fed can encourage banks to take additional loans and thereby increase their reserves. With more reserves, banks will make more loans to households and firms, which will increase checking account deposits and the money supply. Reserve Requirements When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves. Security A financial assetsuch as a stock or a bondthat can be bought and sold in a financial market. Securitization The process of transforming loans or other financial assets into securities. The Process of Securitization Panel (a) shows how in the securitization process banks grant loans to households and bundle the loans into securities that are then sold to investors. Panel (b) shows that banks collect payments on the original loans and, after taking a fee, send the payments to the investors who bought the securities. Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals. The Goals of Monetary Policy The Fed has four main monetary policy goals that are intended to promote a well-functioning economy: 1.Price stability 2.High employment 3.Stability of financial markets and institutions 4.Economic growth High Employment The goal of high employment extends beyond the Fed to other branches of the federal government. Stability of Financial Markets and Institutions When financial markets and institutions are not efficient in matching savers and borrowers, resources are lost. Economic Growth Policymakers aim to encourage stable economic growth because stable growth allows households and firms to plan accurately and encourages the long-run investment that is needed to sustain growth. Monetary Policy Targets

The Fed tries to keep both the unemployment and inflation rates low, but it cant affect either of these economic variables directly. The Fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Feds policy goals, such as real GDP, employment, and the price level. When the Fed increases the money supply, households and firms will initially hold more money than they want, relative to other financial assets. Households and firms use the money they dont want to hold to buy Treasury bills and make deposits in interest-paying bank accounts. This increase in demand allows banks and sellers of Treasury bills and similar securities to offer lower interest rates. Eventually, interest rates will fall enough that households and firms will be willing to hold the additional money the Fed has created. When the Fed decreases the money supply, households and firms will initially hold less money than they want, relative to other financial assets. Households and firms will sell Treasury bills and other financial assets and withdraw money from interest-paying bank accounts. These actions will increase interest rates. Eventually, interest rates will rise to the point at which households and firms will be willing to hold the smaller amount of money that results from the Feds actions. Federal funds rate The interest rate banks charge each other for overnight loans. The Effects of Monetary Policy on Real GDP and the Price Level Expansionary monetary policy The Federal Reserves increasing the money supply and decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserves adjusting the money supply to increase interest rates to reduce inflation. Can the Fed Eliminate Recessions? Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do. What Fiscal Policy Is and What It Isnt Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. Until the Great Depression of the 1930s, the majority of government spending in the United States occurred at the state and local levels. Since World War II, the federal governments share of total government expenditures has been between two-thirds and three-quarters. Federal government purchases can be divided into defense spendingwhich makes up about 24 percent of the federal budgetand spending on everything else the federal government doesfrom paying the salaries of FBI agents, to operating the national parks, to supporting scientific researchwhich makes up about 9 percent of the budget. In addition to purchases, there are three other categories of federal government expenditures: interest on the national debt, grants to state and local governments, and transfer payments. Transfer payments rose from about 25 percent of federal government expenditures in the 1960s to nearly 45 percent in 2008.

Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures. Congress and President Obama intended the spending increases and tax cuts in the stimulus package to increase aggregate demand and help pull the economy out of the 20072009 recession. Panel (a) shows how the increases in spending were distributed, and panel (b) shows how the tax cuts were distributed. Does Government Spending Reduce Private Spending? Crowding out A decline in private expenditures as a result of an increase in government purchases. Budget deficit The situation in which the governments expenditures are greater than its tax revenue. Budget surplus The situation in which the governments expenditures are less than its tax revenue. During wars, government spending increases far more than tax revenues, increasing the budget deficit. The budget deficit also increases during recessions, as government spending increases and tax revenues fall. How Large Are Supply-Side Effects? Most economists would agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on. The magnitude of the effects is the subject of considerable debate, however. ACTIONS BY CONGRESS AND THE PRESIDENT Increase government spending or cut taxes Decrease government spending or raise taxes

PROBLEM Recession

TYPE OF POLICY Expansionary

RESULT Real GDP and the price level rise. Real GDP and the price level fall.

Rising inflation

Contractionary