Download Chapter 31 MONETARY POLICY AND THE NATIONAL ECONOMY

29
Monetary Policy and the
National Economy
Victorians heard with grave attention that the Bank
Rate had been raised. They did not know what it
meant. But they knew that it was an act of extreme
wisdom.
JOHN KENNETH GALBRAITH
Contents
● Money and Income: The Important
Difference
● America’s Central Bank: The Federal
Reserve System
● Implementing Monetary Policy: Open
Market Operations
● Other Methods of Monetary Control
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Contents (continued)
● Supply-Demand Analysis of the Money
Market
● How Monetary Policy Works
● Money and the Price Level in the Keynesian
Model
● From Models to Policy Debates
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Money and Income: The
Important Difference
● Stock variables are measured at a moment
in time.
● Flow variables are measured over time.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Money and Income: The
Important Difference
● Money is a stock, income a flow.
♦ Stock of money influences the rate at which
people earn income.
♦ Money affects GDP.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
America’s Central Bank: The
Federal Reserve System
● The Federal Reserve System, established in
1914, is the U.S. central bank.
♦ Comprised of twelve district banks
♦ Governed by a seven-member Board of
Governors
♦ Decisions on the money supply made by the
Federal Open Market Committee
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
America’s Central Bank:
The Federal Reserve System
● Central Bank Independence
♦ Fed board members:
■Appointed to fourteen-year terms
■Independent of political pressures
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
America’s Central Bank: The
Federal Reserve System
● Central Bank Independence
♦ In some other countries, the central banks are
less independent.
♦ Countries without independent central banks
often have less stable economies.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Implementing Monetary
Policy
● The Fed can increase the money supply by
buying government securities on the open
market.
♦ It pays for these securities by creating new
bank reserves.
♦ These additional reserves  multiple
expansion of the money supply
● To reduce the money supply, the Fed sells
securities.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-1 Effects of an OpenMarket Purchase of Securities
TABLE
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Implementing Monetary
Policy
● Open-Market Operations, Bond Prices and
Interest Rates
● When the Fed buys bonds:
♦  demand for bonds 
♦  price of bonds
●  price of bonds =  interest rate
● Opposite when Fed sell bonds
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-1 Open-Market Sales
and Bond Prices
FIGURE
Price of a Bond
D
P
S 0 S1
A
0
P
1
B
S 0 S1
D
Quantity of Bonds
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Other Methods of Monetary
Control
● Lending to Banks
♦ The Fed lends to member banks, occasionally
as a “lender of last resort.”
♦ Discount rate = interest rate Fed charges
member banks when it makes loans to them
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Other Methods of Monetary
Control
● Lending to Banks
♦  discount rate 
■ Borrowing by member banks 
■ Reserves 
■ Money supply
♦ Opposite if Fed raises discount rate
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-2 Balance Sheet
Changes, Borrowing from Fed
TABLE
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Other Methods of Monetary
Control
● Changing Reserve Requirements
♦  Required reserve ratio 
■ Excess reserves 
■ Loans 
■ Money supply
♦ Opposite if Fed increases reserve requirement
♦ In practice, the Fed seldom changes the reserve
requirements.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Supply-Demand Analysis of
the Money Market
●  Interest rates 
♦  Profit opportunities for banks
♦  Excess reserves
♦  Volume of loans
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Supply-Demand Analysis of
the Money Market
● However, the Fed can shift the relationship
between the money supply and interest rates
by employing any of its principal weapons
of monetary control.
♦ Open-market operations
♦  reserve requirements
♦  lending policy to banks
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-2 (a) The Supply
Schedule for Money
FIGURE
7
S
Interest Rate
5
3
1
M
0
800
820 830
Money Supply
850
(a)
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
29-2 (b, c) The Supply
Schedule for Money
FIGURE
7
S0
7
S1
3
1
3
1
M0
0
S0
5
Interest Rate
Interest Rate
5
S2
800
M1
M2
850
Money Supply
Expansionary Policy Change
(b)
0
800
M0
850
Money Supply
Contractionary Policy Change
(c)
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Supply-Demand Analysis of
the Money Market
● The Money Supply Mechanism
♦ Money supply curve: slightly positive slope
♦ Indicates a weak sensitivity to changes in the
interest rate
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Supply-Demand Analysis of
the Money Market
● The Demand for Money
♦ Money is demanded for transactions.
♦  nominal GDP 
■ Spending
■ Demand for money
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Supply-Demand Analysis of
the Money Market
● The Demand for Money
♦ Interest = opportunity cost of holding money
■ Interest rates   Money demand
♦ Demand curve for money curve
■Negatively sloped
■Shifts as nominal GDP changes
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-3 (a) The Demand
Schedule for Money
FIGURE
Interest Rate
M
D
Quantity of
Money Demanded
(a)
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
29-3 (b, c) The Demand
Schedule for Money
FIGURE
M1
M0
M0
Interest Rate
Interest Rate
M2
D1
D0
Quantity of
Money Demanded
HigherY or P
(b)
D2
D0
Quantity of
Money Demanded
LowerY or P
(c)
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Supply-Demand Analysis of
the Money Market
● Equilibrium in the Money Market
♦ The interest rate equilibrates the demand and
supply of money.
♦ The Fed can lower (raise) interest rates by
increasing (reducing) the money supply.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-4 Equilibrium in the
Money Market
FIGURE
8
M
S
For given Fed policy
7
Interest Rate
6
E
5
4
3
For given
Y and P
2
1
0
D
M
800
830
Money Stock
850
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
29-5 Effects of Monetary
Policy on the Money Market
FIGURE
Interest Rate
E
A
M0
S2
M
S1
Interest Rate
S0
M
D
M1
S0
B
E
M2
D
M0
Money Stock
(a)
Money Stock
(b)
Expansionary Monetary Policy
Contractionary Monetary Policy
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
How Monetary Policy Works
● Of the four components of aggregate
demand, investment and net exports are the
most sensitive to monetary policy.
● Assume that net exports (X - IM) are fixed.
● Focus on monetary policy’s influence on
investment (I)
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
How Monetary Policy Works
● Investment and Interest Rates
♦  interest rates   investment spending
♦  investment  multiplier effect
■Lowers GDP
♦  interest rates  opposite
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-6 Effect of Interest
Rates on Total Expenditure
FIGURE
45
Real Expenditure
C + I + G + (X – IM )
(lower interest rate)
C + I + G + (X – IM )
C + I + G + (X – IM )
(higher interest rate)
Real GDP
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
How Monetary Policy Works
● Monetary Policy and Total Expenditure
♦ Fed actions 
■ money supply
■ interest rates
♦  interest rate   investment
♦  investment   AD
♦  AD   GDP
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-7 Expansionary Policy
on Money Supply & Interest Rate
FIGURE
7
S0
Interest Rate
M
5
S1
E0
3
E1
D
1
M0
M1
800 830 850
Money Stock
880 900
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
How Monetary Policy Affects
GDP
1
Federal Reserve
Policy
2
M and r
3
I
4
C + I + G + (X - IM)
GDP
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
29-8 Expansionary Policy
on Total Expenditure
FIGURE
45
E1
C + I1 + G + (X – IM)
Real Expenditure
C + I0 + G + (X – IM)
$200 billion
E0
5,500
6,000
6,500
Real GDP
7,000
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Money and the Price Level in
the Keynesian Model
● Expansionary monetary policy causes some
inflation under normal circumstances.
● How much inflation it causes depends on
the state of the economy.
♦ Represented by the slope of the AS curve
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
29-9 The Inflationary
Effects of Expansionary Policy
FIGURE
D0
D1
S
Price Level
$500 billion
B
103
E
100
S
D0
6,000
D1
6,400
Real GDP
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Money and the Price Level in
the Keynesian Model
● Fed policy 
♦M&r
♦ AD
♦Y&P
● Both output and prices are normally affected
by monetary policy.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Effect of Monetary Policy on
Output and Prices
1
Federal Reserve
Policy
2
M and r
3
I
4
C + I + G + (X - IM)
Y and P
Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Money and the Price Level in
the Keynesian Model
● Application: Why the AD Curve Slopes
Downward
♦  price level 
■ money demand
■ interest rates
■ investment
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Money and the Price Level in
the Keynesian Model
● Application: Why the AD Curve Slopes
Downward
♦  investment  negative multiplier effect on
GDP
♦ Thus  price level   GDP
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
From Models to Policy
Debates
● We have done all the theory that is needed.
● The next three chapters of the text turn to
policy debates.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.