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Monetary Policy and the Debate
about Macro Policy
Chapter 12
Laugher Curve
A caveman points to two of his hairy relatives
carrying clubs over their shoulders and says:
“OK—you hunt, you gather, and I’ll fine tune
the economy.”
Introduction


Monetary policy influences the economy
through changes in the money supply and
availability of credit.
Monetary policy is controlled by the Federal
Reserve Bank (the Fed), the U.S. central
bank.
Effect of Monetary Policy on the
Macro Policy Model


Expansionary monetary policy shifts the AD
curve to the right.
Contractionary monetary policy shifts the AD
curve to the left.
Effect of Monetary Policy on the
Macro Policy Model
Expansionary monetary policy increases
nominal income.
Its effect on real income depends on how the
price level responds.


% Real Income =
% Nominal Income – % Price Level
Price Level
Monetary Policy
Contractionary
Expansionary
SAS
P1
P0
P2
AD1
AD0
Y2
Y0
AD2
Y1
Real output
Expansionary Monetary Policy
Beyond Potential Output
Price Level
LAS
P1
P0
B
SAS1
SAS0
AD1
A
AD0
YP
Real output
Duties and Structure of the Fed


A central bank conducts monetary policy and
acts as financial adviser to the government.
Central bank – a type of bankers’ bank.
Duties and Structure of the Fed

It is the bank’s ability to create money that
gives the central bank the power to control
the money supply.
Structure of the Fed


The Fed is a semiautonomous organization
composed of 12 regional banks.
It is run by a Board of Governors appointed
by the President with the advice and consent
of the Senate.
Structure of the Fed

–
–
The Fed has much more independence than
most government agencies.
The Fed does not rely on Congress for appropriations.
Its governors serve 14 year terms and cannot be
reappointed.
Structure of the Fed
The President appoints one of the seven
members of the Board of Governors to be
chairman for a four-year term.
The chairman is often called the second most
powerful official in government.


Federal Reserve Districts
Minneapolis
Boston
New York
Chicago
San Francisco
*Alaska and Hawaii are
under the jurisdiction of the
Federal Reserve Bank of
San Francisco
Cleveland
.
Kansas City
Dallas
St. Louis
Atlanta
Philadelphia
Washington DC
Richmond
Federal Reserve Structure
Board of Governors of the
Federal Reserve System
• 7 members appointed by the
president and confirmed
• Chairman and vice chairman
designated by the president and
confirmed by the Senate
Oversees
Regional Reserve Banks and
Branches
• 12 regional Federal Reserve
banks
• 25 branches of Federal Reserve
banks
Federal Open Market Committee
• 7 members of the Board of
Governors
• 5 Federal Reserve bank presidents
Chief policymaking body of the Federal Reserve System
Open market operations
Provides services
Financial institutions
Federal government
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duties of the Fed

Congress gave the Fed six explicit functions.
Duties of the Fed
Conducting monetary policy is the most
important job the Fed has to do.
Monetary policy – influencing the supply of
money and credit in the economy.


Duties of the Fed
The Fed supervises and regulates financial
institutions.
It serves as a lender of last resort to financial
institutions.
It provides banking services to the U.S.
government.



Duties of the Fed

The Fed issues coin and currency.
It provides financial services such as check
clearing to commercial banks, savings and
loan associations, savings banks, and credit
unions.

The Importance of Monetary Policy


Monetary policy is the Fed’s most important
job, and the most-used policy in
macroeconomics.
The Fed conducts and controls monetary
policy.
The Importance of Monetary Policy
Actual decisions about monetary policy are
made by the Federal Open Market
Committee.
Federal Open Market Committee (FOMC) –
the Fed’s chief policymaking body.


The Importance of Monetary Policy

The FOMC is made up of:
– The seven members of the Board Of Governors.
–
–
The president of the New York fed.
A rotating group of four of the presidents of the other
regional banks.
The Conduct of Monetary Policy

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Monetary base – vault cash, deposits of the
Fed, plus currency in circulation.
Allowable reserves – either vault cash or
deposits at the Fed.
Bank reserves are IOUs of the Fed
The Conduct of Monetary Policy

The Fed influences the amount of money in
the economy and the activities of commercial
banks by controlling the monetary base.
The Conduct of Monetary Policy
Monetary policy affects the amount of
reserves in the banking system.
The amount of reserves affect interest rates.

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The Conduct of Monetary Policy
Other things being equal, as reserves
decline, interest rates rise.
As reserves increase, interest rates fall.

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Tools of Monetary Policy

The three tools of monetary policy are:
–
–
–
Changing the reserve requirement
Changing the discount rate.
Executing open market operations (buying and
selling bonds) and thereby affecting the Fed funds
rate.
Changing the Reserve
Requirement

The reserve requirement is the percentage
the Federal Reserve System sets as the
minimum amount of reserves a bank must
have.
Required Reserves and Excess
Reserves

The amount banks keep in reserve for
checking accounts (also called demand
deposits) depend:
–
–
Partly on the reserve requirement.
Partly on how much they think they need for
safety.
Required Reserves and Excess
Reserves
Banks hold as little in reserves as possible
since they earn no interest on them.
In the late 2000s, required reserves for demand
deposits were about 10 percent, and zero for all
other accounts.

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The Reserve Requirement and the
Money Supply

The Fed can increase or decrease the
money supply by changing the reserve
requirement.
The Reserve Requirement and the
Money Supply

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–
If the Fed decreases the reserve
requirement, it expands the money supply.
Banks have more money to lend out.
The money multiplier increases.
The Reserve Requirement and the
Money Supply

–
–
If the Fed increases the reserve requirement,
it contracts the money supply.
Banks have less money to lend out.
The money multiplier increases.
The Reserve Requirement and the
Money Supply

The approximate real-world money multiplier
in the economy is:
1/(r +c)
r = the percentage of deposits banks hold in reserve
c = the ratio of money people hold in cash to the money
they hold as deposits
The Reserve Requirement and the
Money Supply
In reality, banks keep 10% in reserves (r
= 0.1) and the cash-to-deposits ratio is
40% (c = 0.4).
The realistic approximation of the money
multiplier for demand deposits is:
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1/(0.1 +0.4) = 1/0.5 = 2
What If There Is a Shortage of
Reserves


The bank can borrow reserves from another
bank in the Federal funds market and pay
the Federal Funds rate.
It can stop making new loans and keep as
reserves the proceeds of loans that are paid
off.
What If There Is a Shortage of
Reserves

–
The bank can sell Treasury bonds in order to
get reserves.
The bonds themselves cannot be used as reserves
(they are sometimes called secondary reserves) but
the cash that comes from their sales does.
Changing the Discount Rate


A bank can borrow reserves directly from the
Fed, if it experiences a shortage of reserves.
The discount rate is the rate of interest the
Fed charges for those loans it makes to
banks.
Changing the Discount Rate

By changing the discount rate, the Fed can
expand or contract the level of bank reserves
and the money supply.
Changing the Discount Rate
An increase in the discount rate makes it
more expensive for banks to borrow from the
Fed.
A decrease in the discount rate makes it less
expensive for banks to borrow from the Fed.


Changing the Discount Rate

In practice, the discount rate is generally a
slightly higher than other rates banks would
have to pay to borrow reserves.
Executing Open Market
Operations


Changes in the discount rate and reserve
requirements are not used in day-to-day
operations of the Fed.
These tools are used for major changes.
Executing Open Market
Operations
For day-to-day operations the Fed uses a
third tool, open market operations.
Open market operations are the Fed’s
buying and selling of government securities.


Executing Open Market
Operations
To expand money supply, the Fed buys
bonds.
To contract money supply, the Fed sells
bonds.
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
An Open Market Purchase


An open market purchase is an example of
expansionary monetary policy.
Expansionary monetary policy is a
monetary policy that tends to reduce interest
rates and raise income.
An Open Market Purchase
When the Fed buys bonds, it deposits the
money in federal government accounts at a
bank.
Bank cash reserves rise, encouraging banks
to lend out the excess.
The money supply rises.
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An Open Market Sale

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An open market sale is an example of
contractionary monetary policy.
Contractionary monetary policy is a
monetary policy that tends to raise interest
rates and lower income.
An Open Market Sale


Here, the Fed sells bonds.
In return for the bond, the Fed receives a check
drawn against a bank.
The bank’s reserve assets are reduced and
money supply falls.

Bond Prices and Interest Rates


The Fed raises the demand for bonds when
it buys bonds in an open market purchase.
Bond prices rise and interest rates fall.
Bond Prices and Interest Rates
The Fed increases the supply of bonds when
it sells bonds in the open market.
Bond prices fall and interest rates rise.


Open Market Purchase
S
Price of
a bond
B
A
D1
D0
0
Quantity of bonds
Open Market Sale
Price of
a bond
S0
S1
A
C
D0
0
Quantity of bonds
The Fed Funds Market


Banks with surplus reserves can lend them to
banks with a reserve shortage.
They are lent overnight as Fed funds.
The Fed Funds Market
Fed funds – loans of reserves banks make
to each other.
Federal funds rate – the interest rate banks
charge each other for Fed funds.
Federal funds market – the market in which
banks lend and borrow reserves.



The Fed Funds Market
By selling bonds, the Fed reduces reserves
and increases the Fed funds rate.
When the Fed buys bonds, it increases reserves,
causing the Fed funds rate to fall.


Percent
The Fed Funds Rate and the
Discount Rate since 1990
9
8
7
6
5
4
3
2
1
1990
Fed funds rate
Discount rate
1992
1994
1996
1998
2000
2002
Offensive and Defensive Actions


The Fed steps in to buy or sell bonds during
emergencies, such as floods or earthquakes.
Reserves would fall because it is impossible
for businesses or individuals to get to the
bank with their cash.
Offensive and Defensive Actions
Defensive actions are designed to maintain
the current monetary policy.
Offensive actions are designed to have
expansionary or contractionary effects on the
economy.
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
The Fed Funds Rate as an
Operating Target

The Fed looks at the Federal funds rate to
determine whether monetary policy is tight or
loose.
The Fed Funds Rate as an
Intermediate Target
If the Federal funds rate is above the Fed’s
target range, it buys bonds.
This increases reserves and lowers the Federal
funds rate.

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The Fed Funds Rate as an
Intermediate Target
If the Federal funds rate is below the Fed’s
target range, it sells bonds.
This decreases reserves and raises the Federal
funds rate.
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The Complex Nature of Monetary
Policy


The Fed’s ultimate target is price stability,
acceptable employment, sustainable growth,
and moderate long-term interest rates.
These targets are indirectly affected by
changes in the Fed funds rate.
The Complex Nature of Monetary
Policy

–
The Fed watches intermediate targets to see
if it is on track.
Intermediate targets include consumer confidence,
stock prices, interest rate spreads, housing starts, and
a host of others.
The Complex Nature of Monetary
Policy
Fed tools
Open market operations
Discount rate
Reserve requirement
Intermediate targets
Consumer confidence
Stock prices
Interest rate spreads
Housing starts
McGraw-Hill/Irwin
Operating target
Fed funds
Ultimate targets
Stable prices
Sustainable growth
Acceptable employment
Moderate long-term interest
rates
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Taylor Rule

Set the Fed funds rate at 2 percent plus
current inflation if the economy is at desired
output and desired inflation.
The Taylor Rule

If the inflation rate is higher than desired,
increase the Fed funds rate by 0.5 times the
difference between desired and actual
inflation.
The Taylor Rule

If output is higher than desired increase the
Fed funds rate by 0.5 times the percentage
deviation.
The Taylor Rule

Formally the Taylor rule is:
Fed funds rate = 2% + Current inflation
+ 0.5 X (actual inflation less desired inflation)
+ 0.5 X (percent deviation of aggregate output from
potential)
Fed Response to September 11

In defensive actions, the Fed:
–
–
–
Doubled its holdings of repurchase agreements.
Increased discount window lending.
Established “swap lines” with foreign banks to
temporarily exchange currencies to ensure
foreign currency liquidity.
Fed Response to September 11

In offensive actions:
– The open market desk reduced the Fed funds rate.
Monetary Policy in the AS/AD
Model

In AS/AD model, monetary policy is seen
working primarily through its effect on interest
rates.
Contractionary Monetary Policy

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
The Fed decreases the money supply.
The interest rates go up.
As interest rates go up, the quantity of
investment goes down.
Contractionary Monetary Policy
As investment goes down, aggregate
demand goes down.
Aggregate equilibrium demand and income go
down by a multiple of decrease in investment.


Contractionary Monetary Policy
The AD curve shifts to the left by a multiple of
the shift in investment.
Income and output decrease.


M i I Y
Expansionary Monetary Policy

Expansionary monetary policy works in the
opposite direction.
M i I Y
Price level
Contractionary Monetary Policy
Short-run
aggregate supply
P0
P1
AD0
AD1
Y1
Y0
Real output
Price level
Expansionary Monetary Policy
Short-run
aggregate supply
P1
P0
AD1
AD0
Y1
Y0
Real output
Monetary Policy in the Circular
Flow


Expansionary monetary policy tries to
expand the economy by channeling more
saving into investment.
Contractionary monetary policy tries to
reduce inflationary pressures by restricting
demand for consumer loans and investment
Monetary Policy in the Circular
Flow
Wages, rents, interest, profits
Taxes
Households
Government
borrowing
Government
Consumptio expenditures
Government
fiscal policy
Firms
Investment
Savings
Financial sector
Monetary policy
Consumption
Exports
Imports
Emphasis on the Interest Rate


A rising interest rate indicates a tightening
monetary policy.
A falling interest rate indicates a loosening of
monetary policy.
Emphasis on the Interest Rate

A natural conclusion is that the Fed should
target interest rates in setting monetary
policy.
Real and Nominal Interest Rates


There is a problem in using interest rates as
a measure of the tightness or looseness of
monetary policy.
That problem is the real/nominal interest rate
problem.
Real and Nominal Interest Rates
Nominal interest rates are those you
actually see and pay.
Real interest rates are those adjusted for
expected inflation.


Real and Nominal Interest Rates
The real interest rate cannot be observed
since it depends on expected inflation, which
cannot be directly observed.
Nominal interest rate = Real interest rate +
Expected inflation rate

Real and Nominal Interest Rates
and Monetary Policy

Making a distinction between nominal and
real interest rates adds another uncertainty
to the effect on monetary policy.
Real and Nominal Interest Rates
and Monetary Policy

–
–
Most economists believe that a monetary
regime, not a monetary policy, is the best
approach to policy.
Expansionary monetary policy will lead to expectations
of increased inflation.
Increased inflation expectations will lead to higher
nominal interest rates, leaving real interest rates
unchanged.
Real and Nominal Interest Rates
and Monetary Policy
A monetary regime is a predetermined
statement of the policy that will be followed in
various situations.
A monetary policy is a policy response to
events which is chosen without a predetermined
framework.


Real and Nominal Interest Rates
and Monetary Policy
The Fed is currently following a monetary
regime that the involves feedback rules that
center on the Federal funds rate.
If inflation is above its target, the Fed raises the
Fed funds rate.


Problems in the Conduct of
Monetary Policy

The five problems of monetary policy:
–
–
–
–
–
–
Knowing what policy to use.
Understanding the policy you're using.
Lags in monetary policy.
Liquidity traps
Political pressure.
Conflicting international goals.
Knowing What Policy to Use


The potential level of income must be known.
Otherwise you don’t know whether to use
expansionary or contractionary monetary
policy.
Understanding the Policy You’re
Using

You must know whether the policy being
used is expansionary or contractionary in
order to use monetary policy effectively.
Understanding the Policy You’re
Using
The money multiplier is influenced by both
the amount of cash people hold as well as
the lending process at the bank.
Neither of these are stable numbers.


Understanding the Policy You’re
Using

Then there are interest rates.
If interest rates rise, is it because of expected
inflation or is it that the real interest rate is
going up?

Lags in Monetary Policy

Monetary policy takes time to work.
–
–
–
The Fed must recognize what the situation in the
economy is.
Then it must develop a consensus for action.
Then businesses and individuals have to react to
the policy change.
Liquidity Trap

Just because the Fed drops interest rates,
that does not necessarily mean that people
or businesses will go out and borrow money.
Liquidity Trap

Liquidity trap – a situation in which
increasing reserves does not increase the
money supply, but simply leads to excess
reserves.
Political Pressure


The Fed is not totally insulated from political
pressure.
Presidents place great pressure on the Fed
to loosen the purse strings, especially during
an election year.
Conflicting International Goals


Monetary policy is conducted in an
international arena.
It must be coordinated with other nations.
Monetary Policy and the Debate
about Macro Policy
End of Chapter 28