Download The Demand For Money

Chapter 16
Domestic and
International
Dimensions of
Monetary Policy
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Today the total reserves that depository institutions
hold with the Fed exceed $1 trillion, as compared to less
than $45 billion in 2008.
What determines the quantity of reserves that
depository institutions choose to hold with the
Fed? Why are they opting to hold so many more
reserves now than a few years ago?
This chapter will help you understand the answers to
these questions.
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16-2
Learning Objectives
• Identify the key factors that influence the
quantity of money that people desire to hold
• Describe how Federal Reserve monetary policy
actions influence market interest rates
• Evaluate how expansionary and contractionary
monetary policy actions affect equilibrium real
GDP and the price level in the short run
• Understand the equation of exchange and its
importance in the quantity theory of money and
prices
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16-3
Learning Objectives (cont'd)
• Discuss the interest-rate-based transmission
mechanism of monetary policy
• Explain why the Federal Reserve cannot stabilize
both the money supply and interest rates
simultaneously
• Describe how the Federal Reserve achieves a
target value of the federal funds rate
• Explain key issues the Federal Reserve confronts
in selecting its target for the federal funds rate
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16-4
Chapter Outline
•
•
•
•
The Demand for Money
How the Fed Influences Interest Rates
Effects of an Increase in the Money Supply
Open Economy Transmission of Monetary
Policy
• Monetary Policy and Inflation
• Monetary Policy in Action: The
Transmission Mechanism
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16-5
Chapter Outline (cont'd)
• The Way Fed Policy is Currently
Implemented
• Selecting the Federal Funds Rate Target
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16-6
Did You Know That …
• In late 2000s, Zimbabwe’s daily inflation rate
some times exceeded 100 percent, meaning that
the nation’s price level more than doubled within
24-hour periods?
• Meanwhile, daily rates of money supply growth
in Zimbabwe also exceeded 100 percent.
• Why are higher rates of inflation associated with
higher rates of money growth?
• One objective of this chapter is to answer this
question.
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16-7
The Demand for Money
• To see how Fed monetary policy actions have an
impact on the economy by influencing market
interest rates, we must understand how much
money people desire to hold—the demand for
money.
• All flows of nonbarter transactions involve a stock
of money.
• To use money, one must hold money.
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16-8
The Demand For Money
• People have certain motivation that causes
them to want to hold money balances:
– Transactions demand
– Precautionary demand
– Asset demand
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16-9
The Demand for Money (cont'd)
• Money Balances
– Synonymous with money, money stock, and
money holdings
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16-10
The Demand for Money (cont'd)
• Transactions Demand
– Holding money as a medium of exchange to
make payments
– The level varies directly with nominal GDP
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16-11
The Demand for Money (cont'd)
• Precautionary Demand
– Holding money to meet unplanned
expenditures and emergencies
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16-12
The Demand for Money (cont'd)
• Asset Demand
– Holding money as a store of value instead of
other assets such as certificates of deposit,
corporate bonds, and stocks
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16-13
The Demand for Money (cont'd)
• The demand for money curve
– Assume the amount of money demanded for
transactions purposes is proportionate to
income
– Precautionary and asset demand are
determined by the opportunity cost of holding
money (the interest rate)
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16-14
Figure 16-1 The Demand for Money
Curve
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16-15
How the Fed Influences Interest Rates
• The Fed seeks to alter consumption,
investment, and total aggregate
expenditures by altering the rate of growth
of the money supply
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16-16
How the Fed Influences Interest
Rates (cont'd)
• The Fed has four tools at its disposal as
monetary policy actions:
– Open market operations
– Changes in the reserve ratio
– Changes in the interest rate paid on reserves
– Discount rate changes
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16-17
How the Fed Influences Interest
Rates (cont'd)
• Open market operations
– Fed purchases and sells government bonds
issued by the U.S. Treasury
– An open market operation causes a change in
the price of bonds
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16-18
Figure 16-2 Determining the Price of
Bonds, Panel (a)
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• The price of bond falls
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16-19
Figure 16-2 Determining the Price of
Bonds, Panel (b)
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• The price of bond rises
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16-20
How the Fed Influences Interest Rates
(cont'd)
• Example
– You pay $1,000 for a bond that pays $50 per
year in interest
Bond Yield =
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$50 = 5%
$1,000
16-21
How the Fed Influences Interest
Rates (cont'd)
• Example
– Now suppose you pay $500 for the same bond
(with $50 in interest)
Bond Yield = $50 = 10%
$500
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16-22
How the Fed Influences Interest
Rates (cont'd)
• The market price of existing bonds (and all
fixed-income assets) is inversely related to
the rate of interest prevailing in the
economy
• Implications:
– A Fed open market sale that reduces the
equilibrium price of bonds brings about an
increase in the interest rate
– A Fed open market purchase that boosts the
equilibrium price of bonds generates a
decrease in the interest rate
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16-23
Effects of an Increase in The Money
Supply
• What if hundreds of millions of dollars in
just-printed bills is dropped from a
helicopter?
• People pick up the money and put it in
their pockets, but how do they dispose of
the new money?
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16-24
Effects of an Increase in The Money
Supply (cont'd)
• Direct effect
– Aggregate demand rises because with an
increase in the money supply, at any given
price level people now want to purchase more
output of real goods and services
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16-25
Effects of an Increase in The Money
Supply (cont'd)
• Indirect effect
– Not everybody will necessarily spend the
newfound money on goods and services
– Some of the money gets deposited, so banks
have higher reserves (and they lend the excess
out)
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16-26
Effects of an Increase in The Money
Supply (cont'd)
• Indirect effect
– Banks lower rates to induce borrowing
• Businesses engage in investment
• Individuals consume durable goods (like housing and
autos)
– Increased loans generate an increase in
aggregate demand
• More people are involved in more spending (even
those who didn’t get money from the helicopter!)
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16-27
Effects of an Increase in The Money
Supply (cont'd)
• Assume the economy is operating at less
than full employment
– Expansionary monetary policy can close the
recessionary gap
– Direct and indirect effects cause the aggregate
demand curve to shift outward
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16-28
Figure 16-3 Expansionary Monetary Policy
with Underutilized Resources
• The recessionary gap is
due to insufficient AD
• To increase AD,
use expansionary
monetary policy
• AD increases and
real GDP increases
to full employment
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16-29
Effects of an Increase in The Money
Supply (cont'd)
• Assume there is an inflationary gap
– Contractionary monetary policy can eliminate
this inflationary gap
– Direct and indirect effects cause the aggregate
demand curve to shift inward
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16-30
Figure 16-4 Contractionary Monetary Policy
with Overutilized Resources
• The inflationary gap is shown
• To decrease AD, use
contractionary monetary policy
• AD decreases and real
GDP decreases
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16-31
Open Economy Transmission of
Monetary Policy
• So far we have discussed monetary policy
in a closed economy
• When we move to an open economy,
monetary policy becomes more complex
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16-32
Open Economy Transmission of
Monetary Policy (cont'd)
• The net export effect of contractionary
monetary policy
• Boosts the market interest rate
• Higher rates attract foreign investment
• International price of dollar rises
• Appreciation of dollar reduces net exports
• Negative net export effect
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16-33
Open Economy Transmission of
Monetary Policy (cont'd)
• Contractionary monetary policy causes interest
rates to rise
• Such a rise will induce international inflows of
funds, thereby raising the international value of
the dollar and making U.S. goods less attractive
abroad
• The net export effect of contractionary monetary
policy will be in the same direction as the
monetary policy effect, thereby amplifying the
effect of such policy
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16-34
Open Economy Transmission of
Monetary Policy (cont'd)
• The net export effect of expansionary
monetary policy
• Lower interest rates
• Financial capital flows out of the United States
• Demand for dollars will decrease
• International price of dollar goes down
• Foreign goods look more expensive in United States
• Net exports increase (imports fall)
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16-35
Open Economy Transmission of
Monetary Policy (cont'd)
• Globalization of international money
markets
– The Fed’s ability to control the rate of growth of
the money supply may be hampered as U.S.
money markets become less isolated
– If the Fed reduces the growth of the money
supply, individuals and firms in the United
States can obtain dollars from other sources
and more regularly conduct transactions using
other nations’ currencies.
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16-36
Monetary Policy and Inflation
• Most media discussions of inflation focus
on the short run when the price index can
fluctuate due to such events as
– Oil price shocks, labor union strikes
• In the long run, empirical studies show
that excessive growth in the money supply
results in inflation
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16-37
Monetary Policy and Inflation
(cont'd)
• Simple supply and demand analysis can be
used to explain why the price level rises
when the money supply increases
• If the supply of money expands relative to
the demand for money:
– People have more money balances than they
desire, so their spending on goods and services
increases (i.e., the price level has risen)
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16-38
Monetary Policy and Inflation
(cont'd)
• The Equation of Exchange
– The formula indicating that the number of
monetary units (Ms) times the number of times
each unit is spent on final goods and services (V)
is identical to the price level (P) times real GDP
(Y)
– It shows the relationship between changes in the
quantity of money in circulation and the price
level
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16-39
Monetary Policy and Inflation
(cont'd)
MsV  PY
MS = money balances held by nonbanking public
V = income velocity of money
P = price level or price index
Y = real GDP per year
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16-40
Monetary Policy and Inflation
(cont'd)
• Income Velocity of Money
– The number of times per year the dollar is
spent on final goods and services
– Equal to the nominal GDP divided by the
money supply
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16-41
Monetary Policy and Inflation
(cont'd)
• The equation of exchange as an identity
()
– Total funds spent on final output MsV equals
total funds received PY
– The value of goods purchased is equal to the
value of goods sold
– MsV  PY  nominal GDP
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16-42
Monetary Policy and Inflation
(cont'd)
• Quantity Theory of Money and Prices
– The hypothesis that changes in the money
supply lead to equiproportional changes in the
price level
– If we assume that V and Y are constant, than
an increase in the money supply by, say 20%,
can lead only to a 20% increase in the price
level
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16-43
Figure 16-5 The Relationship Between Money
Supply Growth Rates and Rates of Inflation
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16-44
International Policy Example: North Korea
Divides Its Money by 100
• Inflation has been so rampant in North Korea that
even the poorest individuals commonly have held
thousands of won, the nation’s currency, and banks
have routinely transferred single payments
denominated in trillions of won.
• To simplify matters, the North Korean government
recently stripped two zeros from the currency.
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16-45
Figure 16-6 The Interest-Rate-Based Money
Transmission Mechanism
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16-46
Figure 16-7 Adding Monetary Policy to the
Aggregate Demand–Aggregate Supply Model
At lower rates, a larger
quantity of money will
be demanded
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The decrease in the interest
rate stimulates investment
16-47
Monetary Policy in Action: The
Transmission Mechanism
• The Fed’s target choice: The interest rate
or the money supply?
– The Fed has sought to achieve an interest rate
target
– There is a fundamental tension between
targeting the interest rate and controlling the
money supply
– The Fed can attempt to stabilize the interest
rate or the money supply, but not both
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16-48
Figure 16-8 Choosing a Monetary Policy
Target
If the Fed selects re, it
must accept Ms
If the Fed selects M’s,
it must allow the
interest rate to fall
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16-49
Monetary Policy in Action: The
Transmission Mechanism (cont’d)
• Choosing a policy target
– Money supply
• When variations in private spending occur
– Interest rates
• When the demand for (or supply of) money is
unstable
• Interest rate targets are preferred
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16-50
The Way Fed Policy is Currently
Implemented
• At present the Fed announces an interest
rate target
• If the Fed wants to raise “the” interest
rate, it engages in contractionary open
market operations
– Fed sells more Treasury securities than it buys,
thereby reducing the money supply
• This tends to boost “the” rate of interest
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16-51
The Way Fed Policy is Currently
Implemented (cont'd)
• Conversely, if the Fed wants to decrease
“the” rate of interest, it engages in
expansionary open market operations
– Fed buys more Treasury securities, increasing
the money supply
• This tends to lower “the” rate of interest
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16-52
The Way Fed Policy is Currently
Implemented (cont'd)
• In reality, “the” interest rates that are
relevant to Fed policymaking:
– Federal funds rate
– Discount rate
– Interest rate on reserves
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16-53
The Way Fed Policy is Currently
Implemented (cont'd)
• Federal Funds Rate
– The interest rate that depository institutions
pay to borrow reserves in the interbank federal
funds market
• Federal Funds Market
– A private market (made up mostly of banks) in
which banks can borrow reserves from other
banks that want to lend them
– Federal funds are usually lent for overnight use
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16-54
The Way Fed Policy is Currently
Implemented (cont'd)
• Discount Rate
– The interest rate that the Federal Reserve
charges for reserves that it lends to depository
institutions (through the “discount window”)
– It is sometimes referred to as the rediscount
rate or, in Canada and England, as the bank
rate
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16-55
The Way Fed Policy is Currently
Implemented (cont'd)
• The interest rate on reserves
– In October 2008, Congress granted the Fed
authority to pay interest on both required
reserves and excess reserves of depository
institutions
– If the Fed raises the interest rate on reserves
and thereby reduces the differential between
the federal funds rate and the interest rate on
reserves, banks have less incentive to lend
reserves in the federal funds market
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16-56
Figure 16-9 The Market for Bank Reserves and the
Federal Funds Rate, Panel (a)
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16-57
Figure 16-9 The Market for Bank Reserves and the
Federal Funds Rate, Panel (b)
An open market
purchase increases
the supply of
reserves, and thus
lowers the
equilibrium federal
funds rate
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16-58
The Way Fed Policy is Currently
Implemented (cont'd)
• FOMC Directive
– A document that summarizes the Federal Open
Market Committee’s general policy strategy
– Establishes near-term objectives for the federal
funds rate and specifies target ranges for
money supply growth
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16-59
The Way Fed Policy is Currently
Implemented (cont'd)
• Trading Desk
– An office at the Federal Reserve Bank of New
York charged with implementing monetary
policy strategies developed by the FOMC
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16-60
Selecting the Federal Funds Rate Target
• The Neutral Federal Funds Rate
– A value of the interest rate on interbank loans
at which the growth rate of real GDP tends
neither to rise nor to fall relative to the rate of
growth of potential, long-run, real GDP, given
the expected rate of inflation
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16-61
Selecting the Federal Funds Rate Target
(cont’d)
• The value of neutral federal funds rate
varies over time. The potential rate of
growth of real GDP is not constant
• When the rate of growth rises or falls, so
does the value of the neutral federal funds
rate
• The FOMC must respond by changing the
target for the federal funds rate that it
includes in the FOMC Directive transmitted
to the Trading Desk
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16-62
Selecting the Federal Funds Rate Target
(cont’d)
• Taylor Rule
– A suggested guideline for monetary policy
– An equation determining the Fed’s interest rate
target based on
• Estimated long-run real interest rate
• Deviation of the actual inflation rate from the Fed’s
objective
• Gap between actual real GDP and a measure of
potential GDP
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16-63
Figure 16-10 Actual Federal Funds Rates
and Values Predicted by a Taylor Rule
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16-64
Why Not … just follow the Taylor rule?
• After 2008, during the Great Recession, following
the Taylor rule was not feasible for the Fed.
• Figure 16-10 shows that the Taylor rule specified a
negative value for the federal funds rate, which is
not possible.
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16-65
You Are There: How Zimbabwe Undercut
Collectors’ Hopes of Profits
• During Zimbabwe’s periods of hyperinflation—an
inflation rate so high that the Zimbabwe dollar
often lost more than half its value in a single day,
its government printed one-trillion-dollar notes.
• As those notes were printed and distributed in
very large volumes, their market values might
never exceed what money collectors paid for
them.
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16-66
Issues & Applications: Explaining the Rise in the
Quantity of Bank Reserves
• Figure 16-11 shows that since the late summer of
2008, the total reserves of depository institutions
have increased by nearly 25 times, to a level
exceeding $1 trillion.
• Most of this increase came from the rise in
voluntary holdings of excess reserves because
since October 2008, the Federal Reserve has paid
interest on all reserves held at Federal Reserve
district banks.
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16-67
Figure 16-11 Reserves of Depository
Institutions Since June 2008
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16-68
Summary Discussion of Learning
Objectives
• Key factors that influence the quantity of money
that people desire to hold
– When nominal GDP rises
• People generally make more transactions
• They require more money
• They desire to hold more money
– The interest rate is the opportunity cost for holding
money as a precaution against unexpected expenditures
– The quantity of money demanded declines as the market
interest rate increases
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16-69
Summary Discussion of Learning
Objectives (cont'd)
• How the Fed’s Open Market Operations
Influence Market Interest Rates
– The market price of existing bonds and the
prevailing interest rate are inversely related
• The market interest rate rises when the Fed sells
bonds
• The market interest rate declines when the Fed
purchases bonds
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16-70
Summary Discussion of Learning
Objectives
• How expansionary and contractionary
monetary policy affect equilibrium real
GDP and the price level in the short run
– Expansionary monetary policy
• Pushing up money supply, inducing a fall in interest
rates
• Total planned expenditures rise, AD shifts rightward
– Contractionary monetary policy
• Reduces the money supply increasing interest rates
• Total planned expenditures fall, AD shifts leftward
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16-71
Summary Discussion of Learning
Objectives (cont'd)
• The equation of exchange and the quantity
theory of money and prices
– Equation of exchange
• MsV = PY
– Quantity theory of money and prices
• V is constant and Y is stable
• Increases in Ms lead to equiproportional increases in P
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16-72
Summary Discussion of Learning
Objectives (cont'd)
• The interest-rate-based transmission
mechanism of monetary policy
– Operates through effects of monetary policy
actions on market interest rates
• Bring about changes in desired investment and
thereby affect equilibrium GDP via the multiplier
effect
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16-73
Summary Discussion of Learning
Objectives (cont'd)
• Why the Federal Reserve cannot stabilize
the money supply and the interest rate
simultaneously
– To target the money supply the Fed must
permit the interest rate to vary when the
demand for money changes
– To target a market interest rate the Fed must
adjust the money supply as necessary when
the demand for money changes
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16-74
Summary Discussion of Learning
Objectives (cont'd)
• How the Federal Reserve Achieves a Target
Value of the Federal Funds Rate
– The interest rate at which banks can borrow
excess reserves from other banks is at an
equilibrium level when the quantity of reserves
demanded by banks equals the quantity of
reserves supplied by the Fed
– The Trading Desk conducts open market sales
or purchases to alter the supply of reserves as
necessary to keep the federal funds rate at the
FOMC’s target
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16-75
Summary Discussion of Learning
Objectives (cont'd)
• Issues the Federal Reserve Confronts in
Selecting its Target for the Federal Funds
Rate
– The FOMC target is the neutral federal funds
rate
– The Taylor Rule specifies an equation for the
federal funds rate target based on
• an estimated long-run real interest rate
• the current deviation from the Fed’s inflation goal
• the gap between actual real GDP and a measure of
potential real GDP
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16-76
Appendix E: Increasing the Money Supply
• According to the Keynesian approach,
increasing the money supply:
– Pushes interest rates down
– Increases the level of investment spending
– Causes real GDP to rise, which in turn causes
real consumption to rise
– Real GDP rises further (multiplier effect)
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16-77
Figure E-1 An Increase in the Money Supply
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16-78
Appendix E: Decreasing the Money Supply
• According to the Keynesian approach,
decreasing the money supply:
– Pushes interest rates up
– Decreases the level of investment spending
– Causes real GDP to fall, which in turn causes
real consumption to fall
– Real GDP falls further (multiplier effect)
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16-79
Appendix E: Arguments Against Monetary
Policy
• Many traditional Keynesians argue that
monetary policy is likely to be relatively
ineffective as a recession fighter because:
– During recessions, people try to build up as
much as they can in liquid assets to protect
themselves from risks of unemployment and
other losses of income
– An increase in the money supply does not
reduce interest rate as individuals are willing to
allow most of it to accumulate in their bank
accounts, preventing interest rates from falling
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16-80