Download What Is Monetary Policy?

CHAPTER
14
Chapter 14: Monetary Policy
Monetary Policy
Prepared by:
Fernando Quijano
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14.1 LEARNING OBJECTIVE
What Is Monetary Policy?
Define monetary policy and
describe the Federal Reserve’s
monetary policy goals.
The Monetary Policy Goals of the Fed
Monetary policy The actions the Federal Reserve
takes to manipulate the money supply or the interest
rate to pursue macroeconomic objectives.
The Fed has four monetary policy goals that are
intended to promote a well-functioning economy:
Chapter 14: Monetary Policy
1. price stability
2. high employment
3. promote stable long-run economic growth
4. ensure the stability of financial markets and
institutions
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14.1 LEARNING OBJECTIVE
What Is Monetary Policy?
Define monetary policy and
describe the Federal Reserve’s
monetary policy goals.
GOAL # 1: Price Stability
Figure 14-1
Chapter 14: Monetary Policy
The Inflation Rate, January
1952–July 2009
For most of the 1950s and 1960s, the
inflation rate in the United States was
4 percent or less. During the 1970s,
the inflation rate increased, peaking
during 1979–1981, when it averaged
more than 10 percent. After 1992 the
inflation rate was usually less than 4
percent, until increases in oil prices
pushed it above 5 percent during
summer 2008. The effects of the
recession caused several months of
deflation—a falling price level—during
early 2009.
Note: The inflation rate is measured as
the percentage change in the
consumer price index (CPI) from the
same month in the previous year.
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14.1 LEARNING OBJECTIVE
What Is Monetary Policy?
Define monetary policy and
describe the Federal Reserve’s
monetary policy goals.
GOAL # 2: High Employment
The goal of high employment extends beyond the Fed
to other branches of the federal government.
GOAL # 3: Promote Stable Long-Run Economic Growth
Chapter 14: Monetary Policy
Policymakers aim to encourage stable long-run
economic growth because stable growth allows
households and firms to plan accurately and
encourages the long-run investment needed to sustain
growth.
GOAL # 4: Ensure the Stability of Financial Markets and Institutions
When financial markets and institutions are not efficient
in matching savers and borrowers, resources are lost.
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The Money Market and the Fed’s
Choice of Monetary Policy Targets
14.2 LEARNING OBJECTIVE
Describe the Federal Reserve’s
monetary policy targets and explain
how expansionary and contractionary
monetary policies affect the interest
rate.
The Intermediate Policy Targets of the Fed
The Fed tries to keep both the unemployment
and inflation rates low, but it can’t affect either
of these economic variables directly.
Chapter 14: Monetary Policy
The Fed has two intermediate targets of
monetary policy. The Fed can directly affect
these variables, and in turn, these variables
affect the Fed’s policy goals, such as real GDP,
employment, and the price level.
INTERMEDIATE TARGET # 1: the nominal M1
money supply
INTERMEDIATE TARGET # 2: short-term
nominal interest rates
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The Money Market and the Fed’s
Choice of Monetary Policy Targets
The Demand for Money
14.2 LEARNING OBJECTIVE
Describe the Federal Reserve’s
monetary policy targets and explain
how expansionary and contractionary
monetary policies affect the interest
rate.
Figure 14-2
Chapter 14: Monetary Policy
The Demand for Money
The money demand
curve slopes downward
because lower interest
rates cause households
and firms to switch from
financial assets such as
U.S. Treasury bills to
money.
A fall in the interest rate
from 4 percent to 3
percent will increase the
quantity of money
demanded from $900
billion to $950 billion. An
increase in the interest
rate will decrease the
quantity of money
demanded.
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The Money Market and the Fed’s
Choice of Monetary Policy Targets
Shifting the Money Demand Curve
14.2 LEARNING OBJECTIVE
Describe the Federal Reserve’s
monetary policy targets and explain
how expansionary and contractionary
monetary policies affect the interest
rate.
Figure 14-3
Shifts in the Money
Demand Curve
Chapter 14: Monetary Policy
Changes in real
GDP (Y) or the
price level (P)
cause the money
demand curve to
shift.
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14.2 LEARNING OBJECTIVE
The Money Market and the
Describe the Federal Reserve’s
policy targets and explain
Fed’s Choice of Monetary Policy Targets monetary
how expansionary and contractionary
monetary policies affect the interest
rate.
Equilibrium in the Money Market
Figure 14-4
Chapter 14: Monetary Policy
The Impact on the Interest Rate
When the Fed Increases the
Money Supply
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14.2 LEARNING OBJECTIVE
The Money Market and the
Describe the Federal Reserve’s
policy targets and explain
Fed’s Choice of Monetary Policy Targets monetary
how expansionary and contractionary
Equilibrium in the Money Market
monetary policies affect the interest
rate.
Figure 14-5
Chapter 14: Monetary Policy
The Impact on Interest Rates
When the Fed Decreases the
Money Supply
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14.2 LEARNING OBJECTIVE
The Money Market and the
Describe the Federal Reserve’s
policy targets and explain
Fed’s Choice of Monetary Policy Targets monetary
how expansionary and contractionary
A Tale of Two Interest Rates
monetary policies affect the interest
rate.
Why do we need two models of the interest rate?
The answer is that the loanable funds model is
concerned with the long-term real rate of interest,
and the money market model is concerned with the
short-term nominal rate of interest.
Choosing an Intermediate Target
Chapter 14: Monetary Policy
There are many different interest rates in the economy.
For purposes of monetary policy, since the 1980s, the
Fed has targeted the interest rate known as the federal
funds rate.
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14.2 LEARNING OBJECTIVE
The Money Market and the
Describe the Federal Reserve’s
policy targets and explain
Fed’s Choice of Monetary Policy Targets monetary
how expansionary and contractionary
monetary policies affect the interest
rate.
The Importance of the Federal Funds Rate
Federal funds rate The interest rate
banks charge each other for overnight
loans.
Chapter 14: Monetary Policy
Usually just called the “fed funds” rate
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14.2 LEARNING OBJECTIVE
The Money Market and the
Describe the Federal Reserve’s
policy targets and explain
Fed’s Choice of Monetary Policy Targets monetary
how expansionary and contractionary
The Importance of the Federal Funds Rate
monetary policies affect the interest
rate.
Figure 14-6
Chapter 14: Monetary Policy
Federal Funds Rate
Targeting, January 1998–
July 2009
The Fed does not set the federal
funds rate, but its ability to increase
or decrease bank reserves quickly
through open market operations
keeps the actual federal funds rate
close to the Fed’s target rate.
The orange line is the Fed’s target
for the federal funds rate,
and the jagged green line
represents the actual value for the
federal funds rate on a weekly
basis.
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Monetary Policy and
Economic Activity
14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
How Interest Rates Affect Aggregate Demand
Changes in interest rates will not affect
government purchases, but they will affect
the other three components of aggregate
demand :
consumption (C)
investment (I)
Chapter 14: Monetary Policy
net exports (NX)
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Monetary Policy and
Economic Activity
14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
The Effects of Monetary Policy on Real GDP and the Price Level
Expansionary monetary policy The Federal
Reserve’s increasing the money supply and
decreasing interest rates to increase real GDP.
Chapter 14: Monetary Policy
Contractionary monetary policy The Federal
Reserve’s adjusting the money supply to
increase interest rates to reduce inflation.
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14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
Chapter 14: Monetary Policy
Monetary policy in the simple (static) AD-LRAS-SRAS model
Figure 14-7
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Making
Too Low for Zero: The Fed
the
Tries "Quantitative Easing”
Chapter 14: Monetary Policy
Connection
14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
The Fed pushed interest
rates to very low levels
during 2008 and 2009.
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Monetary Policy and
Economic Activity
14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
Can the Fed Eliminate Recessions?
Chapter 14: Monetary Policy
Keeping recessions shorter and milder than
they would otherwise be is usually the best the
Fed can do.
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Monetary Policy and
Economic Activity
14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
Can the Fed Eliminate Recessions?
Figure 14-8
Chapter 14: Monetary Policy
The Effect of a Poorly
Timed Monetary Policy on
the Economy
The upward-sloping straight
line represents the long-run
growth trend in real GDP.
The curved red line represents
the path real GDP takes
because of the business cycle.
If the Fed is too late in
implementing a change in
monetary policy, real GDP will
follow the curved blue line.
The Fed’s expansionary
monetary policy results in too
great an increase in aggregate
demand during the next
expansion, which causes an
increase in the inflation rate.
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Monetary Policy and
Economic Activity
14.3 LEARNING OBJECTIVE
Use aggregate demand and aggregate supply
graphs to show the effects of monetary policy
on real GDP and the price level.
A Summary of How Monetary Policy Works
Table 14-1
Chapter 14: Monetary Policy
Expansionary and Contractionary
Monetary Policies
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Monetary Policy in the Dynamic Aggregate
Demand and Aggregate Supply Model
14.4 LEARNING OBJECTIVE
Use the dynamic aggregate
demand and aggregate supply
model to analyze monetary policy.
Monetary policy in the dynamic AD-LRAS-SRAS model
Figure 14-9
Chapter 14: Monetary Policy
An Expansionary M.P.
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Monetary Policy in the Dynamic Aggregate
Demand and Aggregate Supply Model
14.4 LEARNING OBJECTIVE
Use the dynamic aggregate
demand and aggregate supply
model to analyze monetary policy.
Monetary policy in the dynamic AD-LRAS-SRAS model
Figure 14-10
Chapter 14: Monetary Policy
A Contractionary M.P.
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Solved Problem
14.4 LEARNING OBJECTIVE
14-4
Use the dynamic aggregate
demand and aggregate supply
model to analyze monetary policy.
The Effects of Monetary Policy
The hypothetical information in the table shows what the
values for real GDP and the price level will be in 2013 if the
Fed does not use monetary policy.
POTENTIAL GDP
REAL GDP
PRICE LEVEL
2012
$14.9 trillion
$14.9 trillion
110
2013
$15.3 trillion
$15.2 trillion
112
Chapter 14: Monetary Policy
YEAR
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Solved Problem
14-4
Use the dynamic aggregate
demand and aggregate supply
model to analyze monetary policy.
Chapter 14: Monetary Policy
The Effects of Monetary Policy (continued)
14.4 LEARNING OBJECTIVE
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A Closer Look at the Fed’s Setting
of Monetary Policy Targets
14.5 LEARNING OBJECTIVE
Discuss the Fed’s setting of
monetary policy targets.
Rules vs Discretion Debate 1:
Should the Fed Target the Money Supply Instead?
Some economists have argued that rather than use an
interest rate as its monetary policy target, the Fed should
use the money supply.
Many of the economists who make this argument belong
to a school of thought known as monetarism.
Chapter 14: Monetary Policy
The leader of the monetarist school was Nobel Laureate
Milton Friedman.
Friedman and his followers favored replacing monetary
policy with a monetary growth rule.
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A Closer Look at the Fed’s Setting
of Monetary Policy Targets
14.5 LEARNING OBJECTIVE
Discuss the Fed’s setting of
monetary policy targets.
Why Doesn’t the Fed Just Target Both the Money
Supply and the Interest Rate?
Figure 14-11
Chapter 14: Monetary Policy
The Fed Can’t Target Both the
Money Supply and the Interest
Rate
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A Closer Look at the Fed’s Setting
of Monetary Policy Targets
14.5 LEARNING OBJECTIVE
Discuss the Fed’s setting of
monetary policy targets.
Rules vs Discretion Debate 2:
The Taylor Rule
Taylor rule A rule developed by
John Taylor that links the Fed’s
target for the federal funds rate
to economic variables.
Chapter 14: Monetary Policy
Federal funds target rate =
= current inflation rate
+ real equilibrium federal funds rate
+ (1/2) * inflation gap
+ (1/2) * output gap
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A Closer Look at the Fed’s Setting
of Monetary Policy Targets
14.5 LEARNING OBJECTIVE
Discuss the Fed’s setting of
monetary policy targets.
Rules vs Discretion Debate 3:
Should the Fed Target the Inflation Rate?
Chapter 14: Monetary Policy
Inflation targeting Conducting
monetary policy so as to commit the
central bank to achieving a publicly
announced level of inflation.
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Making
How Does the Fed
the
Measure Inflation?
14.5 LEARNING OBJECTIVE
Discuss the Fed’s setting of
monetary policy targets.
Chapter 14: Monetary Policy
Connection
The Fed excludes food
and energy prices from
its main measure of
inflation.
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Fed Policies During the
2007-2009 Recession
14.6 LEARNING OBJECTIVE
Discuss the policies the Federal
Reserve used during the 20072009 recession.
The Inflation and Deflation of the Housing Market “Bubble”
Figure 14-12
The Housing Bubble
Chapter 14: Monetary Policy
Sales of new homes in the
United States went on a
roller-coaster ride, rising by
60 percent between January
2000 and July 2005, before
falling by 76 percent
between July 2005 and
January 2009.
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Fed Policies During the
2007-2009 Recession
14.6 LEARNING OBJECTIVE
Discuss the policies the Federal
Reserve used during the 20072009 recession.
The Changing Mortgage Market
By the 1990s, a large secondary market existed in mortgages, with funds
flowing from investors through Fannie Mae and Freddie Mac to banks and,
ultimately, to individuals and families borrowing money to buy houses.
The Role of Investment Banks
Chapter 14: Monetary Policy
By mid-2007, the decline in the value of mortgage-backed securities and
the large losses suffered by commercial and investment banks began to
cause turmoil in the financial system. Many investors refused to buy
mortgage-backed securities, and some investors would only buy bonds
issued by the U.S. Treasury.
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14.6 LEARNING OBJECTIVE
Making
Discuss the policies the Federal
Reserve used during the 20072009 recession.
The Wonderful
the World of Leverage
Connection
During the housing boom, many people purchased
houses with down payments of 5 percent or less. In this
sense, borrowers were highly leveraged, which means
that their investment in their house was made mostly
with borrowed money.
RETURN ON YOUR INVESTMENT FROM . . .
DOWN PAYMENT
Chapter 14: Monetary Policy
100%
A 10 PERCENT
INCREASE IN THE PRICE
OF YOUR HOUSE
A 10 PERCENT
DECREASE IN THE PRICE
OF YOUR HOUSE
10%
-10%
20
50
-50
10
100
-100
5
200
-200
Making a very small down
payment on a home
mortgage leaves a buyer
vulnerable to falling house
prices.
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Fed Policies During the
2007-2009 Recession
14.6 LEARNING OBJECTIVE
Discuss the policies the Federal
Reserve used during the 20072009 recession.
The Fed and the Treasury Department Respond
Initial Fed and Treasury Actions
First, although the Fed traditionally made loans only to commercial
banks, in March 2008 it announced the “Primary Dealer Credit
Facility”, under which primary dealers—firms that participate in regular
open market transactions with the Fed—are eligible for discount
window loans.
Chapter 14: Monetary Policy
Second, also in March, the Fed announced the “Term Securities
Lending Facility”, under which the Fed will loan up to $200 billion of
Treasury securities in exchange for mortgage-backed securities (this is
QE1—the Fed buys up all the toxic assets).
Third, once again in March, the Fed and the Treasury helped
JPMorgan Chase acquire the investment bank Bear Stearns, which
was on the edge of failing.
Finally, in early September, the Treasury moved to have the federal
government take control of Fannie Mae and Freddie Mac (which are
now going bankrupt).
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Fed Policies During the
2007-2009 Recession
14.6 LEARNING OBJECTIVE
Discuss the policies the Federal
Reserve used during the 20072009 recession.
The Fed and Treasury Department Respond
Responses to the Failure of Lehman Brothers
Chapter 14: Monetary Policy
In October 2008, Congress passed the “Troubled Asset Relief
Program” (TARP), under which the Treasury attempted to stabilize the
commercial banking system by providing funds to banks in exchange
for stock. Taking partial ownership positions in private commercial
banks was an unprecedented action for the federal government.
Clearly, the recession of 2007–2009, and the accompanying financial
crisis, had led the Fed and the Treasury to implement new approaches
to policy. Many of these new approaches were controversial because
they involved partial government ownership of financial firms, implicit
guarantees to large financial firms that they would not be allowed to go
bankrupt, and unprecedented intervention in financial markets.
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AN INSIDE
LOOK
>> Housing Market Affects the United
States and Europe Differently
Chapter 14: Monetary Policy
ECB Chief Says Boost in Stimulus Not Needed
The European Central Bank’s monetary policy has been less aggressive than
the Federal Reserve’s.
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KEY TERMS
Contractionary monetary policy
Expansionary monetary policy
Federal funds rate
Inflation targeting
Monetary policy
Chapter 14: Monetary Policy
Taylor rule
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