Download Monetary Policy

Chapter 16 -Monetary Policy
This chapter looks at Monetary
Policy, the most frequent use of
policy to correct the economy.
Monetary Policy -- The Federal
Reserve changing bank loaning
conditions to affect the supply of
financial capital, investment, and
aggregate demand.
The Banker’s Problem
Fundamental decision -- how to
allocate their assets to make
reasonable profits and to service
depositor withdrawals.
Reserves – do not earn interest (not a
source of revenue), are used to back
up depositor withdrawals.
Loans – earn interest for the bank
(their major source of revenue), but
funds committed to loans are not
accessible to the bank.
The Federal Reserve (1913)
Original Roles
-- Provider of Discount Window -“Lender of Last Resort”
-- Regulate Banks
(e.g. Reserve Ratios)
Manages Monetary Policy
Structure of
the Federal Reserve
Board of Governors (BOG)
7 members
appointed by the President, with the
consent of the Senate
once approved, independent of the
President
Important Chairs of the BOG
-- Paul Volcker -- 1979-87
-- Alan Greenspan – 1987-2006
-- Ben Bernanke -- 2006-
The Federal Open
Market Committee (FOMC)
12 voting members -- 7 Board of
Governors + 5 District Bank Presidents
(19 members in all).
meets approximately once a month
(more, if needed).
designs monetary policy,
communicated by specifying Federal
Funds rate target.
Federal Reserve
District Banks
Each private bank exists within
one of 12 districts within the US.
Each district has a Federal
Reserve District Bank.
District banks administer
monetary policy, regulate the
private banks within their district.
The Basic Strategy
of Monetary Policy
Expansionary (Y* < YF) -- Federal
Reserve seeks to increase the
supply of financial capital by
encouraging bank loaning.
Contractionary (Y* > YF) -- Federal
Reserve seeks to decrease the
supply of financial capital by
discouraging bank loaning.
Monetary Policy Tools
Instruments that initiate monetary
policy.
(1) The Discount Rate
(2) Reserve Ratio
(3) Open Market Operations
Changing The
Discount Rate
The Discount Rate -- the rate of
interest charged to banks that
borrow from the Federal Reserve.
Expansionary Policy -- Fed lowers
discount rate.
Contractionary Policy -- Fed raises
discount rate.
Changing the Reserve Ratio
Designed to change the minimum
amount of reserves the bank must
hold.
Expansionary Policy -- Fed lowers
the reserve ratio.
Contractionary Policy -- Fed raises
the reserve ratio.
Open Market Operations
Open Market Operations -- the
buying or selling of bonds by the
Federal Reserve in the open
market (the Fed’s predominant
policy tool).
Expansionary -- Fed buys bonds
(gives banks new reserves)
Contractionary -- Fed sells bonds
(drains reserves from banks)
Open Market
Operations: An Example
Example -- Federal Reserve buys a
$1000 bond from Chase.
Chase receives new reserves, can
make new loans.
Therefore, the potential to
increase the supply of financial
capital is increased.
The Federal Funds Rate
The Federal Funds Rate -- the interest
rate paid by one bank to borrow
reserves from another bank.
The “thermostat” of monetary policy.
Changes in target Federal Funds rate
by the FOMC prompt the execution of
open market operations. Open market
operations stop when new target is
achieved.
The Process of Monetary
Policy -- Expansionary
The FOMC lowers the target Federal
Funds Rate.
To achieve this target, the Fed buys
bonds from banks, supplying more
reserves to the system.
The Fed does this until the new
target Federal Funds rate is
achieved.
Expansionary
Monetary Policy, Continued
Increased bank loaning due to having
greater reserves implies an increase in
the supply of financial capital, shifting
the supply of capital curve rightward.
The shift in the supply of financial
capital implies that the interest rate (r*)
decreases and Investment (I*)
increases.
The increase in I* shifts the AD curve
rightward, increasing both Y* and P*.
The Process of Monetary
Policy -- Contractionary
The FOMC raises the target
Federal Funds Rate.
To achieve the new target, the Fed
sells bonds to banks, thereby
removing reserves from the
system.
The Fed does this until the new
target Federal Funds rate is
achieved.
Contractionary
Monetary Policy, Continued
Decreases in bank loaning due to
having less reserves implies a
decrease in the supply of financial
capital, shifting the supply of capital
curve leftward.
As a result, the interest rate (r*)
increases and Investment (I*)
decreases.
The decrease in I* shifts the AD curve
leftward, decreasing both Y* and P*.
Monetary Policy and the
Short-Run Perspective
Monetary policy is interventionist
– believes that the short-run is the
relevant period.
In formal terms, policy works with
the AD and AS curves.
Long-run perspective (AD and
LAS curves) – no need for
monetary policy “medicine”,
economy will cure itself.
Obstacles to Monetary
Policy Effectiveness
When does monetary policy have
difficulty in changing Y* to
improve the economy?
Particularly applies to
expansionary monetary policy -getting the economy out of
sluggishness or recession.
A Potential Obstacle
(1) Banks don’t want to loan the
added reserves (pessimism
about prospects of loan default
or fears of inflation).
 No shifts in demand or supply for
financial capital.
Another Potential Obstacle
2) Banks want to loan, but firms and
consumers don’t want to borrow the
funds (e.g. pessimism about state of
economy).
Described as leftward shift in the
demand for financial capital coupled
with a rightward shift in the supply of
financial capital.
The Volcker Recession:
Ending a Wage-Price Spiral
1970s in US -- Wage-Price Spiral
Started as overly expansionary
government and monetary policies
of the 1960s, with progressively
higher wage increases.
Continued in late 1970s as
expansionary monetary responses
to increase in price of energy.
Continued high wage increases.
The Volcker
Recession of 1981-83
Very contractionary monetary policy
(Federal Funds rate over 17%) -- Supply
of financial capital decreases, I* falls,
AD curve shifts leftward.
High nominal wage increases continue,
big leftward shift in AS curve.
Major recession, lower inflation
eventually eases inflation fears.
The Volcker Recession and
Recovery -- 1981-83
Convinced of Federal Reserve’s
intent to solve inflation problem,
lower wage increases occur,
smaller leftward shifts in AS curve.
Federal Reserve gradually
practices cautious expansionary
monetary policy, shifts AD curve
rightward, Y* returns to YF.
Monetary Policy
in the Greenspan Era
1990-91 recession -- similar to Volcker,
but on a smaller scale.
“Soft Landing” strategy beginning in
1990s -- small monetary policy changes
designed not to arouse inflation fears,
overly large wage increases.
Contractionary in 2000 (Y* > YF),
Monetary Policy: From
Greenspan to Bernanke
2001-03: Expansionary (Y* < YF.).
Policy experienced difficulty getting
economy back to YF.
2004-06: Contractionary. Economy
caught up to YF, concern about
overstimulated economy and increased
energy prices.
2007-08: Expansionary. Addressing
slowdown and ultimate recession of
2008.