Download Chapter 16: Monetary Policy

Chapter 16: Monetary
Policy
Monetary Policy
Monetary policy consists of deliberate
changes in the money supply to influence
interest rates and thus the total level of
spending in the economy.
The goal is to achieve and maintain pricelevel stability, full employment, and
economic growth.
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Interest Rates
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There are many types of interest rates in
the U.S. economy that vary by purpose,
size, risk, maturity, and taxability.
For simplicity, economists speak of a
single interest rate.
The interest rate results from the
interaction of money demand and money
supply.
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Selected U.S. Interest Rates,
April 2005
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The Demand for Money
People demand money for two main
reasons: to make purchases with it and to
hold it as an asset.
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The demand for money as a medium of
exchange is called the transactions demand
for money (Dt).
The amount of money people want to hold as
a store of value is called the asset demand
for money (Da).
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The Demand for Money

The main determinant of the amount of
money demanded for transactions is the
level of nominal GDP.

The transactions demand for money is
vertical.
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The Demand for Money

Holding money incurs an opportunity cost;
therefore, the amount of money demanded
as an asset varies inversely with the rate
of interest, which is the opportunity cost of
holding money.

The asset demand for money is negatively
sloped.
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The Demand for Money
The sum of the transactions demand and
assets demand for money equals the total
demand for money (Dm).
Dm = Dt + Da
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The Equilibrium Interest Rate

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In the money market, the demand for
money and the supply of money determine
the equilibrium rate of interest.
The money supply, Sm, is a vertical line
because the monetary authorities and
financial institutions have provided the
economy with some particular stock of
money.
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The Equilibrium Interest Rate

The intersection of demand and supply in
the money market determines equilibrium
price, or the real interest rate (ic) – the
inflation-adjusted price that is paid for the
use of money over some time period.
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The Money Market
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Tools of Monetary Policy

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The Federal Reserve can change the
money supply and therefore alter interest
rates in the economy.
The three tools of monetary control are:
Open-market operations
 Reserve ratio
 Discount rate

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Open Market Operations
Open market operations consists of the
buying and selling of U.S. government
securities by the Fed for the purpose of
carrying out monetary policy.
Open market operations are the most
important instrument for influencing the
money supply.
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Open Market Operations

Buying securities increases the reserves
of commercial banks.

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Excess reserves allow the banking system to
expand the money supply through loans.
Selling securities reduces the reserves of
commercial banks.

Lower reserves result in a multiple contraction
of the money supply.
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The Reserve Ratio


Changing the reserve ratio is a powerful
technique of monetary control, although it
is seldom used by the Fed.
Manipulation of the reserve ratio
influences the ability of the commercial
banks to lend.
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The Reserve Ratio

If the Fed raises the reserve ratio, the
amount of required reserves that banks
must keep increases.

Banks will either lose excess reserves,
diminishing their ability to create money by
lending, or reduce its checkable deposits due
to deficient reserves, and therefore the money
supply.
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The Reserve Ratio

If the Fed lowers the reserve ratio, the
banks’ required reserves will decrease.

Banks with more excess reserves are able to
create new money by lending.
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The Discount Rate

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The discount rate is the interest rate the
Federal Reserve Banks charge on the
loans they make to commercial banks and
thrifts.
Occasionally, Federal Reserve Banks
makes short-term loans to commercial
banks in their district; the Fed is
considered the “lender of last resort.”
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The Discount Rate

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In providing loans, the Federal Reserve
Bank increases the reserves of the
borrowing bank, enhancing its ability to
extend credit.
From the commercial banks’ perspective,
the discount rate is the cost of acquiring
reserves.
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The Discount Rate


Increasing the discount rate discourages
commercial banks from obtaining
additional reserves through borrowing
from the Federal Reserve Banks.
When the Fed raises the discount rate, it
wants to restrict the money supply.
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Easy Money Policy

Easy money policy (or expansionary
monetary policy) are Fed actions designed
to increase the money supply, lower
interest rates, and expand real GDP.

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These include buying securities, lowering the
reserve ratio and lowering the discount rate.
Its purpose is to make loans less
expensive and more available and thereby
increase aggregate demand, output and
employment.
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Tight Money Policy

The Fed can try to reduce aggregate
demand by limiting or contracting the
money supply. These actions are called a
tight money policy (or restrictive
monetary policy).
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These include selling securities, increasing the
reserve ratio and raising the discount rate.
The objective is to tighten the money
supply in order to reduce spending and
control inflation.
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Monetary Policy, Real GDP,
and the Price Level
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Monetary policy achieves its goals by
affecting the market for money,
investment, and equilibrium GDP.
The cause-effect chain in Figure 16.2
illustrates how monetary policy works.
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Monetary Policy, Real GDP,
and the Price Level
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Effect of an
Easy Money Policy

If real output in the economy is below the
full-employment output, the economy must
be experiencing a recession (a negative
GDP gap) and unemployment; therefore,
the Fed should institute an easy money
policy.

To increase the money supply, the Fed can
buy government securities, lower the legal
reserve ratio, and lower the discount rate.
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Effect of an
Easy Money Policy

Increasing the money supply will reduce
interest rates and will boost investment.
This will cause the aggregate demand
curve to shift rightward, eliminating the
negative GDP gap.
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Effect of a
Tight Money Policy

If real output in the economy is above the
full-employment output, the economy has
a positive GDP gap and demand-pull
inflation; the Fed should institute a tight
money policy.

The Fed will direct Federal Reserve Banks to
undertake some combination of the following
actions: (1) Sell government securities, (2)
increase the legal reserve ratio, (3) increase
the discount rate.
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Effect of a
Tight Money Policy

Decreasing the money supply will raise
interest rates and cause investment to
decline. The decrease in investment will
shift the aggregate demand curve leftward,
eliminating the excessive spending and
halt demand-pull inflation, closing the
positive GDP gap.
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Monetary Policy in Action

Monetary policy, a dominant component of
U.S. national stabilization policy, has two
key advantages over fiscal policy:
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Speed and flexibility
Isolation from political pressure
Monetary policy can be quickly altered and
is a more subtler and more politically
neutral measure.
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The Focus on the
Federal Funds Rate
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
Because the Fed can control the supply of
reserves in the banking system and thus
the Federal funds rate, it currently focuses
monetary policy on altering the this interest
rate as a need to stabilize the economy.
The Federal funds rate is the interest rate
banks and thrifts charge one another on
overnight loans made out of their excess
reserves.
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The Focus on the
Federal Funds Rate


If the Fed wants to increase the Federal
funds rate, it sells securities in the open
market to reduce bank reserves, and vice
versa.
The Fed can target the Federal funds rate
because it knows that interest rates in
general (including the economy’s prime
interest rate) typically rise and fall with that
rate.
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The Focus on the
Federal Funds Rate


The prime interest rate is the benchmark
interest rate that banks and thrifts use as a
reference point for a wide range of loans to
businesses and individuals.
A change in the Federal funds rate will
cause a similar change to the prime rate and
other short-term interest rates.
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Problems and Complications


Monetary policy has certain limitations and
real-world complications.
One problem is that monetary policy faces
recognition lag and operational lag.

The Fed must be able to recognize and respond
to changes in economic activity.
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Problems and Complications

Another problem is monetary policy suffers
from cyclical asymmetry.

Cyclical asymmetry is the potential problem of
monetary policy successfully controlling inflation
during the expansionary phase of the business
cycle but failing to expand spending and real
GDP during the recessionary phase of the cycle.
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“Artful Management” or
“Inflation Targeting”?


Alan Greenspan, in his role and Chairman of
the Fed, has artfully managed the money
supply to avoid escalating inflation or deep
recession and deflation.
Some economists are concerned that this
“artful management” may be a unique
quality of Greenspan and that someone less
insightful may not be as successful.
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“Artful Management” or
“Inflation Targeting”?


Because of this, some feel the Fed should
replace or combine the artful management
of monetary policy with so-called inflation
targeting—the annual statement of a target
range of inflation for future years.
Some countries have already adopted
inflation targeting as it increases the
“transparency” of monetary policy and the
central bank’s accountability.
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