Download Monetary Policy

Monetary Policy
I. Federal Reserve System
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1913
12 District Reserve Banks (a la Federal
District Courts)
Janet Yellen (Chairman Federal Reserve
Board of Governors) monetary policy:
actions Fed takes to influence level real
GDP and rate of inflation
Goals of Monetary Policy
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Not profit motivated
“assist in achieving a full-employment,
noninflationary level of total output”
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1960s: focus full-employment
Post-1970s: focus inflation
Alters M by altering excess reserves to
affect output and prices
Theory of Monetarism
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MV≡PY
Money supply x Velocity = Price Level x
Output = nominal GDP
Assumes velocity relatively fixed (slow,
predictable change)
II. Tools
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1) Open Market Operations
Buying and selling of bonds in open market
Buying
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From C. Banks: increases banks’ reserves by amount
of purchase (if fully “loaned up” $1000 bond
w/20% RR $5000 increase lending + M)
From public: indirectly increases banks’ reserves (less
the reserve requirement: $4000 in lending and $1000
in new demand deposit= $5000 increase M)
Selling: just the reverse
2) Reserve Ratio
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Raise RR A) lose excess reserves
diminish money creation through lending
or B) reserves become deficient contract
checkable deposits and therefore M
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Lowering has opposite effect
∆ RR: 1) ∆ excess reserves and 2) ∆
monetary multiplier (1/RR)
3) Discount Rate
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Commercial Bank borrowing from Fed
increase reserves extension credit
Discount rate: rate charged to borrow
from Fed (cost of acquiring reserves)
raise/lower discourages/encourages C.
Bank borrowing to increase M
4) Moral Suasion
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Speeches, interviews, etc.: try to persuade
people to change behavior so Fed doesn’t
have to act
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“Irrational exuberance”
Easy vs. Tight Policy
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Expand M: buy securities, reduce RR,
lower discount rate
Restrict M: sell, raise, raise
Relative Importance of Tools
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#1 Open market operations (bonds)
Discount rate: 1) C. Banks borrow only 2-3% of
reserves from Fed (and OMO changes in
borrowing); 2) DR effectiveness dependent on
bank decisions (if banks unwilling, Fed unable)
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But, discount rate as “announcement effect”; but
often to keep in line w/other rates
Reserve ratio: used rarely bc impacts bank
profits (reserves earn no interest)
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OMO: 1) flexible (scalpel >
sledgehammer); 2) prompt (timing
problems); 3) powerful: total sale could
take reserves $22B $0
Washington Baby-Sitter Co-op Redux
III. Monetary Policy, Real GDP,
Price Level
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Money Demand
Transaction demand: to use
Asset demand: to hold
Factors affecting: 1) cash needed on
hand, 2) interest rates (opp’y cost of
holding money), 3) price levels, 4) general
level of income
Investment Demand
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Amount investment w/rate of return
greater than real rate of interest
 ∆M ∆i.r. ∆I  ∆GDP + PL
Effectiveness
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1) Speed and flexibility
2) isolation from political pressure
3) “Success” in 1980s + 1990s (Greenspan
the “maestro”) monetary policy primary
stabilization tool in US
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Some now criticize Greenspan for allowing
bubbles (stocks + housing) to form
Shortcomings and Problems
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1) Less control? ∆ banking + globalization undermine Fed
policy power
2) Cyclical assymetry: easy money only works if
willing to loan/borrow: Fed strong in expansions,
weaker in recessions (when arguably most needed)
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∆ biz confidence (movement of investment demand curve) may
require enormous exertions by Fed to offset
3) Changes in velocity: total expenditures = M times
velocity of money (how often spent)
4) Investment Impact: in reality borrowing small source
investment (mostly retained earnings)
5) Interest as income: MP based on assumption
expenditures inversely related i; but i also income, so
direct relationship (probably only partly off-sets)
6) Zero-lower bound: what if interest rates are 0%?
Federal Funds rate
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Rate banks charge other banks for shortterm loans (cover reserve requirements)
“target”: not set by Fed (supply and
demand), but buys/sells bonds to affect
rate
Prime rate follows Federal Funds
Policy Multipliers
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Spending Multiplier: 1/MPS
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Actual multiplier estimated at 2x
Taxing Multiplier: 1xMPC (=.95)
Balanced Budget Multiplier (equal tax hike
and spending hike): 1x change G
Money Multiplier: Excess Reserves x
1/RRR
Monetarism: MV=PY ∆M x V = ∆GDP