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Chapter 10
Monetary
Policy
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Goals, Tools And A Model Of
Monetary Policy
• Central Bank Independence
• Modern Monetary Policy
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The Federal Reserve
• Nicknamed “The Fed”.
• Established in 1913 by Congress primarily as the authority for
bank regulation.
• The power to “coin money” was granted to Congress by
Article 1 Section 8 of the US Constitution but this power was
delegated to the Federal Reserve.
• The power to regulate the amount that exists in the economy
was granted to the Federal Reserve in an attempt to avoid the
boom and bust periods of the late 1800s.
• This power allows the Federal Reserve to alter interest rates
without political interference.
• There are 12 regional Federal Reserve Banks
• Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland,
St. Louis, Kansas City, Chicago, Dallas, Minneapolis, and San
Francisco
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Goals of Monetary Policy
• Provide sufficient money to the
economy so that it may grow at a
sustainable rate.
• Dampen the impact of the business
cycle.
• Control Inflation.
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Measures of the
Amount of Money in the Economy
• Monetary Aggregate: a measure of
the quantity of money in the economy
• The commonly used ones are
• M1 =cash+coin and checking accounts
• M2=M1+saving accounts+ small CDs
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The Banking System
• When a bank takes a deposit into an
account on which a check can be
written, it must place a percentage of
that deposit on reserve at a Federal
Reserve bank. That percentage is
called the reserve ratio.
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Traditional and Ordinary Tools of Monetary
Policy
• Open Market Operations
• A relatively fine tool that can be used to make small
adjustments. These adjustments can be daily and
often occur without much fanfare.
• Targeted Interest Rates
• A relatively blunt tool that can be used to make large
adjustments. In typical years, changes in targeted
interest rates a few times per year.
• Reserve Ratio
• A rather blunt tool that is only used when very large
adjustments are in order.
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Tools of Monetary Policy:
Open Market Operations
• The Fed buys US government debt in
order to get cash into the economy.
• The Fed sells US government Debt in
order to get cash out of the economy.
• More money in the economy puts
downward pressure on interest rates.
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Tools of Monetary Policy:
Targeted Interest Rates
• The Fed seeks to influence the Federal
Funds Rate (the rate at which banks
borrow from one another to meet
reserve requirements).
• Fed Loans Directly to Banks
• Banks with good credit pay the primary
credit rate and can borrow unlimited
amounts.
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Tools of Monetary Policy: The
Reserve Ratio
• The Fed directly controls the
percentage of deposits that banks
must have at their regional Fed bank.
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Money Creation
• The banking system can create more “money” than
physically exists in the form of coin and cash.
• The banking system creates money by a series of loans.
• Person 1 makes a $1000 deposit at Bank 1
• Bank 1 loans Person 2 $900 who buys something
from Person 3
• Person 3 makes a $900 deposit in Bank 2.
• Bank 2 loans $810 to Person 4 who buys something
from Person 5….. and so on.
• In the end there are deposits totaling $10,000
($1,000+$900+$810+$729+....) that resulted from
that initial $1000.
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Modeling Monetary Policy
• If the Fed wants to expand the economy it can
•
•
•
•
buy bonds
decrease the Federal Funds or Discount Rate
lower the reserve ratio.
This increases the supply of loanable funds. This lowers
interest rates which increases aggregate demand.
• If the Fed wants to contract the economy it can
•
•
•
•
sell bonds
increase the Federal Funds or Discount Rate
raise the reserve ratio
This decreases the supply of loanable funds. This raises
interest rates which decreases aggregate demand.
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Expansionary Monetary Policy
Interest Rates
Price Level
S
AS
S’
r
r’
AD2
D
Loanable Funds
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AD1
RGDP
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Contractionary Monetary Policy
Interest rate
Price Level
S’
AS
S
r’
r
AD1
AD2
D
Loanable Funds
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RGDP
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Monetary Transmission
• The Monetary Transmission Mechanism is the
means by which changes in the interest rate impact
the overall economy through changes in business
investment and consumer spending.
• The Fed can impact the interest rate with monetary
policy.
• The Fed cannot count on interest rates changing
business investment and consumer spending.
• When the Monetary Transmission Mechanism fails,
you have a liquidity trap.
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New Tools of Monetary Policy
• Purchases of Commercial Paper,
short term debt of corporations.
• Purchases of longer term Federal
Treasuries
• Purchases of mortgage backed securities.
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Central Bank Independence
• Countries with Central Banks (the
general name for institutions like the US
Federal Reserve) that are more
independent of political control have
higher rates of economic growth.
• This is because political influences tend
to create inflationary tendencies which
raises interest rates and lowers longterm investment.
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Fed History 1975-1983
• In the late 1970s, the Fed battled the
slow growth caused by high oil prices
by increasing loanable funds so as to
lower interest rates.
• The result was high inflation and even
higher interest rates.
• The Fed induced the 1982 recession
with contractionary policy. Once
inflation fell below 6% in 1983 it
engaged in expansionary policy.
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Fed History 1984-1990
• The Fed battled high deficits
(expansionary fiscal policy) by
keeping real interest rates fairly
high.
• The Fed chose not to react to the
1990 recession hoping to persuade
Congress and the first President
Bush to compromise on deficit
reduction.
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Fed History 1990-2003
• The Fed steered a stabilization course
through the 1990’s.
• A fear of inflation led to a rapid increase in
interest rates in 2000.
• A fear of recession led to a rapid decrease
in interest rates in 2001.
• The Fed tried to dampen the economic
impact of the Sept 11, 2001 terrorist
attacks with quick and deep rate cuts.
• Rate cutes left the Federal Funds rate at
1% though 2003
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Fed History 2004-2007
• Began raising interest rates in 2004
• Raised interest rates 17 times until the
Fed Funds rate was at 5.25%
• Maintained that rate for several months.
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Fed History 2008-2011
• In 2008, it began cutting interest rates in
response to the economic slowdown.
• Brought the federal funds rate to zero
(to 0.25) percent in late 2008.
• Purchased AIG in September 2008
• QE2 in 2010-2011
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Key Interest Rates
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The Inflation/Deflation Debate
• The Fed is often criticized by economists
but primarily by politicians for being more
concerned about inflation than preventing
recession or getting the most out of the
US economy.
• There was little the Fed could have done
to stimulate the economy after the final
cut to 1%. There was an active concern
on 2003 that deflation was possible.
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Aggressive Fed Action on the
Federal Funds Rate (1999-2011)
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Inflation Targeting
• The European Central Bank currently targets
inflation rather than a monetary aggregate or
interest rate.
• Inflation targeting: involves publishing a
desired range of a specified inflationary measure
and then using the tools of monetary policy to
bring that measure of inflation into that desired
range.
• The Fed’s target is the core PCE deflator.
• Target range 1-2%
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Yield Curves in Recent History
18
16
Interest Rate
14
12
10
8
6
4
2
0
Fed funds
1-year
10-year
20-year
30-year
Maturity
1981
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2000
2002
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