Download Lecture33(Ch30)

Monetary
Independence
30_01
INFLATION
RATE
Potential GDP
• Rationale
– “gain then pain scenario”
– Kelly M. showed Tom C.
• time inconsistency
• political business cycle
LR
PA (LR )
SR
PA (SR )
New ADI
Old ADI
REAL GDP
Real GDP rises above
potential GDP in
the short run.
– government borrowing from central bank
• How is independence achieved?
– Long terms of governors (14 years!)
– chair’s term does not coincide with POTUS
– district Fed presidents not appointed by POTUS
Arthur Burns, Fed chair under Richard Nixon,
was criticized for letting money grow too
quickly, raising inflation, despite what he said
here in congressional testimony
30_02
AVERAGE INFLATION
(PERCENT, 1955-1988)
9
Spain
8
Italy
7
United Kingdom
New Zealand
Denmark
6
5
Canada
United States
Japan
Belgium
4
Netherlands
Switzerland
3
Germany
2
1.0
1.5
LESS INDEPENDENT
2.0
2.5
3.0
3.5
4.0
MORE INDEPENDENT
Two old tools of monetary policy
• Discount rate: interest rate Fed charges on
loans to commercial banks
– Borrowing is part of lender of last resort role
of the Fed, aim is to discourage bank runs
• Bank runs occur when many depositors want cash at
the same time--scene from It’s a Wonderful Life 
– Discount rate is now a side show
• Fed holds discount rate below federal funds rate
• Changes in reserve ratio: used rarely
– last changed in 1991 to raise bank profits
• Now the federal funds rate is the main focus
How the Fed changes the
federal funds rate
• Example, what does it do to cut the rate
from 5.0 % to 4.75 % as it did last week?
• A “short-cut” explanation is that it buys
bonds which raises bond prices and lowers
the interest rate
• For a fuller explanation we look at money
demand, money supply and the interest rate
that gives equilibrium between them
Money Demand
• Money demand is a negative relationship
between the interest rate and the quantity of
money people are willing to hold
• To derive money demand consider the
choice between two things
– money or a financial asset that pays interest
– interest rate on the other asset is opportunity
cost of holding money
• Thus, when interest rate rises people
want to hold less money
Graph showing money demand
30_0
3
INTEREST
RATE
Money demand
MONEY
Money Supply (Review)
• M = Currency plus deposits
• Fed controls M by controlling monetary
base (MB= currency plus reserves)
• example, M = 4 times MB, where 4 is the
money multiplier
• (1+k)/(r+k) = (1+.2)/(.1+.2) = (1.2)/(.3) = 4
• Buy bonds to raise reserves, MB, and M
• Sell bonds to cut reserves, MB, and M
30_04
INTEREST
RATE
Money supply
Interest rate is
determined by the
intersection of the
money supply line and
the money demand curve.
Money demand
MONEY
30_05
INTEREST
RATE
Money supply
Interest rate falls.
Money demand
MONEY
By increasing the supply
of money, the Fed lowers
the interest rate.
Illustration of a
cut in the federal
funds rate by
increasing supply
of money
30_05
t
h
Illustration of an
increase in the
federal funds rate by
decreasing the
supply of money
INTEREST
RATE
Money supply
Interest rate rises.
Money demand
MONEY
By decreasing the supply
of money, the Fed raises
the interest rate.
r
a
t
e
d
s
Alternative monetary policies
• Recall the monetary
policy rule we used
• Alternatives
– Constant money growth
rule (Milton Friedman)
• not used now
• hard to define and measure
money
– Interest rate responds to
real GDP and inflation
• closer to reality
Questions for Alan Greenspan
• Dr. Greenspan, we’ve heard a lot about the
Fed
• How does the Fed conduct monetary
policy?
• Does it set interest rates?
• What about the money supply?
• Is there any systematic framework?

Key buzz words in
Greenspan’s statement
• we have been setting the funds rate directly
• money demand has become too difficult to predict
• inflation is fundamentally a monetary
phenomenon--determined by the growth rate of
money
• there are lags in the effect of money
• we have a firm commitment to control inflation
END
OF
LECTURE