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A Lecture Presentation
to accompany
Exploring Economics
3 Edition
by Robert L. Sexton
rd
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Printed in the United States of America
ISBN 0-324-26086-5
Copyright © 2002 by Thomson Learning, Inc.
Chapter 24
The Federal Reserve System
and Monetary Policy
Copyright © 2002 by Thomson Learning, Inc.
24.1 The Federal Reserve System

In most countries of the world, the
job of manipulating the supply of
money belongs to the central bank.
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The Functions Of A Central Bank

A central bank has many functions.

First, a central bank is a "banker's bank."


It serves as a bank where commercial banks
maintain their own reserves.
Second, it performs service functions for
commercial banks

transferring funds and checks between
various commercial banks in the banking
system
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

Third, it typically serves as the major
bank for the central government.
Fourth, it buys and sells foreign
currencies and generally assists in
the completion of financial
transactions with other countries.
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

Fifth, it serves as a "lender of last
resort" that helps banking
institutions in financial distress.
Sixth, it is concerned with the
stability of the banking system and
the money supply.
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

The central bank can and does impose
regulations on private commercial banks; it
thereby regulates the size of the money
supply and influences the level of economic
activity.
The central bank also implements
monetary policy, which along with fiscal
policy, forms the basis of efforts to direct
the economy to perform in accordance with
macroeconomic goals.
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Location Of The Federal
Reserve System



In most countries, the central bank
is a single bank.
In the United States, however, the
central bank is 12 institutions,
spread all over the country, closely
tied together and collectively called
the Federal Reserve System.
Each of the 12 banks has branches
in key cities in its district.
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

Each Federal Reserve bank has its own
board of directors and, to some limited
extent, can set its own policies.
Effectively, however, the 12 banks act
largely in unison on major policy issues,
with effective control of major policy
decisions resting with the Board of
Governors and the Federal Open Market
Committee of the Federal Reserve System,
headquartered in Washington, D.C.
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
The Chairman of the Federal Reserve
Board of Governors is generally
regarded as one of the most
important and powerful economic
policy makers in the country.
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The Fed’s Relationship To
The Federal Government


The Federal Reserve was created in
1913 because the U.S. banking
system had little stability and no
central direction.
Technically, the Fed is privately owned
by the banks that “belong” to it.
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

All banks are not required to belong to the
Fed; but since new legislation was passed
in 1980, there is virtually no difference in
the requirements of member and
nonmember banks.
The private ownership of the Fed is
essentially meaningless because the Board
of Governors of the Federal Reserve, which
controls major policy decisions, is
appointed by the president of the United
States, not by the stockholders.
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The Fed’s Ties To The
Executive Branch


Historically, the Fed has had a
considerable amount of independence
from both the executive and
legislative branches of government.
The president appoints the seven
members of the Board of Governors,
subject to Senate approval, but the
term of appointment is 14 years.
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
No member of the Federal Reserve
Board will face reappointment from
the president who initially made the
appointment because presidential
tenure is limited to two four-year
terms.
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

Moreover, the terms of board
members are staggered, so a new
appointment is made only every two
years.
It is practically impossible for a single
president to appoint a majority of the
members of the board, and even if it
were possible, members have little
fear of losing their jobs as a result of
presidential wrath.
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

The Chair of the Federal Reserve
Board is a member of the Board of
Governors who serves a four year
term.
The Chair is truly the chief executive
officer of the system, and he
effectively runs it with considerable
help from the presidents of the 12
regional banks.
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Fed Operations


Many of the key policy decisions of the
Federal Reserve are actually made by
its Federal Open Market Committee
(FOMC), which consists of the seven
members of the Board of Governors.
The president of the New York Federal
Reserve Bank, and four other presidents
of Federal Reserve Banks, who serve on
the committee on a rotating basis.
Copyright © 2002 by Thomson Learning, Inc.

The FOMC makes most of the key
decisions influencing the direction
and size of changes in the money
stock, and their regular, secret
meetings are accordingly considered
very important by the business
community and government.
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24.2 The Equation of Exchange


Perhaps the most important function
of the Federal Reserve is its ability to
regulate the money supply.
In order to fully understand the
significant role that the Federal
Reserve plays in the economy, we will
first examine the role of money in the
national economy.
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The Equation of Exchange

In the early part of this century,
economists noted a useful
relationship that helps our
understanding of the role of money
in the national economy.
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
The relationship, called the equation of
exchange, can be presented as:
M  V = P  Q,
where
M is the money supply
V is the income velocity of money
P is the average prices of final goods and services
Q is the physical quantity of final goods and
services produced in a given period (usually one
year)
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

V, the velocity of money, refers to
the "turnover" rate, or the intensity
with which money is used.
V represents the average number of
times that a dollar is used in
purchasing final goods or services in
a one-year period.
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

If individuals are hoarding their
money, velocity will be low.
If individuals are writing lots of
checks on their checking accounts
and spending currency as fast as
they receive it, velocity will tend to
be high.
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


The expression P  Q represents the
dollar value of all final goods and services
sold in a country in a given year.
But that is the definition of nominal gross
domestic product (GDP).
Thus, the average level of prices (P)
times the physical quantity of final goods
and services (Q) equals nominal GDP.
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
The quantity equation of money could
also be expressed as: M  V =
Nominal GDP, or V = Nominal GDP/M.
That, in fact, is the definition of
velocity.

The total output of goods divided by the
amount of money is the same thing as
the average number of times a dollar is
used in final goods transactions in a year.
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
The magnitude of V will depend on
the definition of money that is used.
The average dollar of money turns
over a few times in the course of a
year, with the precise number
depending on the definition of
money.
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Using The Equation of Exchange


The equation of exchange is a useful tool
when we try to assess the impact in a
change in the money supply (M) on the
aggregate economy.
If M increases, then one of the following
must happen:



V must decline by the same magnitude, so
that M  V remains constant, leaving P  Q
unchanged
P must rise
Y must rise
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Or P and Q must each rise some, so
that the product of P and Q remains
equal to M  V.
 If the money supply increases and the
velocity of money does not change,
there will be either higher prices
(inflation), greater real output of goods
and services, or a combination of both.

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
If one considers a macroeconomic
policy to be successful when real
output is increased but unsuccessful
when the only effect of the policy is
inflation, an increase in M is a good
policy if Q increases but a bad policy
if P increases.
Copyright © 2002 by Thomson Learning, Inc.


Dampening the rate of increase in M or
even causing it to decline will cause
nominal GDP to fall, unless the change in
M is counteracted by a rising velocity of
money.
Intentionally decreasing M can also either
be good or bad, depending on whether
the declining money GDP is reflected
mainly in falling prices (P) or in falling
real output (Q).
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
Expanding the money supply, unless
counteracted by increased hoarding of
currency (leading to a decline in V),
will have the same type of impact on
aggregate demand as an
expansionary fiscal policy:



increasing government purchases,
reducing taxes, or
increases in transfer payments.
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

Likewise, policies designed to reduce
the money supply will have a
contractionary impact (unless offset
by a rising velocity of money) on
aggregate demand.
This is similar to the impact obtained
from increasing taxes, decreasing
transfer payments, or decreasing
government purchases.
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

What the quantity equation of
exchange relationship illustrates is that
monetary policy can be used to obtain
the same objectives as fiscal policy.
Some economists, often called
monetarists, believe that monetary
policy is the most powerful
determinant of macroeconomic results.
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How Volatile Is The Velocity
Of Money?



Economists once considered the
velocity of money a given.
We now know that it is not constant,
but it often moves in a fairly
predictable pattern.
Thus, the connection between
money supply and GDP is still fairly
predictable.
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
Historically, the velocity of money
has been quite stable over a long
period of time, particularly using the
M2 definition. However, velocity is
less stable when measured using the
M1 definition and over shorter
periods of time.
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


For example, an increase in velocity
can occur with anticipated inflation.
When individuals expect inflation,
they will spend their money more
quickly.
They don't want to be caught with
money that is going to be worth less
in the future.
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

Also, an increase in the interest
rates will cause people to hold less
money because people want to hold
less money when the opportunity
cost of holding money increases.
This, in turn, means that the velocity
of money increases.
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The Relationship Between the Inflation
Rate and the Growth in the Money Supply



There is international support for the
fact that the inflation rate tends to rise
more in periods of rapid monetary
expansion.
The relationship is particularly strong
with hyperinflation, as illustrated by the
hyperinflation in Germany in the 1920s.
The cause of hyperinflation is simply
excessive money growth.
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24.3 Implementing Monetary
Policy: Tools of the Fed


The Board of Governors of the Fed and
the FOMC are the prime decision makers
for monetary policy in the United States.
They decide whether to change policies
to expand the supply of money and,
hopefully, the real level of economic
activity, or to contract the money
supply, hoping to cool inflationary
pressures.
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How Does The Fed Manipulate
The Supply Of Money?

The Fed controls the supply of money,
even though privately owned
commercial banks actually create and
destroy money by making loans.
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
The Fed has three major methods to
control the supply of money:





open market operations
change reserve requirements
change its discount rate
Of these three tools, the Fed uses open
market operations the most.
It is by far the most important device used
by the Fed to influence the money supply.
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Open Market Operations


Open market operations involve
the purchase and sale of government
securities by the Federal Reserve
System.
Decisions regarding whether to buy or
sell government bonds are made by
the Federal Open Market Committee
at its regular meetings.
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

For several reasons, open market
operations are the most important
method the Fed uses to change the
supply of money.
To begin, it is a device that can be
implemented quickly and cheaply—
the Fed merely calls an agent who
buys or sells bonds.
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

It can be done quietly, without a lot of
political debate or a public
announcement.
It is also a rather powerful tool, as
any given purchase or sale of
securities usually has an ultimate
impact on the money supply of
several times the amount of the initial
transaction.
Copyright © 2002 by Thomson Learning, Inc.


When the Fed buys bonds, it pays the
seller of the bonds with a check
written from one of the 12 Federal
Reserve banks.
The person receiving the check will
likely deposit it in his or her bank
account, increasing the money supply
in the form of added transactions
deposits.
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
More importantly, the commercial
bank, in return for crediting the
account of the bond seller with a
new deposit, gets cash reserves or a
higher balance in their reserve
account at the Federal Reserve Bank
in its district.
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

Loans R Us National Bank has no
excess reserves and one of its
customers sells a bond for $10,000
through a broker to the Fed.
The customer deposits the check from
the Fed for $10,000 in an account,
and the Fed credits the Loans R Us
Bank with $10,000 in reserves.
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

Suppose the reserve requirement is
10 percent.
The Loans R Us Bank only needs new
reserves of $1,000 ($10,000  .10) to
support its $10,000, meaning that it
has acquired $9,000 in new excess
reserves ($10,000 new actual
reserves minus $1,000 in new
required reserves).
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

Loans R Us can, and probably will,
lend out its excess reserves of
$9,000, creating $9,000 in new
deposits in the process.
The recipients of the loans, in turn,
will likely spend the money, leading to
still more new deposits and excess
reserves in other banks.
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
The Fed's $10,000 bond purchase directly
creates $10,000 in money in the form of
bank deposits, and indirectly permits up to
$90,000 in additional money to be created
through the multiple expansion in bank
deposits.

The money multiplier is the reciprocal of the
reserve requirement ,1/10, or 10.
10  $9,000 = $90,000.
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
If the reserve requirement is 10
percent, a total of up to $100,000 in
new money is potentially created by
the purchase of one $10,000 bond by
the Fed.
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


The process works in reverse when
the Fed sells a bond.
The individual purchasing the bond
will pay the Fed by check, lowering
demand deposits in the banking
system.
Reserves of the bank where the bond
purchaser has a bank account will
likewise fall.
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

If the bank had zero excess reserves
at the beginning of the process, it will
now have a reserve deficiency that
must be met by selling secondary
reserves or by reducing loan volume,
either of which will lead to further
destruction of deposits.
A multiple contraction of deposits will
begin.
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
Generally, in a growing economy
where the real value of goods and
services is increasing over time, an
increase in the supply of money is
needed even to maintain stable
prices.
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
If the velocity of money (V) in the
equation of exchange is fairly
constant and real GDP (denoted by
Q in the equation of exchange) is
rising between 3 and 4 percent a
year (as it has over the period since
1840), then a 3 or 4 percent increase
in M is consistent with stable prices.
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
In periods of rising prices (meaning
M  V would be rising considerably),
if V is fairly constant, the growth of
M likely will exceed 3 percent to 4
percent annual growth, seemingly
consistent with long-term price
stability.
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The Reserve Requirement

While open market operations are
the most important and widely
utilized tool that the Fed has to
achieve its monetary objectives, it
is not its potentially most powerful
tool.
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

The Fed possesses the power to
change the reserve requirements
of member banks by altering the
reserve ratio.
This can have an immediate impact
on the ability of member banks to
create money.
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


Suppose the Fed lowers reserve
requirements.
That will create excess reserves in
the banking system.
The banking system as a whole can
then expand deposits and the money
stock by a multiple of this amount
(equal to 1/10 the required reserve
ratio).
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

Relatively small reserve requirement
changes can have a big impact on
the potential supply of money by
changing the money multiplier.
The tool is so potent, in fact, that it
is seldom used.
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

The Fed changes reserve
requirements rather infrequently,
and when it does make changes, it
is by very small amounts.
Between 1970 and 1980, the Fed
changed the reserve requirement
twice, and less than 1 percent on
each occasion.
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The Discount Rate


Banks having trouble meeting their
reserve requirement can borrow
funds directly from the Fed.
The interest rate the Fed charges on
these borrowed reserves is called
the discount rate.
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

If the Fed raises the discount rate, it
makes it more costly for banks to
borrow funds from it to meet their
reserve requirements.
The higher the interest rate banks have
to pay on the borrowed funds, the lower
the potential profits from any new loans
made from borrowed reserves, and
fewer new loans will be made and less
money created.
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

If the Fed wants to contract the
money supply, it will raise the
discount rate, making it more costly
for banks to borrow reserves
If the Fed is promoting an expansion
of money and credit, it will lower the
discount rate, making it cheaper for
banks to borrow reserves.
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

The discount rate changes fairly
frequently, often several times a
year.
Sometimes the rate will be moved
several times in the same direction
within a single year, which has a
substantial cumulative effect.
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
The discount rate is a relatively
unimportant tool, mainly because
member banks do not rely heavily
on the Fed for borrowed funds.

There seems to be some stigma among
bankers about borrowing from the Fed;
borrowing from the Fed is something
most bankers believe should be reserved
for real emergencies.
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


When banks have short-term needs for
cash to meet reserve requirements, they
are more likely to take a very short-term
(often overnight) loan from other banks
in the federal funds market.
Many people pay a lot of attention to the
interest rate on federal funds.
The discount rate's main significance is
that changes in the rate signal the Fed's
intentions with respect to monetary policy.
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How The Fed Reduces The
Money Supply

The Fed can do three things if it
wants to reduce the money supply:



sell bonds
raise reserve requirements
raise the discount rate
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


The Fed could also opt to use some
combination of these three tools in its
approach.
These moves would tend to decrease
aggregate demand reducing nominal GDP,
hopefully through a decrease in P rather
than Q.
These actions would be the monetary
policy equivalent of a fiscal policy of raising
taxes, lowering transfer payments, and/or
lowering government purchases.
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How The Fed Increases The
Money Supply

If the Fed is concerned about
underutilization of resources (e.g.,
unemployment), it would engage in
precisely the opposite policies



buy bonds
lower reserve requirements
lower the discount rate
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


The government could use some
combination of these three approaches.
These moves would tend to increase
aggregate demand raising nominal GDP,
hopefully through an increase in Q (in the
context of the equation of exchange) rather
than P.
Equivalent expansionary fiscal policy
actions would be to reduce taxes, increase
transfer payments, and/or increase
government purchases.
Copyright © 2002 by Thomson Learning, Inc.
How Else Can The Fed
Influence Economic Activity?

The Fed's control of the money
supply is largely exercised through
the three methods outlined above,
but it can influence the level and
direction of economic activity in
numerous less important ways as
well.
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
The Fed can attempt to influence banks
through moral suasion.


If the Fed thinks the money supply is growing
too fast, it might urge bank presidents to be
more selective in making loans and maintain
some excess reserves.
During business contractions, the Fed may
urge bankers to lend more freely, hoping to
promote an increase in the supply of money.
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
The Fed also has at its command
some selective regulatory authority
over specific types of economic
activity.

Federal Reserve Board of Governors
establishes margin requirements for
the purchase of common stock.

The Fed specifies the proportion of the
purchase price of stock that a purchaser
must pay in cash.
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
By allowing the Fed to control limits on
borrowing for stock purchases,
Congress believes that the Fed can limit
speculative market dealings in securities
and reduce instability in securities
markets (although whether the margin
requirement rule has in fact helped
achieve such stability is open to
question).
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
In the last few decades, the Federal
Reserve regulatory authority has been
extended into new areas.


Beginning in 1969, the Fed began enforcing
provisions of the Truth in Lending Act, which
requires lenders to state actual interest rate
charges when making loans.
In the mid-1970s, the Fed began enforcing
provisions of the Equal Lending Opportunity
Act, designed to eliminate discrimination
against loan applicants.
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24.4 Money, Interest Rates, and
Aggregate Demand


The Federal Reserve's policies with
respect to the supply of money has
a direct impact on short-run real
interest rates, and accordingly, on the
components of aggregate demand.
The money market is the market
where money demand and money
supply determine the equilibrium
nominal interest rate.
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The Money Market


When the Fed acts to change the money
supply by changing one of its policy
variables, it alters the money market
equilibrium.
People have three basic motives for holding
money instead of other assets:



transactions purposes
precautionary reasons
asset purposes
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The Demand For Money And
The Nominal Interest Rate


The quantity of money demanded
varies inversely with the rate of
interest.
When interest rates are higher, the
opportunity cost in terms of the
interest income on alternative assets
forgone of holding monetary assets is
higher, and persons will want to hold
less money for each of these reasons.
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

At the same time, the demand for
money, particularly for transactions
purposes, is highly dependent on
income levels because the
transactions volume varies directly
with income.
And lastly, the demand for money
depends on the price level.
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

If the price level increases, buyers
will need more money to purchase
their goods and services.
Or if the price level falls, buyers will
need less money to purchase their
goods and services.
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
At lower interest rates, the quantity
of money demanded is greater, a
movement from A to B in the
exhibit. An increase in income will
lead to an increase in the demand
for money, depicted by a rightward
shift in the money demand (MD)
curve, a movement from A to C.
Copyright © 2002 by Thomson Learning, Inc.
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Why Is The Supply Of Money
Relatively Inelastic?

The supply of money is largely
governed by the regulatory policies
of the central bank.
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
Whether interest rates are 4% or
14%, banks seeking to maximize
profits will increase lending as long
as they have reserves above their
desired level because even a 4%
return on loans provides more profit
than maintaining those assets in non
interest-bearing cash or reserve
accounts at the Fed.
Copyright © 2002 by Thomson Learning, Inc.


The supply of money is effectively
almost perfectly inelastic with respect
to interest rates over their plausible
range, controlled by Fed policies,
which determine the level of bank
reserves and the money multiplier.
Therefore, we draw the money supply
curve as vertical, other things equal,
with changes in Fed policies acting to
shift the money supply curve.
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Changes In Money Demand And Money
Supply And The Nominal Interest Rate

Combining the money demand and
money supply curves, money market
equilibrium occurs at that nominal
interest rate where the quantity of
money demanded equals the
quantity of money supplied.
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

Rising national income will increase the
amount of money that people want to
hold at any given interest rate;
therefore shifting the demand for money
to the right, leading to a new higher
equilibrium nominal interest rate.
An increase in the money supply lowers
the equilibrium nominal interest rate .
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
The Fed Buys Bonds

Say the Fed wants to pursue an
expansionary monetary policy to
increase aggregate demand.


The Fed will buy bonds on the open
market, increasing the the demand for
bonds causing an increase in the price
of bonds.
Bond sellers will deposit their checks
from the Fed, increasing the money
supply.
Copyright © 2002 by Thomson Learning, Inc.


The immediate impact of
expansionary monetary policy is to
decrease interest rates.
The lower interest rate, or the fall in
the cost of borrowing money, then
leads to an increase in aggregate
demand for goods and services at
each and every price level.
Copyright © 2002 by Thomson Learning, Inc.


The lower interest rate will increase
home sales, car sales, business
investments, and so on.
That is, an increase in the money
supply will lead to lower interest
rates and an increase in aggregate
demand.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
The Fed Sells Bonds


Suppose the Fed wants to pursue a
contractionary monetary policy to
reduce aggregate demand.
It will sell bonds on the open market,
lowering the price of bonds.
Copyright © 2002 by Thomson Learning, Inc.


The purchasers of bonds take the
money out of their checking account
to pay for the bond, and bank
reserves are reduced by the amount
of the check.
This reduction in reserves leads to a
reduction in the supply of money,
which leads to an increase in the
interest rate in the money market.
Copyright © 2002 by Thomson Learning, Inc.


The higher interest rate then leads
to a reduction in aggregate demand
for goods and services.
In sum, when the Fed sells bonds, it



lowers the price of bonds
raises interest rates
reduces aggregate demand, at least in
the short run.
Copyright © 2002 by Thomson Learning, Inc.
Price of Bonds
Copyright © 2002 by Thomson Learning, Inc.
Bond Prices And Interest Rates

There is an inverse correlation
between the interest rate and the
price of bonds.


When the price of bonds falls, the
interest rate rises.
When the price of bonds rises, the
interest rate falls.
Copyright © 2002 by Thomson Learning, Inc.
Does the Fed Target the Money
Supply or Interest Rates?



Some economists believe the Fed
should try to control the money
supply.
Others believe the Fed should try to
control the interest rate.
The Fed cannot do both—it must
pick one or the other.
Copyright © 2002 by Thomson Learning, Inc.

Suppose the demand for money
increases.


If the Fed doesn’t allow the money
supply to increase, interest rates will
rise and aggregate demand will fall.
If the Fed wants to keep the interest
rate stable, it will have to increase the
money supply.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.


The problem with targeting the money
supply is that the demand for money
fluctuates considerably in the short run.
Focusing on the growth in the money
supply when the demand for money is
changing unpredictably will lead to large
fluctuations in the interest rate, which
can seriously disrupt the investment
climate.
Copyright © 2002 by Thomson Learning, Inc.


Keeping interest rates in check
would also create problems.
When the economy grows, the
demand for money also grows, so
the Fed would have to increase the
money supply to keep interest rates
from rising.
Copyright © 2002 by Thomson Learning, Inc.


If the economy was in a recession,
the Fed would have to contract the
money supply.
This would lead to the wrong policy
prescription.


Expanding the money supply during a
boom would eventually lead to inflation.
Contracting the money supply during a
recession would worsen the recession.
Copyright © 2002 by Thomson Learning, Inc.
Which Interest Rate Does The
Fed Target?


The federal funds rate is the interest
rate the Fed has targeted since about
1965.
At the close of the meetings of the
Federal Open Market Committee
(FOMC), the Fed will usually
announce whether the federal funds
rate will be increased, decreased, or
left alone.
Copyright © 2002 by Thomson Learning, Inc.



Monetary policy actions can be conveyed
through either the money supply or the
interest rate.
A contractionary policy can be thought
of as a decrease in the money supply
or an increase in the interest rate.
An expansionary policy can be thought
of as an increase in the money supply
or a decrease in the interest rate.
Copyright © 2002 by Thomson Learning, Inc.

Why is the interest rate used for monetary
policy?




Many economists believe the primary effects
of monetary policy are felt through the interest
rate.
The money supply is difficult to accurately
measure.
Changes in the demand for money can
complicate money supply targets.
People are more familiar with changes in
interest rates than changes in the money
supply.
Copyright © 2002 by Thomson Learning, Inc.
Does the Fed Influence the Real
Interest Rate in the Short Run?



The real interest rate is determined by
investment demand and saving supply.
The nominal interest rate is
determined by the demand and supply
of money.
Many economists believe that in the
short run, the Fed can control the
nominal interest rate and the real
interest rate.
Copyright © 2002 by Thomson Learning, Inc.


The real interest rate is equal to the
nominal interest rate minus the
expected inflation rate.
So a change in the nominal interest
rate tends to change the real interest
rate by the same amount because
the expected inflation rate is slow to
change in the short run.
Copyright © 2002 by Thomson Learning, Inc.

However, in the long run, after the
inflation rate has adjusted, the real
interest rate is determined by the
intersection of the saving supply and
investment demand curve.
Copyright © 2002 by Thomson Learning, Inc.
24.5 Expansionary and Contractionary
Monetary Policy

An increase in AD through monetary
policy can lead to an increase in
real GDP if the economy is initially
operating at less than full
employment.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Expansionary Monetary Policy
At Full Employment

An increase in AD through monetary
policy can lead to only a temporary,
short-run increase in RGDP, if the
economy is initially operating at or
above full employment, with no longrun effect on output or employment.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Contractionary Monetary Policy
Beyond Full Employment


A contractionary monetary policy
would reduce aggregate demand.
When the economy is temporarily
beyond full employment, an
appropriate countercyclical monetary
policy would shift the aggregate
demand curve leftward, to combat a
potential inflationary boom.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Contractionary Monetary
Policy At Full Employment

If the Fed pursues a contractionary
monetary policy when the economy
is at full employment, the Fed could
cause a recession by shifting the
aggregate demand curve leftward,
resulting in higher unemployment
and a lower price level.
Copyright © 2002 by Thomson Learning, Inc.

At a lower than expected price level,
owners of inputs will then revise their
expectations downward, causing a
rightward shift in the SRAS curve,
leading to a new long-run equilibrium
back at full employment.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Monetary Policy In The Open
Economy


For simplicity, we have assumed
that the global economy does not
impact domestic monetary policy.
This is incorrect.
Copyright © 2002 by Thomson Learning, Inc.



Suppose the Fed buys bonds on the open
market, leading to an increase in the
money supply and a fall in interest rates.
Some domestic investors will seek to
invest funds in foreign markets,
exchanging dollars for foreign currency,
leading to a depreciation of the dollar.
This increases exports and decreases
imports, and the increase in net exports
increases RGDP in the short run.
Copyright © 2002 by Thomson Learning, Inc.

Suppose the Fed sells bonds on the
open market.



This leads to a decrease in the money
supply and a rise in interest rates.
Some foreign investors will seek to invest
funds in the U.S. market, exchanging
foreign currency for dollars, leading to an
appreciation of the dollar.
This decreases exports and increases
imports, and the decrease in net exports
decreases RGDP in the short run.
Copyright © 2002 by Thomson Learning, Inc.

The shape of the aggregate supply
curve is a source of debate among
economists, and it has important
policy implications.
Copyright © 2002 by Thomson Learning, Inc.

If the aggregate supply curve is
relatively inelastic, expansionary
monetary and fiscal policy are less
effective at increasing RGDP in the
short run, but have larger effects
on the price level in the short run.
Copyright © 2002 by Thomson Learning, Inc.

If the aggregate supply curve is
relatively elastic, expansionary
monetary and fiscal policy are
more effective at increasing RGDP
in the short run, and have smaller
effects on the price level in the
short run.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.

If the aggregate supply curve is
relatively inelastic, contractionary
monetary and fiscal policy are less
effective at changing RGDP in the
short run, but have larger effects
on the price level in the short run.
Copyright © 2002 by Thomson Learning, Inc.

If the aggregate supply curve is
relatively elastic, contractionary
monetary and fiscal policy are
more effective at changing RGDP
in the short run, and have smaller
effects on the price level in the
short run.
Copyright © 2002 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary and Fiscal Policy


The lag problem inherent in adopting
fiscal policy changes are much less
acute for monetary policy, largely
because the decisions are not slowed
by the same budgetary process.
The FOMC of the Fed, for example, can
act quickly (in emergencies, almost
instantly, by conference call) and even
secretly to buy or sell government
bonds, the key day-to-day operating
tool of monetary policy.
Copyright © 2002 by Thomson Learning, Inc.
Problems in Conducting
Monetary Policy

However the length and variability of
the impact lag before its effects on
output and employment are felt is
still significant and the time before
the full price level effects are felt is
even longer and more variable.
Copyright © 2002 by Thomson Learning, Inc.

According to the Federal Reserve
Bank of San Francisco, the major
effects of a change in policy


on growth in the overall production of
goods and services usually are felt
within three months to two years, and
the effects on inflation tend to involve
even longer lags, perhaps one to three
years, or more.
Copyright © 2002 by Thomson Learning, Inc.
How Do Commercial Banks Implement
The Fed’s Monetary Policies?


One limitation of monetary policy is that
it ultimately must be carried out through
the commercial banking system.
The Central Bank (U.S. Federal Reserve
System) can change the environment in
which banks act, but the banks
themselves must take the steps
necessary to increase or decrease the
supply of money.
Copyright © 2002 by Thomson Learning, Inc.


Usually, when the Fed is trying to
constrain monetary expansion, there is
no difficulty in getting banks to make
appropriate responses.
Banks must meet their reserve
requirements, and if the Fed raises bank
reserve requirements, sells bonds,
and/or raises the discount rate, banks
must obtain the necessary cash or
reserve deposits at the Fed to meet
their reserve requirements.
Copyright © 2002 by Thomson Learning, Inc.

In response, they will call in loans
that are due for collection, sell
secondary reserves, and so on, to
obtain the necessary reserves, and
in the process of contracting loans,
they lower the supply of money.
Copyright © 2002 by Thomson Learning, Inc.

When the Federal Reserve wants
to induce monetary expansion,
however, it can provide banks with
excess reserves (e.g., by lowering
reserve requirements or buying
government bonds), but it cannot
force the banks to make loans,
thereby creating new money.
Copyright © 2002 by Thomson Learning, Inc.


Ordinarily, of course, banks want to
convert their excess reserves to
work earning interest income by
making loans.
But in a deep recession or
depression, banks might be hesitant
to make enough loans to put all
those reserves to work, fearing that
they will not be repaid.
Copyright © 2002 by Thomson Learning, Inc.

Their pessimism might lead them to
perceive that the risks of making
loans to many normally creditworthy
borrowers outweigh any potential
interest earnings.
Copyright © 2002 by Thomson Learning, Inc.

Banks maintaining excess reserves
rather than loaning them out was,
in fact, one of the monetary policy
problems that arose in the Great
Depression.
Copyright © 2002 by Thomson Learning, Inc.
Banks That Are Not Part Of The Federal Reserve
System And Policy Implementation

A second problem with monetary
policy relates to the fact that the Fed
can control deposit expansion at
member banks, but it has no control
over global and nonbank institutions
that also issue credit (loan money)
but are not subject to reserve
requirement limitations, like pension
funds and insurance companies.
Copyright © 2002 by Thomson Learning, Inc.


While the Fed may be able to predict
the impact of its monetary policies on
member bank loans, the actions of global
and nonbanking institutions can serve to
partially offset the impact of monetary
policies adopted by the Fed on the money
and loanable funds markets.
There is a real question of how precisely
the Fed can control the short-run real
interest rates through its monetary policy
instruments.
Copyright © 2002 by Thomson Learning, Inc.
Fiscal And Monetary
Coordination Problems

Another possible problem that arises
out of existing institutional policy
making arrangements is the
coordination of fiscal and monetary
policy.
Copyright © 2002 by Thomson Learning, Inc.


Decision making with respect to fiscal
policy is made by Congress and the
president, while monetary policy
decision making is in the hands of the
Federal Reserve System.
A macroeconomic problem arises if the
federal government's fiscal decision
makers differ on policy objectives or
targets with the Fed's monetary decision
makers.
Copyright © 2002 by Thomson Learning, Inc.
Alleviating Coordination Problems


In recognition of potential
macroeconomic policy coordination
problems, the Chairman of the Federal
Reserve Board has participated for
several years in meetings with top
economic advisers of the president.
An attempt is made in those meetings to
reach a consensus on the appropriate
policy responses, both monetary and
fiscal.
Copyright © 2002 by Thomson Learning, Inc.

There is often some disagreement,
and the Fed occasionally works to
partly offset or even neutralize the
effects of fiscal policies that it
views as inappropriate.
Copyright © 2002 by Thomson Learning, Inc.


Some people believe that monetary
policy should be more directly
controlled by the president and
Congress, so that all macroeconomic
policy will be determined more
directly by the political process.
It is argued that such a move would
enhance coordination considerably.
Copyright © 2002 by Thomson Learning, Inc.

Others argue that it is dangerous to
turn over control of the nation's
money stock to politicians, rather
than allowing decisions to be made by
technically competent administrators
who are focused more on price
stability and more insulated from
political pressures from the public
and from special interest groups.
Copyright © 2002 by Thomson Learning, Inc.
The Shape of the Aggregate Supply
Curve and Policy Implications

Many economists argue that the
SRAS curve is relatively flat at very
low levels of RGDP, when the
economy has substantial excess
capacity, as seen in Exhibits 1 and 2.
Copyright © 2002 by Thomson Learning, Inc.


Why is the SRAS curve flat over the
range when there is considerable
excess capacity?
Firms are operating well below their
potential output at RGDPNR, so the
marginal cost of producing more rises
little as output expands.
Copyright © 2002 by Thomson Learning, Inc.


Firms can also hire more labor
without increasing the wage rate.
In addition, many unemployed
workers are willing to work at the
“going” wage rate, which diminishes
the power of workers to increase
wages.
Copyright © 2002 by Thomson Learning, Inc.

In short, when the economy is
operating at levels significantly less
than full employment output, input
prices are sticky (relatively
inflexible).
Copyright © 2002 by Thomson Learning, Inc.

Empirical evidence for the period
1934-1940, when the U.S. economy
was experiencing double-digit
unemployment, appears to confirm
that the SRAS curve was very flat
when the economy was operating
with significant excess capacity.
Copyright © 2002 by Thomson Learning, Inc.


Near the top of the SRAS curve, the
economy is operating close to
maximum capacity.
That is, it will be very difficult or
impossible for firms to expand output
any further—firms may already be
running double shifts and paying
overtime.
Copyright © 2002 by Thomson Learning, Inc.

In short, if the government is using
fiscal and/or monetary policy to
stimulate aggregate demand, it must
carefully assess where it is operating
on the SRAS curve.
Copyright © 2002 by Thomson Learning, Inc.

If the economy is operating on the
flat portion of the SRAS curve, far
from full capacity, an increase in the
money supply, a tax cut, or an
increase in government spending will
result in an increase in output but
little change in the price level, a
movement from E1 to E2 in Exhibit 1.
Copyright © 2002 by Thomson Learning, Inc.

In this case, the expansionary policy
works well—higher RGDP and
employment with little change in the
price level.
Copyright © 2002 by Thomson Learning, Inc.

However, if the shift in AD occurs
when the economy is operating near
maximum capacity, the result will be
a substantial increase in the price
level, a movement from E3 to E4 in
Exhibit 2.
Copyright © 2002 by Thomson Learning, Inc.

That is, if the economy is operating
on the steep portion of the SRAS
curve, expansionary policy does not
work well.
Copyright © 2002 by Thomson Learning, Inc.


What if the expansionary policy
involves an increase in government
spending, with no change in the
money supply?
If the economy is operating in the
steep portion of the SRAS curve, the
increase in AD largely causes the
price level to rise.
Copyright © 2002 by Thomson Learning, Inc.


The increase in the price level leads
to an increase in the demand for
money and higher interest rates,
which acts to crowd out consumer
and business investment.
This also undermines the
effectiveness of the government
policy.
Copyright © 2002 by Thomson Learning, Inc.

Contractionary monetary or fiscal
policy (a tax increase, a decrease in
government spending, and/or a
decrease in the money supply) to
combat inflation is more effective in
the steep region of the SRAS curve
than in the flat region.
Copyright © 2002 by Thomson Learning, Inc.

In the steep region, contractionary
monetary and/or fiscal policy results
in a large fall in the price level and a
small change in real GDP; in the flat
region of the SRAS curve, the
contractionary policy would result in
a large decrease in output and a
small change in the price level.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Overall Problems With
Monetary And Fiscal Policy

Much of macroeconomic policy in this
country is driven by the idea that the
federal government can counteract
economic fluctuations

Stimulating the economy when it is weak.





increased government purchases
tax cuts
transfer payment increases
easy money
Restraining it when it is overheating.
Copyright © 2002 by Thomson Learning, Inc.


But policy makers must adopt the
right policies in the right amounts at
the right time for such “stabilization”
to do more good than harm.
And for government policy makers
to do more good than harm, they
need far more accurate and timely
information than experts can give
them.
Copyright © 2002 by Thomson Learning, Inc.

First, economists must know not only
which way the economy is heading,
but also how rapidly. And no one
knows exactly what the economy will
do, no matter how sophisticated the
econometric models used.
Copyright © 2002 by Thomson Learning, Inc.

Even if economists could provide
completely accurate economic
forecasts of what will happen if
macroeconomic policies are
unchanged, they could not be
certain of how to best promote
stable economic growth.
Copyright © 2002 by Thomson Learning, Inc.

If economists knew, for example,
that the economy was going to dip
into another recession in six months,
they would then need to know
exactly how much each possible
policy would spur activity in order
to keep the economy stable.
Copyright © 2002 by Thomson Learning, Inc.


But such precision is unattainable,
given the complex forecasting
problems faced.
Further, economists aren’t always
sure what effect a policy will have
on the economy.
Copyright © 2002 by Thomson Learning, Inc.

It is widely assumed that an
increase in government purchases
quicken economic growth.
Copyright © 2002 by Thomson Learning, Inc.


Increasing government purchases
increases the budget deficit, which
could send a frightening signal to the
bond markets.
The result can be to drive up interest
rates and choke off economic activity.
Copyright © 2002 by Thomson Learning, Inc.

Even when policy makers know
which direction to nudge the
economy, they can’t be sure which
policy levers to pull, or how hard to
pull them, to fine tune the economy
to stable economic growth.
Copyright © 2002 by Thomson Learning, Inc.

A third crucial consideration is how
long it will take a policy before it
has its effect on the economy.
Copyright © 2002 by Thomson Learning, Inc.


Even when increased government
purchases or expansionary monetary
policy does give the economy a boost,
no one knows precisely how long it will
take to do so.
The boost may come very quickly, or
many months (or even years) in the
future, when it may add inflationary
pressures to an economy that is already
overheating, rather than helping the
economy recover from a recession.
Copyright © 2002 by Thomson Learning, Inc.


Macroeconomic policy making is like
driving down a twisting road in a car
with an unpredictable lag and degree
of response in the steering
mechanism.
If you turn the wheel to the right, the
car will eventually veer to the right,
but you don’t know exactly when or
how much.
Copyright © 2002 by Thomson Learning, Inc.


There are severe practical
difficulties in trying to fine-tune
the economy.
Even the best forecasting models
and methods are far from perfect.
Copyright © 2002 by Thomson Learning, Inc.


Economists are not exactly sure
where the economy is or where or
how fast it is going, making it very
difficult to prescribe an effective
policy.
Even if we do know where the
economy is headed, we can not be
sure how large a policy’s effect will
be or when it will take effect.
Copyright © 2002 by Thomson Learning, Inc.



The Fed must take into account the
many different factors that can either
offset or reinforce monetary policy.
This isn’t easy because sometimes these
developments occur unexpectedly, and
because the size and timing of their
effects are difficult to estimate.
The 1997-98 currency crisis in East Asia
is an example.
Copyright © 2002 by Thomson Learning, Inc.


The “new” economy may increase
productivity, allowing for greater
economic growth without creating
inflationary pressures.
The Fed must estimate how much
faster productivity is increasing and
whether those increases are
temporary or permanent, which is
not an easy task.
Copyright © 2002 by Thomson Learning, Inc.