Download Intro to Monetary Policy

Monetary Policy
Regulating Money Supply
Money Supply
• Total amount of money in circulation
• Federal Reserve “controls” size of the money supply
– U.S. uses a fiat currency
• Changing the money supply directly affects short term interest
rates and future inflation
– Rapidly ↑ Money Supply leads to high inflation
The Money Market
Model of short term interest rates called the federal funds rate
–
Currently 0.0%
The Money Market
Interest
Rate
Supply of Money is fixed by the Fed
Fed “controls” money supply by buying
or selling Gov’t Bonds
MS
Demand for money is downward sloping
as interest rates ↓ more $ is demanded
MD
Qty $
2 Types of Monetary Policy
• Expansionary Monetary Policy (loose)
– Goal: to increase the money supply
– MS ↑ => Short Term Interest rates ↓ => AD ↑ => GDP ↑
• Contractionary Monetary policy (tight)
– Goal: to decrease the money supply
– MS ↓ =>Short Term Interest rates ↑ => AD ↓ => GDP ↓
GDP
2-Tools of Monetary Policy
1.
Discount Rate Changes
•
•
•
2.
Interest rate at which Banks borrow directly from the Fed
It is only used in an “emergency” (currently 0.75%)
Fed can simply raise or lower discount rate
GDP
Open Market Operations
–
–
–
(to change MS which moves the federal funds rate)
Process of buying or selling government bonds to change money supply
Change in MS alters the federal funds rate (currently 0.0%)
Federal Funds Rate= rate banks borrow directly from each other at
Monetary Policy Worksheet
• Graphing both MS & AD/AS
Example:
Expansionary Monetary Policy
• Step #1: Lower the discount rate
• Step #2: Use Open Market Operations to increase
money supply--the Fed Buys government bonds
Federal
Reserve
Government bonds
Money supply
↑
7
Economic Situation
GDP growth = -1.0%,
Unemployment = 10.0%
Little to no inflation
Solution:
Loose Monetary Policy
(also called expansionary)
Buy Bonds => ↑ MS => ↓ Federal Funds Rate
↓ Discount Rate
Interest
Rate
GDP
MS1
MS2
Affects AD
i1
---------
i2 ------------------
P2
-----------
E2
MD
Qty of $
Lower interest rates =>
More Loans taken by Consumers & Business
C ↑ + I ↑ => so AD ↑
Tight Monetary Policy
• Step #1: Raise the discount rate
• Step #2: Open Market Operations– to DECREASE
money supply Fed SELLS government bonds
Federal
Reserve
Government bonds
Money supply ↓
9
Economic Situation:
GDP growth at +5.0%,
Inflation rising, Unemployment 3.0%
↑ Discount Rate
Interest
Rate
Solution:
Tight Monetary Policy
Sell Bonds ↓MS => ↑Federal Funds Rate
GDP
MS2 MS1
Affects AD
i2
---------
i1 --------------MD
Qty of $
End Result: Lower GDP & less inflation!
Higher interest rates =>
Less Loans taken by Consumers & Business
C ↓ + I ↓ => so AD ↓
Bernanke Interview #1
(2009)
• http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?ta
g=mncol;lst;1
AS1
Inflation
AD1
Real
GDP
60 minutes interview 1 year after
financial crisis began in 2008
Stimulus Debates
• Economists argue over the benefits versus costs of Loose
Monetary Policy
Benefits
AS1
Inflation
AD1
Real
GDP
Costs/Risks
US Economy
GDP growth +1.7%
Unemployment = 8.3%
Low inflation except for gas prices
Solution:
Loose Monetary Policy
Buy Bonds => ↑ MS => ↓ Federal Funds Rate
↓ Discount Rate
Interest
Rate
GDP
MS1
MS2
AS1
Inflation
Affects AD
i1
---------
i2 ------------------
MD
Qty of $
AD1
AD2
Real
GDP
Lower interest rates =>
More Loans taken by Consumers & Business
C ↑ + I ↑ => so AD ↑
Federal Reserve in action 1999 - 2012
Loose
Monetary Policy
2012
Bernanke Interview #1
(2009)
• http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?ta
g=mncol;lst;1
AS1
Inflation
AD1
Real
GDP
60 minutes interview 1 year after
financial crisis began in 2008
GDP growth by quarter
+0.4%
Bernanke’s Challenge
Quantitative Easing
http://www.npr.org/blogs/money/2010/10/07/130408926/quantitative-easing-explained
• Fed controls only short term interest rates
– Which are already at ZERO percent (liquidity trap)
– Traditional monetary policy can’t do anymore
• Goal: is to solve the credit crunch
– Get banks to make loans again…
•
buy Gov’t & Mortgage bonds to lower long term
interest rates
Strategy:
– Lower long term interest rates => lead to more investment
– Lower mortgage rates => lead to more houses sold
Bernanke Interview #2
(2010)
http://www.youtube.com/watch?v=LxSv2rnBGA8
AS1
Inflation
AD1
Real
GDP
Got Quantitative Easing?
Austrian Economics
• Friedrich Hayek (1899 – 1992)
– Austrian School of Economics
• Against active Fed Policy
• Promoted “self regulation” of free market
• Believed low interest rates led to Malinvestment
FNMA & FHLMC
Gov’t
Bailouts
Government takeover
Wall Street Firms Bankrupt or Bought
Bear Stearns
Merrill Lynch
Lehman Brothers
AIG Insurance Company
Government Takeover
http://finance.yahoo.com/tech-ticker/article/328342/Can-Regulators-%22Save-Us-From-Ourselves%22-The-Risk-of-Another-Wall-St.-Crisis?tickers=gs,ms,skf,xlf,spy,dia
Current Problem
AS1
5.25%
AD2
AD1
0.0%
Discount Rate
Federal Funds Rate
Real
GDP
Fed Chief
Why is this
man smiling?
Glen Hubbard
This is so
WRONG!
Ben Bernanke
http://youtube.com/watch?v=CHQ_4cZY2Xk
Economic Situation:
GDP growth at +5.0%, Inflation rising, Unemployment 3%
Solution:
Interest
Rate
Tight Monetary Policy
MS2 MS1
Inflation
AS1
Affects AD
i2
AD1
---------
i1 --------------MD
AD2
End Result: Lower GDP & less inflation!
Qty of $
Real
GDP
Federal Reserve in action 1999 - 2009
Problem #10
Hamburger
Price
S1
$3
-------------- E1
-------------
$5
1,000
Price Ceiling
D1
Qty
Tight Monetary Policy
Open-Market Operations
Fed. Sells Securities
Nominal
Interest
Rate
i2
MS2 MS1
---------
i1 --------------MD
Qty of $
What Now?
Fiscal Policy
Monetary Policy
U.S. Economy
Monetary POLICY
Monetary Policy can shift AD curve right or left
The Fed adjusts Money Supply
AS1
Inflation
1) Discount Rate
AD1
Real
GDP
AD2
2) Open Market Operations
Monetary POLICY
Monetary Policy will shift AD curve
Economy in recession
AS1
Inflation
Loose monetary policy needed
AD1
Real
GDP
AD2
AD shifts right
End result: higher GDP, more
Jobs & risk of higher inflation
Bernanke Interview
• http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?ta
g=mncol;lst;1
AS1
Inflation
AD1
Real
GDP