Download Monetary policy

Chapter 12
Monetary Policy
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• List the three uses of money.
• Describe the history and structure of the Federal
Reserve System.
• Identify the major goals of monetary policy and
list the policy tools used by the Federal Reserve.
• Explain how changing the fed funds rate can
affect the economy.
• Discuss how the Federal Reserve can use direct
lending to fight a financial crisis.
• Compare and contrast monetary policy and fiscal
policy.
12-2
The Uses of Money
• Money is an asset that serves three
purposes:
– First, it is a medium of exchange. You
can use money to buy goods and
services and accept it in exchange for the
goods and services that you provide.
• A market economy depends on money.
– Second, money is a store of value.
– Finally, money is a standard of value.
12-3
The Federal Reserve
• The Federal Reserve (Fed) is the
country’s central bank.
• It was created by Congress in 1913 in
response to the financial panic of
1907.
• The Federal Reserve has the power to
issue currency, set interest rates, and
lend directly to banks.
12-4
The Structure of the
Federal Reserve
• The Federal Reserve is a system of banks.
• It is headed by the Federal Reserve board,
located in Washington, and consists of
seven members, including the Chairman.
• There are also twelve regional Federal
Reserve banks located around the country.
• The Federal Reserve was designed to have
considerable independence in making policy
decisions.
12-5
The Goals of Monetary Policy
• The original goal of the Federal
Reserve was to maintain the stability
of the financial system.
• The Humphrey-Hawkins Act in 1978
specified a broader set of goals.
• The main goals of the Fed today are
controlling inflation, smoothing out the
business cycle, and ensuring financial
stability.
12-6
Controlling Inflation
• The top goal of the Federal Reserve is
to keep inflation under control.
– Prior Chairmen of the Fed have argued
that a low and stable inflation is the best
way to achieve strong economic growth.
– The question is, how low should inflation
be?
• It is generally believed that a rate anywhere
between zero and 2% is acceptable.
12-7
Smoothing Out the
Business Cycle
• The Federal Reserve also has the goal
of fighting recessions.
– When the economy slows and
unemployment rises, the Federal Reserve
is expected to act.
– To boost the economy, the Federal
Reserve should cut interest rates.
• This will stimulate purchases of goods that
require financing, such as autos and homes.
12-8
Ensuring Financial Stability
• Another goal of the Federal Reserve is
to serve as the lender of last resort in
the event of a financial crisis.
– Financial markets are subject to
occasional bouts of panic and fear.
– If this happens, the Fed will calm things
down by making sure that banks and Wall
Street firms have the money they need to
function.
12-9
The Financial Crisis: The Stock
Market and the Housing Market
12-10
Policy Tools
•
There are three main tools of
monetary policy:
– Control over short-term interest rates
through open market operations.
– Direct lending to banks and other
financial institutions in times of crisis.
– Changes in the reserve requirement
and other financial regulations.
12-11
Open Market Operations
• The Fed’s most-used policy tool is its
ability to control short-term interest
rates.
• The rate the Fed controls is the federal
funds rate.
• The fed funds rate is the rate that
banks charge each other for lending
reserves or cash overnight.
12-12
Open Market Operations
• The Federal Reserve can directly
control the fed funds rate via open
market operations, which increase or
decrease the amount of money
available to banks to lend out.
• To cut the fed funds rate, the Fed
executes an open market operation
that makes more money available to
the banks.
– This shifts the supply curve for loans to
the right, and interest rates fall.
12-13
Open Market Operations
Supply curve for
loans
Short-term
interest
rate
Supply curve for
loans after Fed
makes more
money available
for banks to lend
r
r1
Demand curve for
loans
Q
Q1
Quantity of funds borrowed/lent
12-14
Federal Open
Market Committee
• The fed funds rate is set by a vote of the
Federal Open Market Committee (FOMC)
based on conditions in the economy.
• The FOMC consists of all seven members
of the Board of Governors and the
presidents of five of the twelve Reserve
banks on a rotating basis.
• The FOMC meets eight times a year to
discuss the economy and set the direction
for monetary policy.
12-15
New Car Loans and the
Fed Funds Rate
The Fed’s control over the fed funds rate affects all other short-term
interest rates, including credit cards, auto loans, adjustable rate
mortgages, and rates on money market funds. In general, most
short-term rates move together.
12-16
Effect of Monetary Policy on
the Economy
• Fed policy actions impact the
interest-sensitive sectors of the
economy.
– These sectors, such as housing and auto
sales, depend on borrowing.
• In general, a decrease in the fed funds
rate will boost spending and GDP,
while an increase in the fed funds rate
will push spending and GDP down.
12-17
Effect of Lower Rates on
Car Sales
Original demand
curve for cars
Price
per car
Demand curve for
cars with lower
interest rates
Supply curve for
cars
B
P1
A
P
Q
Q1
Quantity of cars bought/sold
12-18
Effect of Monetary Policy on
the Economy
• It’s important to note here that
monetary stimulus requires about 12 to
18 months to have its full effect.
• These monetary policy lags have a
big influence on the way monetary
policy is conducted.
• While the Fed controls short-term
rates, its influence on long-term rates
is limited.
12-19
Effect of Monetary Policy on
Inflation
• In general, decreases in the fed funds
rate will put upward pressure on
prices.
• Increases in the fed funds rate puts
downward pressure on prices.
• But exact impact depends on where
the economy is in terms of actual and
potential GDP.
– If actual GDP is below potential, rate cuts
are likely to boost GDP.
– If actual GDP is above potential, rate cuts
may lead to higher inflation.
12-20
Fed Funds Rate, 1970-2010
12-21
Direct Lending
• During a financial crisis, the Fed needs to lend
vulnerable financial institutions as much as
they need.
• The Fed does this using the discount
window.
• The discount window allows the Fed to lend
money to financial institutions that are running
short of funds.
• The interest cost of borrowing from the Fed is
called the discount rate.
• During the Great Recession, the Fed came up
with new ways to lend to financial institutions,
including: TAF, PDCF, MMIFF, and TSLF.
12-22
The Fed Extends Credit to the U.S.
and the Rest of the World, 2007-2010
12-23
Reserve Requirements and
Other Regulations
• The Fed plays a key role in regulating the
financial institutions.
• Through regulations, the Fed can exert
control over the economy.
• The fed controls the interest rate on
reserves that it pays banks.
• Two other important regulations that the Fed
controls are the reserve requirement and
the margin requirement.
12-24
Reserve Requirements and
Other Regulations
• Reserve requirements require banks to
keep a portion of their deposits either in
cash in their vaults or on reserve with the
Fed.
• For most banks, this reserve requirement
is 10% of deposits (less for smaller banks).
• Raising the reserve requirement means
that banks must keep more money as
reserves, so they have less money to lend.
– Less lending by banks means less
spending by borrowers, which slows the
economy.
12-25
Reserve Requirements and
Other Regulations
• Alternatively, cutting the reserve
requirement gives banks more money to
lend and helps boost the economy.
• The margin requirement determines
how much people can borrow when they
buy stock.
• The higher the margin requirements (now
at 50% for most stock purchases), the
more cash investors must use to buy
stocks.
12-26
Practice of Monetary Policy
• Monetary policy has certain
advantages over fiscal policy:
– Monetary policy is more flexible and less
political than fiscal policy.
– Monetary policy can be conducted in
small steps (raising or lowering rates a
little bit at a time).
– If the economy recovers, the Fed can
take back a stimulus more easily than
Congress can rescind a tax cut or
spending increase.
12-27
Discretion versus Rules
• A debate exists within the Fed about
whether it should use a rules-based
approach or a discretionary
approach to policy.
• The rules-based approach is based on
the idea that the Fed should state
ahead of time the rules it should follow.
– The rules are followed no matter what the
state of the economy.
12-28
Discretion versus Rules
– One example of a rules-based approach
is inflation targeting. In this case, the Fed
sets an inflation target and runs monetary
policy to hit that target.
• Discretionary policy is based on the
notion that, as the economy changes,
monetary policy needs to adjust as
well.
– So if inflation is rising, the Fed must raise
interest rates.
– Alternatively, if unemployment is rising,
the Fed should cut rates.
12-29
Long-term Effects of
Monetary Policy
• Most economists agree that monetary
policy affects long-term inflation.
• But monetary policy has little or no
direct impact on long-term growth or
on the rate of unemployment.
• Indirectly, it can have a favorable
impact on long-term growth through
lower inflation and by smoothing out
the business cycle.
12-30