Download Monetary Policy - McGraw Hill Higher Education

Chapter 12
Managing the Economy:
Monetary Policy
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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The uses of money
The structure of the Fed
The goals of monetary policy
Effect of money policy on the economy
Effect of money policy on inflation
Policy tools
The practice of monetary 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 the 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 12 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 a 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 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
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.
12-10
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 federal funds rate is the rate that
banks charge each other for lending
reserves or cash to each other overnight.
12-11
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 for the banks.
– This shifts the supply curve for loans to the
right, and interest rates fall.
12-12
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
12-13
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 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.
12-14
Effect on Other Interest Rates
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.
12-15
Effect of Monetary Policy on the
Economy
• Fed policy actions impact the interestsensitive 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.
12-16
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
12-17
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.
12-18
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, rates cuts
may lead to higher inflation.
12-19
Fed Funds Rate, Historical
12-20
The Discount Window
• 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.
12-21
The Housing Boom and Bust
12-22
Reserve Requirements and Other
Regulations
• Fed plays a key role in regulating the financial
institutions.
• Through the regulations, the Fed can exert
control over the economy.
• Two of the important regulations that the Fed
controls are the reserve requirement and the
margin requirement.
12-23
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 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.
12-24
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.
12-25
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.
12-26
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.
12-27
Discretion versus Rules
– One example of a rules-based approach is
inflation targeting. In this case, the Fed sets
an inflation target and conducts policy to hit
the 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.
12-28
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.
12-29