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Monetary Policy
chapter 33
I. Learning Objectives—
A. How the equilibrium interest rate is
determined in the market for money.
B. The goals and tools of monetary policy.
C. About the Federal funds rate and how
the Fed directly influences it.
D. The mechanisms by which monetary
policy affects GDP and the price level.
E. The effectiveness of monetary policy
and its shortcomings.
I. Interest Rates
A. The Fed’s primary influence on the
economy in normal economic times is
through its ability to change the money
supply and therefore affect interest rates.
B. Interest is the price paid for the use of
money.
C. The Demand for Money
1. Transactions demand, Dt, is money kept for
purchases as a medium of exchange. a.
The
level of nominal GDP is the main determinant
of the amount of money demanded for
transactions. b. The transactions demand for
money varies directly with GDP; the higher the
nominal GDP, the more money is needed to
finance those transactions. c.
Figure 33.1a shows transactions demand as
a vertical demand curve at the level of
nominal GDP.
2. Asset demand, Da, is money kept as a store of
value for later use.
a. The interest rate is the main determinant of
the amount of money demanded for assets.
b. Asset demand varies inversely with the
interest rate, because that is the price
(opportunity cost) of holding idle money; the
higher the interest rate, the less money people
want to hold in cash.
c. Figure 33.1b shows asset demand as a
downsloping demand curve.
3. Total demand equals the quantity of money
demanded for assets plus that for transactions,
added horizontally (Figure 33.1c).
An increase in nominal GDP shifts money demand
to the right; a decrease shifts money demand to
the left.
D. The Equilibrium Interest Rate
1. Figure 33.1c illustrates the money market. The
money supply is a vertical line, representing the
money supply that has been set by the Federal
Reserve.
2. The intersection of supply and demand for
money determines the interest rate.
3. An increase in the money supply reduces interest
rates; a decrease in the money supply increases
interest rates.
E. Interest Rates and Bond Prices
1. Interest rates and bond prices are inversely related.
When the interest rate increases, bond prices fall;
when interest rates decrease, bond prices rise.
2. If other interest rates in the economy rise, bonds
with lower interest rates are not as attractive. So
bond owners must lower the bond price in order to sell
it, so that the bond’s yield reaches the same yield the
new investor could earn on other competitive
investments.
3. If other interest rates in the economy fall, bonds
with higher interest rates will look more attractive to
investors, who will bid up the price of the bond.
I. The Consolidated Balance Sheet of the Federal
Reserve Banks A. Assets (Table 33.1)
1. Securities, which are federal government bonds
purchased by Fed 2. Loans to commercial banks
(including other thrift institutions) B. Liabilities 1.
Reserves of commercial banks held as deposits
at Federal Reserve Banks
2. Treasury deposits of tax receipts and borrowed
funds
3. Federal Reserve Notes outstanding, our paper
currency C. Global Perspective 33.1 lists the central
banks of several nations.
3. Selling Securities
a. When the Fed sells securities, bank reserves will
go down.
b. Eventually the money supply will go down by a
multiple of the banks’ decrease in reserves.
4. How the Fed attracts buyers or sellers:
a. When Fed buys, it raises the demand and price
of bonds, which in turn lowers effective interest
rate on bonds. The higher price and lower
interest rate make selling bonds to the Fed
attractive.
b. When Fed sells, the bond supply increases and
bond prices fall, which raises the effective
interest rate yield on bonds. The lower price
and higher interest rate make buying bonds
from Fed attractive.
B. The Reserve Ratio
1. The reserve ratio is the fraction of customer
deposits banks are required to hold in reserve,
either in vault cash or on deposit with the Federal
Reserve (Table 33.2).
a. Raising the reserve ratio increases required
reserves and shrinks excess reserves. The loss of
excess reserves shrinks banks’ lending ability and,
therefore, the potential money supply by a
multiple amount of the change in excess
reserves.
b.
Lowering the reserve ratio decreases the
required reserves and expands excess reserves.
The gain in excess reserves increases banks’
lending ability and, therefore, the potential
money supply by a multiple amount of the
increase in excess reserves.
B. The Reserve Ratio
2.Changing the reserve ratio affects the
money-creating ability of the banking
system in two ways.
a. It changes the amount of excess reserves.
b. It changes the size of the monetary
multiplier. For example, if reserve ratio is
raised from 10 percent to 20 percent, the
multiplier falls from 10 to 5.
3.Changing the reserve ratio is very powerful
because it immediately affects banks’ lending
ability. It could create instability, so Fed rarely
changes it.
C.The Discount Rate
1. The discount rate is the interest rate that the
Fed charges to commercial banks that borrow from
the Fed.
2.An increase in the discount rate discourages banks
from borrowing from the Fed, which reduces excess
reserves.
3.
A decrease in the discount rate reduces the cost
for banks to borrow from the Fed, so they are
more willing to borrow to expand excess
reserves, increasing the money supply when
they loan out those reserves.
C.The Term Auction Facility
1. This tool was introduced in December 2007 in
response to the financial crisis.
2. Under the term auction facility, the Fed holds
two auctions each month, and banks secretly bid for
the right to borrow reserves for 28 or 84 days. The
bids are ranked from highest to lowest interest rate
offered, and the bank offering to pay the lowest
interest rate among the bids accepted sets the
interest rate for all of the banks.
3. The tool helps the Fed to ensure that all the
money it wants to pump into the money supply is
borrowed by banks (which cannot be assured by
changes in discount rates). It also helps banks that
want or need to borrow from the Fed but do not want
that information made public for fear of causing
concerns that the bank may be insolvent.
E. Open-market operations are the most important of the four tools over the
business cycle.
1. This tool is flexible because securities can be bought or sold quickly and in
great quantities, and reserves change quickly in response.
2. The reserve ratio is rarely changed since this could destabilize banks’
lending and profit positions. The reserve requirement was last changed in
1992.
3.Until recently, the discount rate was mainly a passive tool of monetary
policy. During the financial crisis, the Fed significantly reduced the discount
rate to ensure plenty of money was available for banks to meet their reserve
requirements and still be able to extend loans.
4. As the financial crisis deepened and banks began to collapse, many banks
became reluctant to borrow from the Fed, fearing lenders and stockholders
would see such borrowing as a signal that the bank was in serious financial
trouble. The secret bidding of the term auction facility allows banks to
borrow without concern about the public response. While the Fed has adopted
this as a fourth permanent tool, most economists believe the Fed will
primarily use it during times of financial crisis.
V. Targeting the Federal Funds Rate
A. The Federal funds rate is the interest rate that banks charge each other
for overnight loans.
B. Banks lend to each other from their excess reserves, but because the Fed is
the only supplier of Federal funds (the currency used as reserves), it can
set a target for the Federal funds rate and use open-market operations to
achieve that rate (Figure 33.3).
1. The Fed will increase the availability of reserves if it wants the Federal
funds rate to fall (or keep it from rising).
2. The Fed will withdraw reserves if it wants to raise the Federal funds
rate (or keep it from falling).
A. Expansionary Monetary Policy
1.
If the economy is experiencing a recession and rising unemployment,
the Fed may use expansionary monetary policy (“easy money policy”) to increase
the money supply.
2.
The Fed will initially announce a lower target for the Federal funds
rate, and then use open-market operations (buying bonds). The Fed may also
lower the reserve requirement or the discount rate or auction off more reserves,
but open-market operations are the most frequently used tool of the Fed.
3. Increasing reserves will generate two results:
a.
The supply of Federal funds increases, lowering the Federal funds rate.
b.
A greater expansion of the money supply will occur through the money
multiplier.
4. Expansionary monetary policy will put downward pressure on interest rates,
including the prime interest rate—the benchmark interest rate banks use to set
many other interest rates. The Federal funds rate and the prime rate closely
track each other (Figure 33.4).
A. Restrictive Monetary Policy
1.
To combat rising inflation, the Fed uses contractionary monetary
policy (“tight money policy”).
2. The initial step is for the Fed to announce a higher target for the
Federal funds rate, followed by the selling of bonds to soak up
reserves. Raising the reserve requirement, raising the discount rate,
and auctioning off fewer reserves are also options.
3.
4.
Reducing reserves will produce results opposite of those for
expansionary monetary policy.
a. The reduced supply of Federal funds raises the Federal funds
rate to the new target.
b. Multiple contraction of the money supply occurs through the
money multiplier.
Restrictive monetary policy results in higher interest rates,
including the prime rate.
A. Consider This … The Fed as a Sponge
1. If reserves in the banking system are like a bowl of water, the Fed can
use open-market operations as a sponge that can change the amount of
water (reserves) in the bowl.
2.If there are too many reserves, the Fed “soaks up” the excess by selling
bonds.
3.If the Fed wants more reserves in the system, it “squeezes the sponge,”
putting more money into the banking system by buying bonds.
B. The Taylor Rule
1.This rule of thumb for targeting the Federal funds rate closely models
Fed policy.
2.The rule assumes a target inflation rate of 2 percent and says the FOMC
follows three rules:
a. When real GDP is at its potential and inflation is at its 2 percent target,
the Federal funds rate should be at 4 percent (implying a real interest rate
of 2 percent).
b. For each 1 percent increase of real GDP above potential, the Federal
funds rate should be raised by 1/2 percentage point.
c. For each 1 percent increase in the inflation rate above the 2 percent
target, the Fed should raise the real Federal funds rate by 1/2 percentage
point (meaning a 1 1/2 percent increase in the nominal rate, because 1
percent is for the inflation increase).
2. The rule works in reverse, as well, if real GDP is below its potential and
inflation is below the 2% target.
3. While the Fed has roughly followed the Taylor rule in recent years, it has also
deviated under certain circumstances.
V. Monetary Policy, Real GDP, and the Price Level
A.
Cause-Effect Chain (Key Graph 33.5)
1.
The demand for money is made up of asset and transactions
demand, while the supply of money is determined by the Fed.
The equilibrium real interest rate is where supply and demand
are equal (Figure 33.5a).
2.
The interest rate determines amount of investment businesses
are willing to make. Investment demand is inversely related to
interest rates (Figure 33.5b).
3.
Interest rate changes have a great effect on the level of
investment because the interest cost of large, long-term
investment is a sizable part of investment cost.
4.
As investment rises or falls, equilibrium GDP rises or falls by a
multiple of that initial investment (Figures 33.5c and 33.5d).
B. Effects of an Expansionary Monetary Policy: If unemployment and
recession are the problem, the Fed increases excess reserves, which
lowers the interest rate and increases investment, which, in turn,
increases aggregate demand and real GDP (Table 33.3, Column 1).
C. Effects of a Restrictive Monetary Policy: If inflation is the problem,
the Fed reduces excess reserves, which raises the interest rate and
decreases investment, which, in turn, reduces aggregate demand and
inflation (Table 33.3, Column 2).