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ECONOMICS 5e Michael Parkin CHAPTER 15 Monetary Policy Chapter 32 in Economics Learning Objectives • Describe the structure of the Federal Reserve System (the Fed) • Describe the tools used by the Fed to conduct its monetary policy • Explain what an open market operation is and how it works Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives (cont.) • Explain how an open market operation changes the money supply • Explain what determines the demand for money Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives (cont.) • Explain how the Fed influences interest rates • Explain how interest rates influence the economy Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives • Describe the structure of the Federal Reserve System (the Fed) • Describe the tools used by the Fed to conduct its monetary policy • Explain what an open market operation is and how it works Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Federal Reserve System serves as the central bank for the United States. A central bank is a bank’s bank and a public authority that regulates a nation’s financial institutions and markets. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System Monetary policy is conducted by the Fed. Monetary policy is the adjustment of the quantity of money in circulation to achieve specific economic goals. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System These goals include: 1) Keeping inflation in check. 2) Maintaining full employment. 3) Moderating the business cycle. 4) Contributing toward achieving long-term growth. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Structure of the Federal Reserve System The primary elements in the Federal Reserve System are: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Board of Governors • Seven members • Appointed by the President • Confirmed by the Senate • Serve 14-year term Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Board of Governors (cont.) • Terms are staggered so that one comes vacant every two years • President appoints a member as Chairman to serve a four-year term Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Federal Reserve Banks 12 District banks • Nine directors • Three are appointed by the Board of Governors • Six are elected by the commercial banks in the district • The directors appoint the district president which is approved by the Board of Governors Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Federal Reserve Banks The New York Fed implements some of the Fed’s most important policy decisions. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Federal Open Market Committee (FOMC) • Serves as the main policy-making organ of the Federal Reserve System • Meets approximately every six weeks to review the economy Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Federal Open Market Committee (FOMC) Made up of the following voting members: • The chairman and the other six members of the Board of Governors • The president of the Federal Reserve Bank of New York • The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis) Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Power Center The chairman of the Board of Governors has the largest influence on the Fed’s monetary policy actions. • Paul Volcker • Alan Greenspan Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Power Center (cont.) The chairman’s power and influence stem from: • First, the chairman controls the agenda and dominates the meetings of the FOMC. • Secondly, contact with a staff of economists and other experts provides the chairman with detailed briefings on monetary policy issues. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Power Center (cont.) The chairman’s power and influence stem from: • Lastly, the chairman is the Fed’s spokesperson and the point of contact with the President and government and with foreign central banks and governments. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives • Describe the structure of the Federal Reserve System (the Fed) • Describe the tools used by the Fed to conduct its monetary policy • Explain what an open market operation is and how it works Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Policy Tools • The Fed controls the money supply by adjusting the reserves of the banking system. • The Fed has three main tools it uses to achieve this objective. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Policy Tools The three main policy tools are: 1) Required reserve ratios 2) Discount rate 3) Open market operations Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System Required Reserve Ratios The Fed determines a required reserve ratio for each type of deposit. • In 1997, banks were required to keep 3 percent of checking deposits up to $49 million and 10 percent of deposits in excess of $49 million. • Other deposits had no reserve requirement. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System Discount Rate The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System Open Market Operations Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Structure of the Fed Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Balance Sheet The Fed’s three main assets are: 1) Gold and foreign exchange 2) U.S. government securities 3) Loans to banks Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Balance Sheet The Fed’s two main liabilities are: 1) Federal Reserve notes in circulation • Nonconvertible notes or “fiat money” • Federal reserve notes are backed by the Fed’s holdings of U.S. government securities 2) Bank’s deposits Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Federal Reserve System The Fed’s Balance Sheet • The Fed’s liabilities along with the coins in circulation make up the monetary base. • Note: Coins are issued by the Treasury and not liabilities of the Fed. • The monetary base serves as the base for the nation’s money supply. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Fed’s Balance Sheet, December 1996 Assets Liabilities (billions of dollars) (billions of dollars) Gold and foreign exchange 21 U.S. government securities 460 Loans to banks Total assets Copyright © 2000 Addison Wesley Longman, Inc. 0 481 Federal Reserve notes 427 Bank’s deposits 25 Other liabilities (net) 29 Total liabilities (net) 481 Slide 15-‹#› Learning Objectives • Describe the structure of the Federal Reserve System (the Fed) • Describe the tools used by the Fed to conduct its monetary policy • Explain what an open market operation is and how it works Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply How Required Reserve Ratios Work When the Fed increases the required reserve ratio: • Banks must hold more reserves. • To increase reserves, banks must decrease lending. • The decrease in lending decreases the quantity of money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply How Required Reserve Ratios Work When the Fed decreases the required reserve ratio: • Banks may hold less reserves. • As a result of the decrease in reserves, banks increase lending. • The increase in lending increases the quantity of money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply How the Discount Rate Works When the Fed increases the discount rate: • Banks must pay a higher price for any reserves that they borrow from the Fed. • Banks try to get by with smaller reserves. • But given the required reserve ratio, banks must decrease their lending. • This decreases the quantity of money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply How the Discount Rate Works When the Fed decreases the discount rate: • Banks pay a lower price for any reserves that they borrow from the Fed. • Banks are willing to borrow more reserves and increase their lending. • This increases the quantity of money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply How an Open Market Operation Works When the Fed buys securities in an open market operation: • The monetary base increases. • Banks increase their lending. • The quantity of money increases. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply How an Open Market Operation Works When the Fed sells securities in an open market operation: • The monetary base decreases. • Banks decrease their lending. • The quantity of money decreases. Open market operations are used more often than the other two options. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply The Fed Buys Securities The Fed can buy securities from either: • A commercial bank • The public Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives (cont.) • Explain how an open market operation changes the money supply • Explain what determines the demand for money Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Two things occur when the Fed buys $100 million of securities from a Manhattan Commercial Bank: 1) The bank has $100 million less securities, and the Fed has $100 million more securities. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Two things occur when the Fed buys $100 million of securities from a Manhattan Commercial Bank: 2) The Fed pays for the securities by crediting the bank’s deposit account at the Fed with $100 million. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Fed Buys Securities in the Open Market (a) The Fed buys securities from a commercial bank Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› (a) The Fed buys securities from a commercial bank The Federal Reserve Bank of New York Assets Liabilities Reserves of Securities +$100 Manhattan The Fed buys Commercial securities from +$100 Bank a commercial … and pays for the securities by increasing bank ... the reserves of the commercial bank. The Manhattan Commercial Bank Assets Liabilities Securities -$100 Reserves +$100 Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Three things occur when the Fed buys $100 million of securities from the Goldman Sachs: 1) Goldman Sachs has $100 million less securities, and the Fed has $100 million more securities. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Three things occur when the Fed buys $100 million of securities from the Goldman Sachs: 2) The Fed pays for the securities with a check for $100 million drawn on itself, which Goldman Sachs deposits in its account at the Manhattan Commercial Bank. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Three things occur when the Fed buys $100 million of securities from the Goldman Sachs: 3) The Manhattan Commercial Bank collects payment of this check from the Fed, and $100 million is deposited in Manhattan’s deposit account at the Fed. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Fed Buys Securities in the Open Market (b) The Fed buys securities from the public Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› (b) The Fed buys securities from the public The Federal Reserve Bank of New York Assets Liabilities Securities +$100 The Fed buys securities Goldman Sachs, a member of the general public ... Assets Reserves of Manhattan Commercial Bank Goldman Sachs +$100 Liabilities Securities -$100 … and pays for the securities by writing a check that is deposited Deposits at to Goldman Sachs’s account and Manhattan that increases the reserves of the Commercial Bank commercial banks. +$100 The Manhattan Commercial Bank Assets Liabilities Reserves +$100 Copyright © 2000 Addison Wesley Longman, Inc. Goldman Sach’s Deposit +$100 Slide 15-‹#› Controlling the Money Supply When the Fed sells securities, the events are the reverse of what was just presented. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply The effects of an open market operation are far reaching: • Banks are able to make more loans, which increases the quantity of money (multiplier effect). • It changes interest rates. • It changes aggregate expenditure and real GDP. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Monetary Base and Bank Reserves • The money multiplier is the amount by which a change in the monetary base is multiplied to determine the resulting change in the quantity of money. • It differs from the deposit multiplier. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply Monetary Base and Bank Reserves • A currency drain is an increase in currency held outside the banks. • This reduces the amount of additional money that can be created. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply The Multiplier Effect of an Open Market Operation • If the Fed purchases securities from banks a series of events occur. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply The purchase of securities from a bank leads to: 1) An increase in the bank’s reserves (no change in the quantity of money). 2) Banks lend excess reserves. 3) New deposits are used to make payments. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply The purchase of securities from a bank leads to: 4) The money supply increases. 5) Some of the new money is held as currency — a currency drain. 6) Some of the new money remains on deposit in banks. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Controlling the Money Supply The purchase of securities from a bank leads to: 7) Banks’ required reserves increase. 8) Excess reserves decrease, but remain positive. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› A Round in the Multiplier Process Following an Open Market Operation Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Multiplier Effect of an Open Market Operation The Sequence The Running Tally Reserves Deposits Currency Money $33,333 $100,000 Open Market Operation $100,000 Loan $100,000 Currency $33,333 Deposit $66,667 Reserve $6,667 Loan $60,000 Copyright © 2000 Addison Wesley Longman, Inc. $66,667 Slide 15-‹#› The Multiplier Effect of an Open Market Operation The Sequence Currency $20,000 The Running Tally Deposit $40,000 Reserve $4,000 Currency $12,000 Reserves Deposits Currency Money $6,667 $106,667 $53,333 $160,000 $10,667 $130,667 $65,333 $196,000 $16,667 $166,667 $83,333 Loan $36,000 Deposit $24,000 and so on... Copyright © 2000 Addison Wesley Longman, Inc. $250,000 Slide 15-‹#› Learning Objectives (cont.) • Explain how an open market operation changes the money supply • Explain what determines the demand for money Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money The Influences on Money Holding The quantity of money people hold depends on: 1) The price level 2) The interest rate 3) Real GDP 4) Financial innovation Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money The Price Level Nominal money is the quantity of money measured in dollars. • The quantity of nominal money demanded is proportional to the price level. Real money is the quantity of money measured in constant dollars. • The quantity of real money demanded is independent of the price level. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money The Interest Rate The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money Real GDP • Money holdings depend upon planned spending. • The quantity of money demanded in the economy as a whole depends on Real GDP. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money Financial Innovation Changing technologies affect the quantity of money held. These include: • Daily interest checking deposits • Automatic transfers between checking and savings deposits • Automatic teller machines • Credit cards Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money The Demand for Money Curve The demand for money is the relationship between the quantity of real money demanded and the interest rate. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest rate (percent per year) The Demand for Money Effect of an increase in the interest rate 6 5 4 0 Effect of an increase in the interest rate 2.9 MD 3.0 3.1 Real money (trillions of 1992 dollars) Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money Shifts in the Demand Curve for Real Money Changes in real GDP or financial innovation changes the demand for money and shifts the demand curve for real money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest rate (percent per year) Changes in the Demand for Money 6 Effect of increase in real GDP 5 4 MD2 Effect of decrease in real GDP or financial innovation MD1 0 2.9 3.0 MD0 3.1 Real money (trillions of 1992 dollars) Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money in the United States Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Demand for Money in the United States Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives (cont.) • Explain How the Fed influences interest rates • Explain how interest rates influence the economy Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest Rate Determination • A percentage yield on a financial security is the interest rate. • The higher the price of a financial security, other things remaining the same, the lower is the interest rate. • We will focus on the market for money, since the Fed can influence the supply of money. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest Rate Determination Money Market Equilibrium • The interest rate is determined by the supply of and demand for money. • At any given moment in time, the quantity of real money supplied is a fixed amount. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Money Market Equilibrium Interest rate (percent per year) MS 6 Excess supply of money. People buy bonds and interest rate falls 5 4 Excess demand for money. People sell bonds and interest rate rises MD 0 2.9 3.0 3.1 Real money (trillions of 1992 dollars) Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Learning Objectives (cont.) • Explain How the Fed influences interest rates • Explain how interest rates influence the economy Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest Rate Determination Changing the Interest Rate • Suppose the Fed begins to fear inflation. • It decides to raise interest rates to discourage borrowing and the purchase of goods and services. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest Rate Determination Changing the Interest Rate • To do so, the Fed sells securities in the open market. • Bank reserves decline. • Less new loans are made. • The money supply decreases. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest rate (percent per year) Interest Rate Changes MS1 MS0 MS2 6 An increase in the money supply lowers the interest rate 5 4 A decrease in the money supply raises the interest rate 0 2.8 MD 2.9 3.0 3.1 3.2 Real money (trillions of 1992 dollars) Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Does the Fed actually change the money supply and interest rates? We will look at two different things: • Short-term interest rates since 1970 and see how the Fed influenced their fluctuations • The period since the stock market crash of 1987 Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Short-Term Interest Rates Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Money and Interest Rates Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Paul Volcker’s Fed • When Volcker became chairman, in 1979, the U.S. was experiencing double-digit inflation. • Volcker ended the inflation. • He did so by increasing interest rates sharply between 1979 and 1981. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Paul Volcker’s Fed (cont.) • This was accomplished by open market operations and increases in the discount rate. • The interest rates increased not because Volcker decreased the money supply, but because he slowed the growth of the money supply. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Paul Volcker’s Fed (cont.) • T-bill rates increased form 10 to 14 percent. • The prime increased from 9 to 14 percent. • Mortgage rates increased from 11 to 15 percent. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Paul Volcker’s Fed (cont.) • The economy went into recession. • Real GDP fell and the inflation rate slowed. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Alan Greenspan’s Fed • Greenspan became chairman in 1987. • During the two preceding years, the money supply had grown rapidly, and interest rates had fallen. • The stock market was recording record closings regularly. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Alan Greenspan’s Fed (cont.) • Then, without warning, the stock market crashed. • The Fed immediately emphasized their flexibility and sensitivity in the attempt to avoid any fear of a banking crisis. • It soon became clear that the economy was not heading for a recession. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Alan Greenspan’s Fed (cont.) • Again, the economy began to grow. • The Fed cut the growth of the money supply in the attempt to avoid an increase in the inflation rate. • By 1989 the economy began to slow, and fears of a recession became prominent. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Alan Greenspan’s Fed (cont.) • The money supply growth rate was increased and interest rates were lowered. • In 1990, the recession had become a reality. • The Fed took actions that cut interest rates by 3 percentage points. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Alan Greenspan’s Fed (cont.) • By mid-1991, the economy had begun to recover and real GDP expanded. • The economy continued to grow, and by 1997 was threatening to set a record for the longest peacetime expansion. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Monetary Policy Profiting by Predicting the Fed • People try to anticipate what the Fed is about to do buy and sell bonds in the hope of incurring a profit. • People who anticipate that the Fed is about to increase the money supply buy bonds right away, pushing their prices upward and pushing interest rates downward before the Fed acts. Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Ripple Effects of Monetary Policy Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The Fed buys securities in the open market The Fed sells securities in the open market Bank reserves increase, and the quantity of money increases Bank reserves decrease, and the quantity of money increases Interest rates fall Interest rates rise The dollar falls on the foreign exchange market Net exports increase Consumption and investment increases The dollar rises on the foreign exchange market Net Consumption exports and investment decrease decreases Aggregate demand increases Aggregate demand decreases Real GDP and inflation speed up Real GDP and inflation slow down Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› Interest Rates and Real GDP Growth Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#› The End Copyright © 2000 Addison Wesley Longman, Inc. Slide 15-‹#›