Download Federal Reserve and Monetary Policy

C H A P T E R 14
The Federal Reserve
and Monetary Policy
Copyright © 2012 Pearson
Prentice
Hall.
All rights
reserved.
Copyright
© 2012
Pearson
Prentice
Hall. All rights reserved.
14-1
CHAPTER
The Federal Reserve and
Monetary Policy
14
Little did Ben S. Bernanke know when he took over the reins as chairman
of the Federal Reserve on February 1, 2006, that he would face a novel
and complex crisis brought on by the fall in housing prices and its
reverberations throughout the entire financial system in 2007 and 2008.
PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 14
The Federal Reserve
and Monetary Policy
APPLYING THE CONCEPTS
1
How has the Fed recently expanded its role in financial
markets?
Beyond Purchasing Treasury Securities
2
What happens to interest rates when the economy
recovers from a recession?
Rising Interest Rates during an Economic Recovery
3
Is it better for decisions about monetary policy to be
made by a single individual or by a committee?
The Effectiveness of Committees
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-3
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.1
THE MONEY MARKET
• money market
The market for money in which the
amount supplied and the amount
demanded meet to determine the
nominal interest rate.
The Demand for Money
INTEREST RATES AFFECT MONEY DEMAND
• transaction demand for money
The demand for money based on
the desire to facilitate transactions.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-4
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.1
THE MONEY MARKET (cont’d)
The Demand for Money
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
 FIGURE 14.1
Demand for Money
As interest rates increase
from r0 to r1, the quantity of
money demanded falls from
M0 to M1.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-5
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.1
THE MONEY MARKET (cont’d)
The Demand for Money
THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income— its purchasing
power—not the face value of money or income.
 FIGURE 14.2
Shifting the
Demand for Money
Changes in prices
and real GDP shift
the demand for
money.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-6
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.1
THE MONEY MARKET (cont’d)
The Demand for Money
OTHER COMPONENTS OF MONEY DEMAND
• illiquid
Not easily transferable to money.
• liquidity demand for money
The demand for money that represents
the needs and desires individuals and
firms have to make transactions on short
notice without incurring excessive costs.
• speculative demand for money
The demand for money that arises
because holding money over short
periods is less risky than holding
stocks or bonds.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-7
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.2
HOW THE FEDERAL RESERVE CAN
CHANGE THE MONEY SUPPLY
Open Market Operations
• open market operations
The purchase or sale of U.S.
government securities by the Fed.
• open market purchases
The Fed’s purchase of government
bonds from the private sector.
• open market sales
The Fed’s sale of government
bonds to the private sector.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-8
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.2
HOW THE FEDERAL RESERVE CAN
CHANGE THE MONEY SUPPLY (cont’d)
Other Tools of the Fed
CHANGING RESERVE REQUIREMENTS
If the Fed wishes to increase the supply of money, it can reduce banks’ reserve
requirements so they have more money to loan out.
CHANGING THE DISCOUNT RATE
• discount rate
The interest rate at which banks
can borrow from the Fed.
• federal funds market
The market in which banks borrow
and lend reserves to and from one
another.
• federal funds rate
The interest rate on reserves
that banks lend each other.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-9
C H A P T E R 14
The Federal Reserve
and Monetary Policy
APPLICATION
1
BEYOND PURCHASING TREASURY SECURITIES
APPLYING THE CONCEPTS #1: How has the Fed recently
expanded its role in financial markets??
•Traditionally, to expand the money supply, the Fed purchased treasury securities. It
credited the reserve accounts in banks and, in part, determined the money and credit
in the economy. The Fed did not intervene in security or credit markets.
•After the crisis of 2008, the Fed changed policy and expanded its involvement.
•The Fed increased its assets from less than $1 trillion to over $2 trillion.
•In 2010 the Fed held over $1 trillion in mortgage-backed securities.
•Critics suggest the Fed has crossed a political threshold that may pose risks to its
long-term independence.
•The Fed has reduced its investments in many markets, but increased its holdings of
mortgage-backed securities and is still playing a direct role in the housing market.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-10
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.3
HOW INTEREST RATES ARE DETERMINED:
COMBINING THE DEMAND AND SUPPLY OF MONEY
 FIGURE 14.3
Equilibrium in the
Money Market
Equilibrium in the money
market occurs at an
interest rate of r*, at
which the quantity of
money demanded equals
the quantity of money
supplied.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-11
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.3
HOW INTEREST RATES ARE DETERMINED: COMBINING
THE DEMAND AND SUPPLY OF MONEY (cont’d)
 FIGURE 14.4
Federal Reserve and Interest Rates
Changes in the supply of money will change interest rates.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-12
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.3
HOW INTEREST RATES ARE DETERMINED: COMBINING
THE DEMAND AND SUPPLY OF MONEY (cont’d)
Interest Rates and Bond Prices
HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT
BOND PRICES
Bond prices rise as interest rates fall.
GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR
BOND PRICES
Increased money demand will increase interest rates.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-13
C H A P T E R 14
The Federal Reserve
and Monetary Policy
APPLICATION
2
RISING INTEREST RATES DURING AN ECONOMIC RECOVERY
APPLYING THE CONCEPTS #2: What happens to interest rates
when the economy recovers from a recession?
•Economists have often noticed that as an economy recovers from a recession,
interest rates start to rise.
•Some observers think this is puzzling because they associate higher interest rates
with lower output. Why should a recovery be associated with higher interest rates?
•The simple model of the money market helps explain why interest rates can rise
during an economic recovery. One key to understanding this phenomenon is that the
extra income being generated by firms and individuals during the recovery will
increase the demand for money. Because the demand for money increases while the
supply of money remains fixed, interest rates rise.
•Another factor is that the Federal Reserve itself may want to raise interest rates as
the economy grows rapidly to avoid overheating the economy. In this case, the Fed
cuts back on the supply of money to raise interest rates. In both cases, however, the
public should expect rising interest rates during a period of economic recovery and
rapid GDP growth.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-14
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP) (cont’d)
 FIGURE 14.5
The Money Market and Investment Spending
The equilibrium interest rate r* is determined in the money market.
At that interest rate, investment spending is given by I*.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-15
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP) (cont’d)
 FIGURE 14.6
Monetary Policy and Interest Rates
As the money supply increases, interest rates fall from r0 to r1. Investment spending increases
from I0 to I1.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-16
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP) (cont’d)
 FIGURE 14.7
Money Supply and Aggregate Demand
When the money supply is increased, investment spending increases, shifting the AD curve to
the right. Output increases and prices increase in the short run.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-17
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.4
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP) (cont’d)
14-18
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP) (cont’d)
Monetary Policy and International Trade
• exchange rate
The rate at which currencies
trade for one another in the
market.
• depreciation of a currency
A decrease in the value of a
currency.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-19
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP) (cont’d)
Monetary Policy and International Trade
• appreciation of a currency
An increase in the value of a
currency.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-20
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.5
MONETARY POLICY CHALLENGES
FOR THE FED
Lags in Monetary Policy
Inside lags are the time it takes for policymakers to recognize and
implement policy changes. Outside lags are the time it
takes for policy to actually work.
Influencing Market Expectations: From the Federal
Funds Rate to Interest Rates on Long-Term Bonds
It is important to recognize that the Fed directly controls only very
short-term interest rates in the economy, not long-term interest rates.
For the Fed to control investment spending, it must also somehow
influence long-term rates. It can do this indirectly by influencing shortterm rates. The Fed also tries to influence long-term rates by
influencing market expectations about future short-term interest rates
and inflation.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-21
C H A P T E R 14
The Federal Reserve
and Monetary Policy
APPLICATION
3
THE EFFECTIVENESS OF COMMITTEES
APPLYING THE CONCEPTS #3: Is it better for
decisions about monetary policy to be made by a
single individual or by a committee?
•When Professor Alan Blinder returned to teaching after serving as vice-chairman of the
Federal Reserve from 1994 to 1996, he was convinced that committees were not
effective for making decisions about monetary policy. With another researcher, Blinder
developed an experiment to determine whether in fact individuals or groups make better
decisions.
•The results of the experiment showed that committees make decisions as quickly as,
and more accurately than, individuals making decisions by themselves. Moreover, it
was not the performance of the individual committee members that contributed to the
superiority of committee decisions—the actual process of having meetings and
discussions appears to have improved the group’s overall performance.
•In later research, Blinder also found that it did not really matter whether the committee
had a strong leader. His findings suggest it is the wisdom of the group, not its leader,
that really matters. And to the extent the leader has too much power—and the
committee functions more like an individual than a group—monetary policy will actually
be worse!
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-22
C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.5
MONETARY POLICY CHALLENGES
FOR THE FED (cont’d)
Looking Ahead: From the Short Run to the Long Run
•Monetary policy can affect output in the short run when prices
are largely fixed, but in the long run changes in the money
supply affect only the price level and inflation.
•In the long run, the Federal Reserve can only indirectly control
nominal interest rates, and it can’t control real interest rates—
the rate after inflation is figured in.
•In the next part of the book, we will explain how output and
prices change over time, and how the economy makes the
transition by itself from the short to the long run regardless of
what the Fed does.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-23
C H A P T E R 14
The Federal Reserve
and Monetary Policy
KEY TERMS
appreciation of a currency
liquidity demand for money
depreciation of a currency
money market
discount rate
open market operations
exchange rate
open market purchases
federal funds market
open market sales
federal funds rate
speculative demand for money
illiquid
transaction demand for money
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
14-24