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Transcript
CHAPTER 14 MONETARY POLICY WHAT IS THIS CHAPTER ALL ABOUT? This second chapter devoted to money and the banking system describes the structure of the Federal Reserve System and looks at the impact of Fed policies on aggregate demand. In addition to providing an understanding of the basic structure and operations of the Fed, the purpose of this chapter is to encourage students to think about the following questions: 1. How does the government control the amount of money in the economy? 2. How does the money supply affect macroeconomic outcomes? NEW TO THIS EDITION New headline on China's reserve requirement New headline on interest rate cuts Living Econ on “Why should I care about interest rates?” LECTURE LAUNCHERS Where should you start? 1. Ask students who is the most powerful man in the U.S. or the world. Some say the Chair of the Federal Reserve is. The Fed has tools it can use to affect the economy. When the U.S. economy is affected, this also affects the world economy. This conversation helps you lead into a discussion of the monetary tools. 2. Ask the students what are the responsibilities of the Federal Reserve. Regional functions are listed and explained on page 315. Don’t forget to include monetary policy in the list. 3. Discuss the independence of the Fed. Should it be independent? Chapter 14 – Monetary Policy – Page 276 The Fed was created by an act of Congress in an attempt to remove political considerations in monetary policy. As a result, the Fed can take actions that cancel out fiscal policy decisions made by congress. Note that the members of the Fed are appointed, not elected. Are they truly nonpolitical? Who should regulate the Fed? 4. Ask students what would happen to the economy if the money supply was either increased or decreased. This question allows you to begin discussing monetary policy and the monetary tools the fed has available. 5. Ask students how they would react if banks offered lower interest loans. Some students will say they would take out loans to buy cars, stereos, houses, or other expensive items if they could get cheap loans. Use this discussion to talk about how interest rates are determined and how aggregate demand relates to the interest rate. 6. Illustrate that monetary policy is primarily designed to change AD. This discussion helps illustrate that the effectiveness of monetary policy depends upon the location of AD and the shape of AS as illustration in Figure 14.6. COMMON STUDENT ERRORS Many students make these common errors. This same list is included in the student study guide. The first statement in each “common error” below is incorrect. Each incorrect statement is followed by a corrected version and an explanation. 1. 2. Bank reserves are required for the safety of depositor’s money. WRONG! Bank reserves are for the control of the money supply. RIGHT! Many people have the idea that bank reserves provide for the safety of depositors’ money. They don’t! The amount of demand deposits is several times larger than that of reserves. Reserves are for control of the money supply. The FDIC provides for safety of deposits by insuring them. Reserves are not principally for depositors’ safety. Deposits of cash are necessary to start the process of lending and deposit creation. WRONG! To start the lending process, then banks must acquire reserves from outside of the banking system. RIGHT! Many find it difficult to understand that for deposit creation to occur, the banking system needs only to acquire reserves from outside the system or be able to stretch existing reserves further. It may acquire reserves by selling a security to the Fed or by borrowing from the Fed. An individual bank, however, may acquire reserves from another bank. Therefore, to the extent that it has increased its reserves, reserves of Chapter 14 – Monetary Policy – Page 277 another bank have shrunk. Thus, the system has no more reserves after the transaction than it had before and so the system’s lending capacity is unchanged. 3. When the Fed sells government bonds in open-market operations, it is increasing the money supply. WRONG! When the Fed sells government bonds in open-market operations, it is decreasing the money supply. RIGHT! Think of it this way. If the Fed sold a bond to you, it would give you the bond in exchange for money that you have. This in effect decreases the amount of money you have to spend. Since the Fed does not put this money back in circulation, the nations money supply is reduced. 4. Monetary policy is easy to determine and to administer. WRONG! Monetary policy is difficult to determine and to administer. RIGHT! One could easily get the idea that monetary policy is easy to administer and that the Fed always knows the rate at which the money supply should grow. This is not so. Many variables intervene to make monetary policy difficult to prescribe and implement. Such variables include timing and the duration of a given policy, unanticipated events on the fiscal side, and problems abroad. The Fed’s policymakers analyze the data available and do the best they can to achieve a given objective, which often involves compromises. The process is much more difficult than turning a printing press on and off. HEADLINES This chapter has three Headlines boxes dealing with Fed actions: "Central Bank in China Raises Reserve Requirement” (Reserve Requirements) In 2003, the central bank of China raised the deposit reserve ratio from 6 percent to 7 percent. The stated reason was to alleviate “an excessive increase in current monetary lending.” “Fed Cuts Key Rate by Half a Point” (Discount Rates) In 2002 the Federal Reserve cut short-term interest rates by half a percentage point to help the economy over a “current soft spot.” The new rate, 1.25 percent, was lowest in more than four decades. “Fed increases dosage of anti-inflation medicine” (Monetary Restraint) The Federal Reserve increases the interest rate to help fight inflation. When the Fed fears that aggregate demand is growing too fast, it tries to cool the economy down with higher interest rates. Chapter 14 – Monetary Policy – Page 278 ANNOTATED CONTENTS IN DETAIL I. Monetary Policy (Figure 14.1) Definition: Monetary Policy – The use of money and credit controls to influence macroeconomic activity. II. The Federal Reserve System (Figure 14.2) A. Federal Reserve Banks - functions of 1. Clears checks between private banks 2. Holds bank reserves 3. Provides currency 4. Provides loans B. The Board of Governors (Figure 14.2) 1. Key decision - maker for monetary policy. 2. Seven members appointed by President of U.S. for 14-year terms. C. The Fed Chairman 1. Most visible member of the Fed system. 2. Selected by the President for a four-year term. 3. Can be reappointed Example: President Reagan appointed Alan Greenspan. Greenspan was reappointed by President George H. Bush, President Clinton and again by President George W. Bush in 2004. III. Monetary Tools A. Money Supply (M1) Definition: Money Supply (M1) – Currency held by the public, plus balances in transaction accounts. B. The basic tools of monetary policy are: 1. Reserve requirements. 2. Discount rates. 3. Open-market operations. C. Reserve Requirements 1. Required reserves Definition: Required Reserves – The minimum amount of reserves a bank is required to hold by government regulation; equal to required reserve ratio times transaction deposits. 2. By changing the reserve requirement, the Fed can directly alter the lending capacity of the banking system. 3. Formula Available lending capacity of banking system excess reserves money multiplier 4. Excess reserves a. Definition: Excess Reserves – Bank reserves in excess of required reserves. Chapter 14 – Monetary Policy – Page 279 b. Formula: Excess reserves total reserves required reserves 5. 6. 7. A decrease in required reserves increases excess reserves (Table 14.1). A lower reserve requirement directly increases value of money multiplier. Money Multiplier Definition: Money Multiplier – The number of deposit (loan) dollars that the banking system can create from $1 of excess reserves; equal to 1 ÷ required reserve ratio. Formula: 1 required reserve ratio 8. A change in the reserve requirement causes a. A change in excess reserves b. A change in the money multiplier D. Headline: "Central Bank in China Raises Reserve Requirement” (Reserve Requirements) In 2003, the central bank of China raised the deposit reserve ratio from 6 percent to 7 percent. The stated reason was to alleviate “an excessive increase in current monetary lending.” E. The Discount Rate (Figure 14.2) 1. Discount rate Definition: Discount Rate – The rate of interest charged by the Federal Reserve banks for lending reserves to private bank. 2. Since reserves earn no interest, banks have an incentive to maintain excess reserves at the minimum possible level. 3. Sometimes banks reserves run low and they must replenish their reserves temporarily. Sources of last minute reserves are: a. Borrow from a reserve-rich bank. b. Sale of securities. c. Reserve credits from Federal Reserve System. (Discounting) 4. Discounting Definition: Discounting – Federal Reserve lending of reserves to private banks. Note: By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves. 5. Headline: “Fed Cuts Key Rate by Half a Point” (Discount Rates) In 2002 the Federal Reserve cut short-term interest rates by half a percentage point to help the economy over a “current soft spot.” The new rate, 1.25 percent, was lowest in more than four decades. Chapter 14 – Monetary Policy – Page 280 F. Open - Market Operations (Figure 14.4) 1. Open-market operations are the principal mechanism for directly altering the reserves of the banking system. 2. Open market operations are designed to affect these decisions: a. Portfolio decisions - where should idle funds be held, in cash or some other asset. b. Hold money or bonds - the Fed attempts to influence whether individuals hold idle funds in transaction accounts or government bonds. Note: When the Fed buys bonds from the public, it increases the flow of deposits (reserves) to the banking system. Bond sales by the Fed reduce the flow. 3. 4. IV. Open-Market Activity a. Changes in bond prices will alter portfolio choices b. The Fed buys or sells bonds to alter the level of bank reserves. c. Open-Market Operations Definition: Open-Market Operations - Federal Reserve purchases and sales of government bonds for purpose of altering bank reserves. d. Buying Bonds – By buying bonds, the Fed increases bank reserves. e. Selling Bonds – By selling bonds, the Fed decreases bank reserves. Powerful Levers - How the Fed controls the nation's money supply. a. Reserve requirements b. Discount rates c. Open-market operations Shifting Aggregate Demand (Table 14.2) A. Expansionary Policy 1. Aggregate Demand Definition: Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. 2. Monetary policy may be used to shift aggregate demand. (Figure 14.5) Example: B. If the Fed lowers reserve requirements, drops the discount rate or buys more bonds it increases bank lending capacity. Banks make more loans so AD shifts to the right reflecting increased purchasing power. Restrictive Policy 1. Monetary policy can be used to cool an overheating economy. 2. Fed can reduce money supply. (Decrease AD) a. Raise reserve requirements b. Increase discount rate Chapter 14 – Monetary Policy – Page 281 3. V. Price vs. Output Effects A. Aggregate Demand - increases in money supply shift AD to the right. B. Aggregate Supply Definition: Aggregate Supply – The total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus. 1. 2. VI. c. Sell bonds “Fed Increases Dosage of Anti-Inflation Medicine” (Monetary Restraint) The Federal Reserve increases the interest rate to help fight inflation. When the Fed fears that aggregate demand is growing too fast, it tries to cool the economy down with higher interest rates. The effects of an aggregate demand shift on prices and output depends on the shape of the aggregate supply curve (Figure 14.6). a. Horizontal AS - output increases without any inflation. b. Vertical AS - inflation occurs without changing output. c. Upward sloped AS - both prices and output are affected by monetary policy. With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment. Policy Perspectives A. Fixed Rules or Discretion? 1. Should the Fed try to fine-tune the economy with constant adjustments of the money supply? 2. Or should the Fed instead simply keep the money supply growing at a steady pace? B. Discretionary Policy 1. The economy is constantly beset by expansionary and recessionary forces. 2. Thus, there is a need for continual adjustments to money supply, restraining or stimulating the economy as needed. C. Fixed Rules 1. Monetary policy under fixed rules is less prone to error than is discretionary policy. 2. Fixed rules call for increasing the money supply by a constant amount each year. 3. The AS curve could be vertical or at least upward sloping. As a result, too much expansionary monetary policy would lead to inflation. D. The Fed's Eclecticism 1. Flexible rules 2. Limited discretion 3. Mix of money supply and interest-rate adjustments to do whatever is necessary to promote price stability and economic growth. Chapter 14 – Monetary Policy – Page 282 IN-CLASS DEBATE, EXTENDING THE DEBATE, AND DEBATE PROJECTS In-class Debate Should the FED be independent? As chapter 14 points out, the Federal Reserve System has a large measure of political independence. The Board of Governors, appointed by the US president and confirmed by the US Senate, serve 14 year terms. In addition, the Federal Open Market Committee includes representatives of private banks in the Federal Reserve system. Proposed: The public should directly elect some of the representatives who make monetary policy (as the public elects representatives who make fiscal policy) Identify two strong arguments in favor this proposal. Identify two strong arguments against this proposal. Teaching notes Classroom discussion often encourages students to debate one another. Although lively, such discussion usually involves no more than a minority of students. The cooperative controversy ensures that every student is involved in the debate while using a relatively short period of class time. Moreover, it can help students see the arguments on both sides of an issue, often a difficult task for college students. Finally, the technique helps focus on an outcome such as identification of the strongest argument on each side or a final position. These outcomes may be useful in a follow-up student essay or paper. Format: Organize students into groups of two. (Use instructor assignment or random assignment so that friends don’t work together.) One half of the groups take the pro side; the other half take the con side. Each pair lists the strongest three arguments for their position. Then pairs combine into groups of four with one pair on each side of the debate. One pair reads their reasons while the other side listens. Then reverse so that the other pair reads their reasons. Group of four selects strongest argument on each side and, if appropriate, reaches consensus on final position. Extending the Debate What are the best goals for the FED? Shout it lean toward restraint or toward expansion? Policy advisors differ in their advice to the US Federal Reserve Board. Should the Fed be more concerned about inflation, or should it be more concerned about jobs and economic growth in the short run? Chapter 14 – Monetary Policy – Page 283 For a summary of these two sides go to: The National Center for Policy Analysis for a description of the dangers of an expansionary monetary policy (“restraint is better”). http://www.ncpa.org/pi/internat/pd050799f.html The Financial Markets Center for a description of the costs of a restrictive monetary policy (“expansion is better”). http://www.fmcenter.org/fmc_superpage.asp?ID=127 What are the weak points in the argument on each side? Overall, which side makes the strongest case? Teaching notes Use information gathered by students out of class to conduct an in-class cooperative controversy. Or, use the information for individually-written essays on the topic. Format: Organize students into groups of two. (Use instructor assignment or random assignment so that friends don’t work together.) One half of the groups take the pro side; the other half takes the con side. Each pair lists the strongest three arguments for their position. Then pairs combine into groups of four with one pair on each side of the debate. One pair reads their reasons while the other side listens. Then reverse so that the other pair reads their reasons. Group of four selects strongest argument on each side and, if appropriate, reaches consensus on final position. Debate Project Monetary Policy: What works? Monetary policy by the US Federal Reserve is important for the US economy. However, economists disagree about several aspects of Federal Reserve decision-making powers including the composition of the Federal Reserve committees, Federal Reserve goals, and the actual impact Federal Reserve of policy on the economy. Should the Federal Reserve Board focus exclusively on the problem of inflation? What other goals are appropriate for Federal Reserve policy? What is the appropriate goal for the inflation rate? How should the Federal Reserve Board use its policy to achieve its goals? How effective is Federal Reserve monetary policy in achieving its goals? Is the composition of the decision-making bodies of the Federal Reserve appropriate for a democracy? For information from the Federal Reserve Board itself, go to the Board of Governors of the Federal Reserve System at http://www.federalreserve.gov/ The Board of Governors site contains the Fed's Beige Book, Congressional testimony and speeches of Federal Reserve Board members, Federal Open Market Committee (FOMC) information, press releases, current interest rate information, and general information about the Chapter 14 – Monetary Policy – Page 284 Federal Reserve system. A PDF-format version of The Federal Reserve System: Purposes and Functions, a thorough overview of the Federal Reserve System, is available by chapter or as a single document. In addition, the site contains a summary of Federal Reserve regulations. Particularly useful is the publication, “Purposes and Functions of the Federal Reserve System” at http://www.federalreserve.gov/pf/pf.htm Federal Reserve Banks publish research papers. See “What Is the Right Inflation Rate? by David E. Altig” at http://www.clevelandfed.org/research/Com2003/0915.pdf and, “The Science (and Art) of Monetary Policy” by Carl E. Walsh at http://www.frbsf.org/publications/economics/letter/2001/el2001-13.html Criticism of the Federal Reserve Board comes from both conservatives and liberals sides. For a liberal viewpoint see the Financial Markets Center at: http://www.fmcenter.org/ It calls itself “an independent, nonprofit institute that provides research and education resources to grassroots groups, unions, policymakers and journalists interested in the Federal Reserve System and financial markets. Through its work, the Center seeks to promote democratic values, accountable public institutions and improved living standards for ordinary citizens.” For a conservative viewpoint, see the Shadow Open Market Committee at: http://www.somc.rochester.edu/ It is a group that recommends “that the Federal Reserve: Adopt a clear public statement of its primary objective, the control of inflation; Announce a specific target for inflation, with a goal of 1 percent CPI inflation; and Announce a policy process that it will follow consistent with this objective. For discussion of the Federal Reserves decision-making structures see: “Righting the Balance: The Reserve Banks and Policymaking” at http://www.fmcenter.org/fmc_superpage.asp?ID=162 For description by the Federal Reserve of its disclosure, see http://www.federalreserve.gov/boarddocs/press/general/2000/20000119/default.htm ANSWERS TO QUESTIONS FOR DISCUSSION, WEB ACTIVITIES AND PROBLEMS QUESTIONS FOR DISCUSSION 1. Why do banks want to maintain as little excess reserves as possible? Under what circumstances might banks desire to hold excess reserves? (Hint: see Figure 14.3.) Excess reserves represent unused lending power. The opportunity cost of excess reserves can be high. Banks are in the business of making profits. They need to put their reserves to work by loaning them out and earning interest. In some Chapter 14 – Monetary Policy – Page 285 cases, banks may be hesitant to make loans and therefore might want to hold excess reserves if they expect a relatively high withdrawal rate from the bank. 2. Why do people hold bonds rather than larger savings-account or checking-account balances? Under what circumstances might they change their portfolios, moving their funds out of bonds and into bank accounts? Bonds have the advantage of offering possible capital appreciation as well as interest payments. Neither savings nor checking accounts do that. A significant depreciation in the selling price of bonds - occasioned by an increase in interest rates - might cause bondholders to sell them and move their funds into bank accounts. 3. If the Federal Reserve banks mailed everyone a brand-new $100 bill, what would happen to prices, output, and income? Illustrate with aggregate demand and supply curves. The initial impact would be to increase aggregate demand. This could increase prices or output or both, depending on the shape of the aggregate supply curve. The possibilities are illustrated in Figure 14.6. 4. How does an increase in the money supply get into the hands of consumers? What do they do with it? An increase in the money supply occurs when banks make loans. If the loans are to consumers, then consumers are direct recipients of the increase in the money supply. If these loans are used to finance business investment, then consumers are indirect recipients of the increase in the money supply as total payrolls increase and the household sector’s income and spending increases. 5. Is a reduction in interest rates likely to affect spending on pizza? What kinds of spending are sensitive to interest rate fluctuations? Since consumers usually pay cash for pizza, a change in interest rates would not directly affect spending on pizza. For the most part, interest rate changes only directly affect spending on items that are purchased with borrowed money such as houses, cars,, etc. 6. If banks and credit card companies charged zero interest, would people spend and invest more? What would inhibit business or consumer borrowing? When consumers borrow money for consumption, their main concern is the amount of the monthly payment. At zero interest, they could increase consumption without increasing their monthly payment. Businesses would, in a similar fashion, be able to increase investment expenditures. As long as the rate return on capital is greater than the interest rate, it is a viable investment, ceteris paribus. Even though there would not be any interest on these loans, the principle still needs to be re-paid. Consumer and business spending would be inhibited by two by their available income. 7. Which aggregate supply curve in Figure 14.6 does the Fed chairman fear the most? Why? The Fed chairman would fear the vertical AS curve in panel ‘b’ the most. In an economy with a vertical AS curve, an change in AD will only affect prices without changing the rate of real GDP. In such cases, all changes in AD will Chapter 14 – Monetary Policy – Page 286 either be inflationary or deflationary and will have no effect on the level of output. 8. Like all human institutions, the Fed makes occasional errors in altering the money supply. Would a constant (fixed) rate of money-supply growth eliminate errors? Although some policy analysts call for a constant rate of money-supply growth, according to the Keynesian perspective this will not eliminate errors. We know that the economy is going to have its ups and downs as it moves through the business cycle. When the economy needs to be stimulated, then the money supply growth rage should be increased; when it needs to be slowed down, the money supply growth rate should be decreased. Having a constant rate of money supply growth guarantees that it will not be the right rate all of the time. 9. Congress sometimes demands more control of monetary policy. Is this a good idea? Why is fiscal policy, but not monetary policy, entrusted to elected politicians? Giving congress control of the money supply would be a bad idea. Monetary policy is an art of fine-tuning the economy. Because of political pressures, congress has a tendency to: a) take a long time to make decisions, and b) overreact to economic problems. In addition, having fiscal and monetary policy controlled by different institutions is another example of “checks and balances” that are prevalent in our political system. There is the fear of having too much power rest with any one institution. Fiscal policy is usually used to resolve major economic problems and to help resolve specific social issues. This social engineering is better left to the politicians where the electoral process helps determine what specific taxation and spending programs are enacted. 10. Would you advocate monetary restraint or stimulus for today’s economy? Who would disagree with you? The answer to this question obviously depends on the current state of the economy. If the economy is expanding near full employment, monetary restraint is needed to help prevent the economy from experiencing increased inflation. If the economy is contracting away from full employment, then monetary stimulus is needed to prevent the economy from going into a recession. In each of these situations, those who believe in “fixed rules,” i.e., the money supply should be increased by a constant (fixed) rate would disagree. WEB ACTIVITIES 1. Log on to www.federalreserve.gov and read the description of the role of the Federal Reserve System. Summarize the role of the Federal Reserve System from this information. The Fed describes its four general areas of responsibility as: Conducting the nation’s monetary policy. Supervising and regulating banking institutions and protecting the credit rights of consumers. Maintaining the stability of the financial system. Chapter 14 – Monetary Policy – Page 287 2. Providing certain financial services to the U.S. government, the public, financial institutions, and foreign official institutions. Log on to www.federalreserve.gov/pubs/frseries/frseri.htm and find a description of the current structure of the Federal Reserve System. Summarize the structure of the Federal Reserve System from this information. The Fed was created on December 23, 1913 by an Act of Congress. The System consists of a seven member Board of Governors with headquarters in Washington, D.C., and twelve Reserve Banks located in major cities throughout the United States. 3. Log on to www.federalreserve.gov/policy.htm then click on the Monetary Policy Report to Congress. Click on the most recent report and access the section on Monetary Policy and Economic Outlook. Read the report and summarize the Fed’s perception of the economy and their monetary policy response. The answer to this question will depend upon when you access the report. 4. Log into www.federalreserve.gov/releases/h15/ and click on the most recent release data. Find the general trend for the Federal funds interest rate. What have been the likely actions of the Fed that have caused the interest rates to move in the directions shown? The answer to this question will depend upon when you access the report. The most frequently used tool of the Fed is Open Market operations and changing the discount rate. PROBLEMS 1. Suppose the following data apply: Total Bank Reserves Total Bank Deposits Cash Held by the Public $5 billion Stocks held by public $140 billion $100 billion $5 trillion $10 billion Gross Domestic Product Interest rate Bonds Held by the Public $220 billion Required reserve ratio 0.04 a. b. c. d. How large is the money supply as measured by M1? How much excess reserves are there? What is the money multiplier? What is the available lending capacity? Chapter 14 – Monetary Policy – Page 288 6 percent a. b. c. d. 2. The basic money supply (M1) is transaction account balances and cash. Assuming that the total bank deposits are in transaction accounts, the money supply is $110 billion. If the required reserve ratio is 0.04, then banks are required to keep $4 billion in reserve ($100 billion X 0.04). Since banks have total reserves of $5 billion, there is $1 billion in excess reserves. The money multiplier is calculates as 1/(required reserve ratio). Thus, the money multiplier is 1/0.04 = 25. Since there are $1 billion in excess reserves and the money multiplier is 25, there is $25 billion in available lending capacity. Assume that the following data describe the condition of the commercial banking system: Total Reserves: Transactions deposits: Cash held by public: Reserve requirement: a. b. c. d. e. f. $200 billion $800 billion $100 billion 0.20 How large is the money supply (M1)? Are the banks fully utilizing their lending capacity? Explain. What would happen to the money supply initially if the public deposited another $50 billion in cash in transactions accounts? Explain. What would the lending capacity of the banking system be after such a portfolio switch? How large would the money supply be if the banks fully utilized their lending capacity? What three steps could the Fed take to offset the potential growth in M1? a. The money supply (M1) is $900 billion ($100 cash plus $800 Transactions Deposits). b. In this situation banks are not fully utilizing their lending capacity. Only $160 billion of reserves are required at the required reserve ratio of 0.20. This is calculated as $800 billion in deposits x 0.20. Thus, $40 billion is excess reserves, where ER=0 when fully utilizing lending capacity. c. Assuming this $50 billion cash is not new money in the system, i.e., it is part of the $100 billion in cash currently being held, then there will be no change in M1. d. After the additional deposit of $50 billion in cash, excess reserves jump by another $40 billion to $80 billion. Lending capacity increases to 5 x $80 billion = $400 billion. e. Assuming the lending capacity of $400 billion is fully used, the money supply will rise to $1,250 billion. This consists of the current $800 billion in transactions deposits, $50 billion in cash remaining after the Chapter 14 – Monetary Policy – Page 289 deposit was made, plus $400 billion in new money created through the lending process. f. 3. To offset the potential growth in M1 illustrated in ‘e’, the Fed could increase the reserve requirement, raise the discount rate, or sell bonds in the open market. Suppose the Federal Reserve decided to purchase $10 billion worth of government securities in the open market. a. How will M1 be affected initially? b. How will the lending capacity of the banking system be affected if the reserve requirement is 25 percent? c. How will banks induce investors to utilize this expanded lending capacity? When the Fed purchases $10 billion of securities on the open market: a. b. c. 4. M1 will increase by $10 billion, assuming that the sellers of the securities hold the proceeds as cash or deposit them in a transaction account, e.g., checking account.. Lending capacity will increase by $30 billion. (A money multiplier of 4 x excess reserves of $7.5 billion.) As the money supply increases, interest rates go down and investors will want to borrow more funds. Suppose the economy is initially in equilibrium at an output level of 100 and price level of 100. The Fed then manages to shift aggregate demand rightward by 20. a. Illustrate the initial equilibrium (E1) and the shift of AD. b. Show what happens to output and prices if the aggregate supply curve is (1) horizontal, (2) vertical, and (3) upward sloping. When the economy is at an equilibrium output of 100 and a price level is 100, the impact of a shift in AD rightward by 20 is illustrated below: (a) Initial equilibrium is E1. (b) Output and price changes vary according to the shape of the AS curve. Chapter 14 – Monetary Policy – Page 290 1 1 Aggregate supply P1 P5 Aggregate supply P4 AD1 0 0 0 E1 AD2 AD5 0 1 QF 0 AD4 0 E1 R ATE O F OU T PUT RATE OF OUTPUT 1 A gg re ga te su pply P7 P6 A D7 AD6 0 0 0 E1 Q7 1 R AT E O F O U TP U T 5. Illustrate the effects on bank reserve of an open-market sale (See Figure 14.4) An open market sale of government securities by the Federal Reserve would have exactly the opposite effect of the change illustrated in Figure 14.4: Step 1, FMOC sells government bond to the public, who pays by check. Step 2, Funds are withdrawn from buyer’s private bank. Step 3, Private bank’s account at Regional Federal Reserve Bank is debited. 6. How did the money multiplier change when China increased its reserve requirement? (see Headline p. 318) When the reserve requirement increased from 6 percent to 7 percent, the money multiplier decreased from 16.7% to 14.3%. Chapter 14 – Monetary Policy – Page 291 1 PRINT MEDIA EXERCISE Chapter 14 Monetary Policy Name: ___________________ Section: __________________ Grade: ___________________ Find an article that represents a shift of demand or supply for money. Use the article you have found to fulfill the following instructions and questions: 1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page or print an article from an Internet news agency such as www.cnn.com, www.msnbc.com, www.abc.com, www.nytimes.com, etc. 2. Below the article, write one of the following four shifts that you will illustrate with the article you have chosen: b. A shift of the money supply curve to the left. c. A shift of the money supply curve to the right. d. A shift of the money demand curve to the left. e. A shift of the money demand curve to the right. 3. Use an arrow to indicate in the article the desired or actual (past, present, or future) changes in the quantity of money. 4. Underline the single sentence (not more than a sentence) that describes the change in the determinant of demand or supply that has caused the shift you chose in number 2 above. The demand for money changes as people receive larger incomes, as the speed with which they use money changes, and as the inflation rate changes. The supply of money is determined by the actions of the Federal Reserve System, the willingness of the financial system (banks) to make loans, and individual perceptions of the future course of the economy. 5. Circle the single sentence (not more than a sentence) indicating the effect on interest rates (or expectations about interest rates) that results from the shift in money demand or supply. (Hint: Be sure the changes are consistent with the shift you chose in number 2 above.) 6. In the remaining space below your article, indicate the source (name of newspaper, magazine or web site), title (newspaper headline, magazine article, or web article title), date, and page for the article you have chosen. Use this format: Source: _____________________ Date: ______________ Page: _____________ Title: ___________________________________________________________ If this information also appears in the article itself, circle each item. 7. Neatness counts. Chapter 14 – Monetary Policy – Page 292 Professor's Note Learning Objective for Media Exercise To show students what to look for in the media to find if the demand or supply of money is changing and to have students learn how to apply the tools of supply and demand to the money market. Suggestions for Correcting Media Exercise 1. Check for consistency between the shift in money demand or supply chosen in number 2 and the change in the quantity of money indicated by the arrow in the article (as instructed in number 3). 2. Check for consistency between the shift you chose in number 2 and the direction that interest rates take in the passage circled (as instructed in number 5). 3. The underlined passage should indicate an event that will clearly change money supply or demand. Likely Student Mistakes and Lecture Opportunities 1. The relationship of interest rates and inflation rates to the price of money is often difficult for the students to conceptualize. There are likely to be mistakes in the submitted articles, reflecting students’ confusion. 2. Students also confuse money, income, sales, and other dollar-denominated quantities. It may be useful here to distinguish the concepts of stocks (like money) from flows that have been dealt with in earlier chapters. 3. Some students may turn in articles about money targets published by the Fed, changes in currency denominations, articles about increased incomes of firms, etc., which totally miss the point of the assignment. This may be an indication that some students haven't a clue about the use of money supply and demand curves. Evidence of correct work by other students can sometimes jog such students in the right direction. SUPPLEMENTARY SOURCES Friedman, Milton: "The Case for Overhauling the Federal Reserve," Challenge, JulyAugust 1985, pp. 4-12. On Greenspan and the Federal Reserve see: Martin, Justin, Greenspan: The Man Behind the Money, Woodward, Bob, Greenspan’s Fed and the American Boom, and Greider, William, Secrets of the Temple: How the Federal Reserve Runs the Country. Chapter 14 – Monetary Policy – Page 293