1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 16 Domestic and International Dimensions of Monetary Policy

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-2 Introduction Today the total reserves that depository institutions hold with the Fed exceed $1 trillion, as compared to less than $45 billion in 2008. What determines the quantity of reserves that depository institutions choose to hold with the Fed? Why are they opting to hold so many more reserves now than a few years ago? This chapter will help you understand the answers to these questions.

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-3 Learning Objectives Identify the key factors that influence the quantity of money that people desire to hold Describe how Federal Reserve monetary policy actions influence market interest rates Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run Understand the equation of exchange and its importance in the quantity theory of money and prices

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-4 Learning Objectives (cont'd) Discuss the interest-rate-based transmission mechanism of monetary policy Explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously Describe how the Federal Reserve achieves a target value of the federal funds rate Explain key issues the Federal Reserve confronts in selecting its target for the federal funds rate

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-5 Chapter Outline The Demand for Money How the Fed Influences Interest Rates Effects of an Increase in the Money Supply Open Economy Transmission of Monetary Policy Monetary Policy and Inflation Monetary Policy in Action: The Transmission Mechanism

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-6 Chapter Outline (cont'd) The Way Fed Policy is Currently Implemented Selecting the Federal Funds Rate Target

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-7 Did You Know That … In late 2000s, Zimbabwe’s daily inflation rate some times exceeded 100 percent, meaning that the nation’s price level more than doubled within 24-hour periods? Meanwhile, daily rates of money supply growth in Zimbabwe also exceeded 100 percent. Why are higher rates of inflation associated with higher rates of money growth? One objective of this chapter is to answer this question.

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-8 The Demand for Money To see how Fed monetary policy actions have an impact on the economy by influencing market interest rates, we must understand how much money people desire to hold—the demand for money. All flows of nonbarter transactions involve a stock of money. To use money, one must hold money.

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-9 People have certain motivation that causes them to want to hold money balances: –Transactions demand –Precautionary demand –Asset demand The Demand For Money

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-10 The Demand for Money (cont'd) Money Balances –Synonymous with money, money stock, and money holdings

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-11 The Demand for Money (cont'd) Transactions Demand –Holding money as a medium of exchange to make payments –The level varies directly with nominal GDP

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-12 The Demand for Money (cont'd) Precautionary Demand –Holding money to meet unplanned expenditures and emergencies

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-13 The Demand for Money (cont'd) Asset Demand –Holding money as a store of value instead of other assets such as certificates of deposit, corporate bonds, and stocks

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-14 The Demand for Money (cont'd) The demand for money curve –Assume the amount of money demanded for transactions purposes is proportionate to income –Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate)

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-15 Figure 16-1 The Demand for Money Curve

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-16 How the Fed Influences Interest Rates The Fed seeks to alter consumption, investment, and total aggregate expenditures by altering the rate of growth of the money supply

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-17 How the Fed Influences Interest Rates (cont'd) The Fed has four tools at its disposal as monetary policy actions: –Open market operations –Changes in the reserve ratio –Changes in the interest rate paid on reserves –Discount rate changes

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-18 How the Fed Influences Interest Rates (cont'd) Open market operations –Fed purchases and sells government bonds issued by the U.S. Treasury –An open market operation causes a change in the price of bonds

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-19 Figure 16-2 Determining the Price of Bonds, Panel (a) Contractionary Policy Fed sells bonds Supply of bonds increases The price of bond falls

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-20 Figure 16-2 Determining the Price of Bonds, Panel (b) Expansionary Policy Fed buys bonds Supply of bonds falls The price of bond rises

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-21 How the Fed Influences Interest Rates (cont'd) Example –You pay $1,000 for a bond that pays $50 per year in interest Bond Yield = $50 = 5% $1,000

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-22 How the Fed Influences Interest Rates (cont'd) Example –Now suppose you pay $500 for the same bond (with $50 in interest) Bond Yield = $50 = 10% $500

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-23 How the Fed Influences Interest Rates (cont'd) The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy Implications: –A Fed open market sale that reduces the equilibrium price of bonds brings about an increase in the interest rate –A Fed open market purchase that boosts the equilibrium price of bonds generates a decrease in the interest rate

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-24 Effects of an Increase in The Money Supply What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter? People pick up the money and put it in their pockets, but how do they dispose of the new money?

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-25 Effects of an Increase in The Money Supply (cont'd) Direct effect –Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-26 Effects of an Increase in The Money Supply (cont'd) Indirect effect –Not everybody will necessarily spend the newfound money on goods and services –Some of the money gets deposited, so banks have higher reserves (and they lend the excess out)

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-27 Effects of an Increase in The Money Supply (cont'd) Indirect effect –Banks lower rates to induce borrowing Businesses engage in investment Individuals consume durable goods (like housing and autos) –Increased loans generate an increase in aggregate demand More people are involved in more spending (even those who didn’t get money from the helicopter!)

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-28 Effects of an Increase in The Money Supply (cont'd) Assume the economy is operating at less than full employment –Expansionary monetary policy can close the recessionary gap –Direct and indirect effects cause the aggregate demand curve to shift outward

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-29 Figure 16-3 Expansionary Monetary Policy with Underutilized Resources The recessionary gap is due to insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-30 Effects of an Increase in The Money Supply (cont'd) Assume there is an inflationary gap –Contractionary monetary policy can eliminate this inflationary gap –Direct and indirect effects cause the aggregate demand curve to shift inward

31. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-31 The inflationary gap is shown To decrease AD, use contractionary monetary policy AD decreases and real GDP decreases Figure 16-4 Contractionary Monetary Policy with Overutilized Resources

32. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-32 Open Economy Transmission of Monetary Policy So far we have discussed monetary policy in a closed economy When we move to an open economy, monetary policy becomes more complex

33. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-33 Open Economy Transmission of Monetary Policy (cont'd) The net export effect of contractionary monetary policy Boosts the market interest rate Higher rates attract foreign investment International price of dollar rises Appreciation of dollar reduces net exports Negative net export effect

34. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-34 Open Economy Transmission of Monetary Policy (cont'd) Contractionary monetary policy causes interest rates to rise Such a rise will induce international inflows of funds, thereby raising the international value of the dollar and making U.S. goods less attractive abroad The net export effect of contractionary monetary policy will be in the same direction as the monetary policy effect, thereby amplifying the effect of such policy

35. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-35 Open Economy Transmission of Monetary Policy (cont'd) The net export effect of expansionary monetary policy Lower interest rates Financial capital flows out of the United States Demand for dollars will decrease International price of dollar goes down Foreign goods look more expensive in United States Net exports increase (imports fall)

36. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-36 Open Economy Transmission of Monetary Policy (cont'd) Globalization of international money markets –The Fed’s ability to control the rate of growth of the money supply may be hampered as U.S. money markets become less isolated –If the Fed reduces the growth of the money supply, individuals and firms in the United States can obtain dollars from other sources and more regularly conduct transactions using other nations’ currencies.

37. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-37 Monetary Policy and Inflation Most media discussions of inflation focus on the short run when the price index can fluctuate due to such events as –Oil price shocks, labor union strikes In the long run, empirical studies show that excessive growth in the money supply results in inflation

38. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-38 Monetary Policy and Inflation (cont'd) Simple supply and demand analysis can be used to explain why the price level rises when the money supply increases If the supply of money expands relative to the demand for money: –People have more money balances than they desire, so their spending on goods and services increases (i.e., the price level has risen)

39. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-39 Monetary Policy and Inflation (cont'd) The Equation of Exchange –The formula indicating that the number of monetary units (M s ) times the number of times each unit is spent on final goods and services (V) is identical to the price level (P) times real GDP (Y) –It shows the relationship between changes in the quantity of money in circulation and the price level

40. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-40 Monetary Policy and Inflation (cont'd) M S = money balances held by nonbanking public V = income velocity of money P = price level or price index Y = real GDP per year M s V  PY

41. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-41 Monetary Policy and Inflation (cont'd) Income Velocity of Money –The number of times per year the dollar is spent on final goods and services –Equal to the nominal GDP divided by the money supply

42. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-42 Monetary Policy and Inflation (cont'd) The equation of exchange as an identity () –Total funds spent on final output M s V equals total funds received PY –The value of goods purchased is equal to the value of goods sold –M s V  PY  nominal GDP

43. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-43 Monetary Policy and Inflation (cont'd) Quantity Theory of Money and Prices –The hypothesis that changes in the money supply lead to equiproportional changes in the price level –If we assume that V and Y are constant, than an increase in the money supply by, say 20%, can lead only to a 20% increase in the price level

44. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-44 Figure 16-5 The Relationship Between Money Supply Growth Rates and Rates of Inflation

45. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-45 International Policy Example: North Korea Divides Its Money by 100 Inflation has been so rampant in North Korea that even the poorest individuals commonly have held thousands of won, the nation’s currency, and banks have routinely transferred single payments denominated in trillions of won. To simplify matters, the North Korean government recently stripped two zeros from the currency.

46. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-46 Figure 16-6 The Interest-Rate-Based Money Transmission Mechanism

47. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-47 Figure 16-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model At lower rates, a larger quantity of money will be demanded The decrease in the interest rate stimulates investment

48. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-48 The Fed’s target choice: The interest rate or the money supply? –The Fed has sought to achieve an interest rate target –There is a fundamental tension between targeting the interest rate and controlling the money supply –The Fed can attempt to stabilize the interest rate or the money supply, but not both Monetary Policy in Action: The Transmission Mechanism

49. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-49 Figure 16-8 Choosing a Monetary Policy Target If the Fed selects r e, it must accept M s If the Fed selects M’ s, it must allow the interest rate to fall

50. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-50 Monetary Policy in Action: The Transmission Mechanism (cont’d) Choosing a policy target –Money supply When variations in private spending occur –Interest rates When the demand for (or supply of) money is unstable Interest rate targets are preferred

51. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-51 The Way Fed Policy is Currently Implemented At present the Fed announces an interest rate target If the Fed wants to raise “the” interest rate, it engages in contractionary open market operations –Fed sells more Treasury securities than it buys, thereby reducing the money supply This tends to boost “the” rate of interest

52. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-52 The Way Fed Policy is Currently Implemented (cont'd) Conversely, if the Fed wants to decrease “the” rate of interest, it engages in expansionary open market operations –Fed buys more Treasury securities, increasing the money supply This tends to lower “the” rate of interest

53. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-53 The Way Fed Policy is Currently Implemented (cont'd) In reality, “the” interest rates that are relevant to Fed policymaking: –Federal funds rate –Discount rate –Interest rate on reserves

54. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-54 The Way Fed Policy is Currently Implemented (cont'd) Federal Funds Rate –The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market Federal Funds Market –A private market (made up mostly of banks) in which banks can borrow reserves from other banks that want to lend them –Federal funds are usually lent for overnight use

55. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-55 The Way Fed Policy is Currently Implemented (cont'd) Discount Rate –The interest rate that the Federal Reserve charges for reserves that it lends to depository institutions (through the “discount window”) –It is sometimes referred to as the rediscount rate or, in Canada and England, as the bank rate

56. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-56 The Way Fed Policy is Currently Implemented (cont'd) The interest rate on reserves –In October 2008, Congress granted the Fed authority to pay interest on both required reserves and excess reserves of depository institutions –If the Fed raises the interest rate on reserves and thereby reduces the differential between the federal funds rate and the interest rate on reserves, banks have less incentive to lend reserves in the federal funds market

57. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-57 Figure 16-9 The Market for Bank Reserves and the Federal Funds Rate, Panel (a)

58. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-58 Figure 16-9 The Market for Bank Reserves and the Federal Funds Rate, Panel (b) An open market purchase increases the supply of reserves, and thus lowers the equilibrium federal funds rate

59. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-59 The Way Fed Policy is Currently Implemented (cont'd) FOMC Directive –A document that summarizes the Federal Open Market Committee’s general policy strategy –Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth

60. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-60 The Way Fed Policy is Currently Implemented (cont'd) Trading Desk –An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC

61. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-61 Selecting the Federal Funds Rate Target The Neutral Federal Funds Rate –A value of the interest rate on interbank loans at which the growth rate of real GDP tends neither to rise nor to fall relative to the rate of growth of potential, long-run, real GDP, given the expected rate of inflation

62. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-62 Selecting the Federal Funds Rate Target (cont’d) The value of neutral federal funds rate varies over time. The potential rate of growth of real GDP is not constant When the rate of growth rises or falls, so does the value of the neutral federal funds rate The FOMC must respond by changing the target for the federal funds rate that it includes in the FOMC Directive transmitted to the Trading Desk

63. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-63 Selecting the Federal Funds Rate Target (cont’d) Taylor Rule –A suggested guideline for monetary policy –An equation determining the Fed’s interest rate target based on Estimated long-run real interest rate Deviation of the actual inflation rate from the Fed’s objective Gap between actual real GDP and a measure of potential GDP

64. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-64 Figure 16-10 Actual Federal Funds Rates and Values Predicted by a Taylor Rule

65. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-65 Why Not … just follow the Taylor rule? After 2008, during the Great Recession, following the Taylor rule was not feasible for the Fed. Figure 16-10 shows that the Taylor rule specified a negative value for the federal funds rate, which is not possible.

66. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-66 You Are There: How Zimbabwe Undercut Collectors’ Hopes of Profits During Zimbabwe’s periods of hyperinflation—an inflation rate so high that the Zimbabwe dollar often lost more than half its value in a single day, its government printed one-trillion-dollar notes. As those notes were printed and distributed in very large volumes, their market values might never exceed what money collectors paid for them.

67. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-67 Issues & Applications: Explaining the Rise in the Quantity of Bank Reserves Figure 16-11 shows that since the late summer of 2008, the total reserves of depository institutions have increased by nearly 25 times, to a level exceeding $1 trillion. Most of this increase came from the rise in voluntary holdings of excess reserves because since October 2008, the Federal Reserve has paid interest on all reserves held at Federal Reserve district banks.

68. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-68 Figure 16-11 Reserves of Depository Institutions Since June 2008

69. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-69 Summary Discussion of Learning Objectives Key factors that influence the quantity of money that people desire to hold –When nominal GDP rises People generally make more transactions They require more money They desire to hold more money –The interest rate is the opportunity cost for holding money as a precaution against unexpected expenditures –The quantity of money demanded declines as the market interest rate increases

70. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-70 Summary Discussion of Learning Objectives (cont'd) How the Fed’s Open Market Operations Influence Market Interest Rates –The market price of existing bonds and the prevailing interest rate are inversely related The market interest rate rises when the Fed sells bonds The market interest rate declines when the Fed purchases bonds

71. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-71 Summary Discussion of Learning Objectives How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run –Expansionary monetary policy Pushing up money supply, inducing a fall in interest rates Total planned expenditures rise, AD shifts rightward –Contractionary monetary policy Reduces the money supply increasing interest rates Total planned expenditures fall, AD shifts leftward

72. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-72 Summary Discussion of Learning Objectives (cont'd) The equation of exchange and the quantity theory of money and prices –Equation of exchange M s V = PY –Quantity theory of money and prices V is constant and Y is stable Increases in M s lead to equiproportional increases in P

73. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-73 Summary Discussion of Learning Objectives (cont'd) The interest-rate-based transmission mechanism of monetary policy –Operates through effects of monetary policy actions on market interest rates Bring about changes in desired investment and thereby affect equilibrium GDP via the multiplier effect

74. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-74 Summary Discussion of Learning Objectives (cont'd) Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously –To target the money supply the Fed must permit the interest rate to vary when the demand for money changes –To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes

75. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-75 Summary Discussion of Learning Objectives (cont'd) How the Federal Reserve Achieves a Target Value of the Federal Funds Rate –The interest rate at which banks can borrow excess reserves from other banks is at an equilibrium level when the quantity of reserves demanded by banks equals the quantity of reserves supplied by the Fed –The Trading Desk conducts open market sales or purchases to alter the supply of reserves as necessary to keep the federal funds rate at the FOMC’s target

76. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-76 Summary Discussion of Learning Objectives (cont'd) Issues the Federal Reserve Confronts in Selecting its Target for the Federal Funds Rate –The FOMC target is the neutral federal funds rate –The Taylor Rule specifies an equation for the federal funds rate target based on an estimated long-run real interest rate the current deviation from the Fed’s inflation goal the gap between actual real GDP and a measure of potential real GDP

77. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-77 Appendix E: Increasing the Money Supply According to the Keynesian approach, increasing the money supply: –Pushes interest rates down –Increases the level of investment spending –Causes real GDP to rise, which in turn causes real consumption to rise –Real GDP rises further (multiplier effect)

78. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-78 Figure E-1 An Increase in the Money Supply

79. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-79 Appendix E: Decreasing the Money Supply According to the Keynesian approach, decreasing the money supply: –Pushes interest rates up –Decreases the level of investment spending –Causes real GDP to fall, which in turn causes real consumption to fall –Real GDP falls further (multiplier effect)

80. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 16-80 Appendix E: Arguments Against Monetary Policy Many traditional Keynesians argue that monetary policy is likely to be relatively ineffective as a recession fighter because: –During recessions, people try to build up as much as they can in liquid assets to protect themselves from risks of unemployment and other losses of income –An increase in the money supply does not reduce interest rate as individuals are willing to allow most of it to accumulate in their bank accounts, preventing interest rates from falling