1 of 38 Chapter 15: Monetary Policy

2 of 38 Chapter 15: Monetary Policy CHAPTER 15 Monetary Policy Beginning in 2008, the Fed was forced to turn to new policies to try to pull the economy out of recession. Fernando Quijano Prepared by:

3 of 38 Chapter 15: Monetary Policy CHAPTER What is Monetary policy? Define monetary policy and describe the Federal Reserve’s monetary policy goals. 15.2The Money Market and the Fed’s Choice Of Monetary Policy Targets Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate. 15.3Monetary Policy and Economic Activity Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level. 15.6Fed Policies During the 2007–2009 Recession Discuss the policies the Federal Reserve used during the 2007–2009 recession. Chapter Outline and Learning Objectives Monetary Policy

4 of 38 Chapter 15: Monetary Policy edition The Impact of Monetary Policy: A Brief Historical Background

5 of 38 Chapter 15: Monetary Policy Impact of Monetary Policy A brief historical background: –The Keynesian view dominated during the 1950s and 1960s. Keynesians argued that money supply did not matter much. –Monetarists challenged the Keynesian view during the 1960s and 1970s. Monetarists argued that changes in the money supply caused both inflation and economic instability. –While minor disagreements remain, the modern view emerged from this debate. Modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy. The following slides present this modern view.

6 of 38 Chapter 15: Monetary Policy The Federal Reserve System

7 of 38 Chapter 15: Monetary Policy The Public: Households & businesses Commercial Banks Savings & Loans Credit Unions Mutual Savings Banks The Federal Reserve System The Fed is the central bank of the U.S., responsible for the conduct of monetary policy. The Fed is a ‘banker’s bank.’ The Board of Governors of the Federal Reserve is at the center of the banking system in the U.S. The board sets all the rates and regulations for all depository institutions. The seven members of the Board of Governors also serve on the Federal Open Market Committee The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities. Federal Reserve Board of Governors 7 members appointed by the president, with the consent of the U.S. Senate 12 Federal Reserve District Banks (25 branches) Open Market Committee Board of Governors & 5 Federal Reserve Bank Presidents (alternating terms, New York Bank always represented).

8 of 38 Chapter 15: Monetary Policy Philadelphia 3 San Francisco 12 1 Boston 4 Cleveland 9 Minneapolis 11 Dallas Washington, D.C. (Board of Governors) 10 Kansas City 7 Chicago 5 Richmond 2 New York Atlanta 6 St. Louis 8 The Federal Reserve Districts The map indicates the 12 Federal Reserve districts and the cities in which the district banks are located. Each district bank monitors the commercial banks in their region and assists them with the clearing of checks. The Board of Governors of the Federal Reserve System is located in Washington D.C.

9 of 38 Chapter 15: Monetary Policy What Is Monetary Policy? Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals. 1.Promote economic growth by increasing real GDP 2.Low and stable inflation 3.Low unemployment rates 4. Stable financial markets The Goals of Monetary Policy The Fed has four main monetary policy goals that are intended to promote a well-functioning economy: Define monetary policy and describe the Federal Reserve’s monetary policy goals LEARNING OBJECTIVE

10 of 38 Chapter 15: Monetary Policy What Is Monetary Policy? Price Stability Figure 15-1 The Inflation Rate, January 1952–July 2009 The Goals of Monetary Policy For most of the 1950s and 1960s, the inflation rate in the United States was 4 percent or less. During the 1970s, the inflation rate increased, peaking during 1979–1981, when it averaged more than 10 percent. After 1992 the inflation rate was usually less than 4 percent, until increases in oil prices pushed it above 5 percent during summer The effects of the recession caused several months of deflation—a falling price level—during early Note: The inflation rate is measured as the percentage change in the consumer price index (CPI) from the same month in the previous year. Define monetary policy and describe the Federal Reserve’s monetary policy goals LEARNING OBJECTIVE

11 of 38 Chapter 15: Monetary Policy The 3 Tools the Fed Uses to Control the Money Supply: 1)Change Banks’ Reserve Requirement 2)Change the Discount rate 3)Open Market Securities (buying or selling securities)

12 of 38 Chapter 15: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets Monetary Policy Targets 1)Money supply 2)Interest rates Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

13 of 38 Chapter 15: Monetary Policy The Fed Moves Interest Rates

14 of 38 Chapter 15: Monetary Policy The Demand for Money 15.2 LEARNING OBJECTIVE

15 of 38 Chapter 15: Monetary Policy Shifts in the Money Demand Curve 15.2 LEARNING OBJECTIVE

16 of 38 Chapter 15: Monetary Policy How the Fed Manages the Money Supply: A Quick Review Equilibrium in the Money Market The Impact on the Interest Rate When the Fed Increases the Money Supply 15.2 LEARNING OBJECTIVE

17 of 38 Chapter 15: Monetary Policy The Impact on Interest Rates When the Fed Decreases the Money Supply Equilibrium in the Money Market 15.2 LEARNING OBJECTIVE

18 of 38 Chapter 15: Monetary Policy Choosing a Monetary Policy Target There are many different interest rates in the economy LEARNING OBJECTIVE

19 of 38 Chapter 15: Monetary Policy The Importance of the Federal Funds Rate Federal Funds Rate Targeting, January 1998– July LEARNING OBJECTIVE

20 of 38 Chapter 15: Monetary Policy Consumption Investment Spending Net Exports How Interest Rates Affect Aggregate Demand Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand : 15.3 LEARNING OBJECTIVE

21 of 38 Chapter 15: Monetary Policy Expansionary monetary policy The Effects of Monetary Policy on Real GDP and the Price Level Contractionary monetary policy 15.3 LEARNING OBJECTIVE

22 of 38 Chapter 15: Monetary Policy edition How Does Monetary Policy Affect the Economy?

23 of 38 Chapter 15: Monetary Policy The Effects of Monetary Policy on Real GDP and the Price Level 15.3 LEARNING OBJECTIVE

24 of 38 Chapter 15: Monetary Policy (increased net exports) and … an increase in the general level of asset prices … (and with the increased personal wealth) increased investment & consumption. Here, a shift to an expansionary monetary policy is shown. The Fed buys bonds (expanding the money supply) … which increases bank reserves … Transmission of Monetary Policy pushing real interest rates down … leading to increased investment and consumption … a depreciation of the dollar … So, an unanticipated shift to a more expansionary monetary policy will stimulate AD and, thereby, increase both output and employment. Fed buys bonds Real interest rates fall Increases in investment & consumption Depreciation of the dollar Increase in asset prices Increases in investment & consumption Net exports rise Increase in aggregate demand This increases money supply and bank reserves

25 of 38 Chapter 15: Monetary Policy Too Low for Zero: The Fed Tries "Quantitative Easing” The Fed pushed interest rates to very low levels during 2008 and LEARNING OBJECTIVE

26 of 38 Chapter 15: Monetary Policy A Shift to More Restrictive Monetary Policy Suppose the Fed shifts to a more restrictive monetary policy. Typically it will do so by selling bonds which will: –depress bond prices and –drain reserves from the banking system, –which places upward pressure on real interest rates. As a result, an unanticipated shift to a more restrictive monetary policy reduces aggregate demand and thereby decreases both output and employment.

27 of 38 Chapter 15: Monetary Policy Shifts in Monetary Policy and Economic Stability If a change in monetary policy is timed poorly, it can be a source of instability. –It can cause either recession or inflation. Proper timing of monetary policy: –If expansionary effects occur during a recession and restrictive effects during an inflationary boom, the impact would be stabilizing. –However, if expansionary effects occur when an economy is already at or beyond full employment and restrictive effects occur when an economy is in a recession, the impact would be destabilizing.

28 of 38 Chapter 15: Monetary Policy Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? The Fed Can’t Target Both the Money Supply and the Interest Rate 15.5 LEARNING OBJECTIVE

29 of 38 Chapter 15: Monetary Policy edition Fed Policies During the 2007 – 2009 Recession

30 of 38 Chapter 15: Monetary Policy Fed Policies During the Recession The Inflation and Deflation of the Housing Market “Bubble” Figure The Housing Bubble Sales of new homes in the United States went on a roller-coaster ride, rising by 60 percent between January 2000 and July 2005, before falling by 76 percent between July 2005 and January LEARNING OBJECTIVE

31 of 38 Chapter 15: Monetary Policy Fed Policies During the Recession The Changing Mortgage Market The Role of Investment Banks Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors through Fannie Mae and Freddie Mac to banks and, ultimately, to individuals and families borrowing money to buy houses. By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury.

32 of 38 Chapter 15: Monetary Policy YOUR TURN: Test your understanding by doing related problem 6.8 at the end of this chapter. Making the Connection The Wonderful World of Leverage Making a very small down payment on a home mortgage leaves a buyer vulnerable to falling house prices. RETURN ON YOUR INVESTMENT FROM... DOWN PAYMENT A 10 PERCENT INCREASE IN THE PRICE OF YOUR HOUSE A 10 PERCENT DECREASE IN THE PRICE OF YOUR HOUSE 100% 10% -10% Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE During the housing boom, many people purchased houses with down payments of 5 percent or less. In this sense, borrowers were highly leveraged, which means that their investment in their house was made mostly with borrowed money.

33 of 38 Chapter 15: Monetary Policy The Fed and the Treasury Department Respond Initial Fed and Treasury Actions Fed Policies During the Recession Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE First, although the Fed traditionally made loans only to commercial banks, in March 2008 it announced the Primary Dealer Credit Facility, under which primary dealers—firms that participate in regular open market transactions with the Fed—are eligible for discount loans. Second, also in March, the Fed announced the Term Securities Lending Facility, under which the Fed will loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities. Third, once again in March, the Fed and the Treasury helped JPMorgan Chase acquire the investment bank Bear Stearns, which was on the edge of failing. Finally, in early September, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac.

34 of 38 Chapter 15: Monetary Policy The Fed and Treasury Department Respond Responses to the Failure of Lehmann Brothers Fed Policies During the Recession Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock. Taking partial ownership positions in private commercial banks was an unprecedented action for the federal government. Clearly, the recession of 2007–2009, and the accompanying financial crisis, had led the Fed and the Treasury to implement new approaches to policy. Many of these new approaches were controversial because they involved partial government ownership of financial firms, implicit guarantees to large financial firms that they would not be allowed to go bankrupt, and unprecedented intervention in financial markets.

35 of 38 Chapter 15: Monetary Policy ECB Chief Says Boost in Stimulus Not Needed The European Central Bank’s monetary policy has been less aggressive than the Federal Reserve’s. Housing Market Affects the United States and Europe Differently AN INSIDE LOOK >>

36 of 38 Chapter 15: Monetary Policy Practice Questions 1) An increase in the interest rate A) decreases the opportunity cost of holding money. B) increases the opportunity cost of holding money. C) shifts the money demand curve left. D) shifts the money demand curve right. 2) For purposes of monetary policy, the Federal Reserve has targeted the interest rate known as the A) federal funds rate. B) Treasury bill rate. C) discount rate. D) prime rate. Answers: 1) B) 2) A)

37 of 38 Chapter 15: Monetary Policy In-Class Assignment X 1)When the U.S. economy is experiencing a recession the Federal Reserve will conduct ____________ monetary policy. a) contractionary b) expansionary 2) When there is fear of rising inflation in the U.S. the Federal Reserve will conduct _____________ monetary policy. a) contractionary b) expansionary Answers: 1) b) expansionary 2) a) contractionary