Monetary Policy

Monetary Policy The Federal Reserve’s control over the supply of money is the key mechanism to monetary policy. Monetary policy is the use of money and credit controls to influence macroeconomic activity.

Monetary Policy DETERMINANTS OUTCOMES Jobs Internal market AS forces Output Jobs Prices Growth International balances Internal market forces External shocks AD AS Policy levers: Fiscal policy Monetary policy

The Federal Reserve System Control of the U.S. money supply starts with the Federal Reserve System (the Fed).

Federal Reserve Banks The core of the Federal Reserve system consists of 12 Federal Reserve banks.

Functions of Regional Fed Banks Clear checks between private banks Hold bank reserves Provide currency Provide loans (discounting)

The Board of Governors Key decision-maker for monetary policy. Seven members appointed by President of U.S. for 14 year terms.

Structure of the Federal Reserve System Private banks (depository institutions) Federal Reserve banks (12 banks, 24 branches) Board of Governors (7 members)

The Federal Chairman Most visible member of the Fed system. Selected by the President for a four year term — can be re-appointed.

The Federal Chairman Alan Greenspan was appointed by President Reagan, re-appointed by Presidents Bush, Clinton, and Bush.

Monetary Tools The Fed has the power to alter the money supply. The money supply (M1) consists of currency held by the public, plus balances in transaction accounts.

Monetary Tools The Fed has three basic tools of monetary policy: Reserve requirements Discount rates Open-market operations

Reserve Requirements The Fed directly alters the lending capacity of the banking system by changing the reserve requirement. Required reserves are the minimum amount of reserves a bank is required to hold by government regulation.

Reserve Requirements The ability of the banking system to create deposits is determined by the money multiplier and the amount of excess reserves.

Reserve Requirements A decrease in required reserves increases excess reserves.

Reserve Requirements Excess reserves are bank reserves in excess of required reserves.

A Decrease in Required Reserves A change in the reserve requirement causes: A change in excess reserves. A change in the money multiplier.

A Decrease in Required Reserves A lower reserve requirement increases the size of the money multiplier. The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

A Decrease in Required Reserves A lower reserve requirement increases the size of the money multiplier. Money multiplier = 1 required reserve ratio

The Impact of Reduced Reserve Requirement

The Discount Rate Discounting is Federal Reserve lending of reserves to private banks. The discount rate is the rate of interest charged by Federal Reserve banks for lending reserves to private bank.

The Discount Rate Sometimes banks reserves run low and they must replenish their reserves temporarily.

The Discount Rate There are three sources of last-minute reserves: Fed funds market – borrow from a reserve-rich bank. Sell securities. Discounting – obtaining reserve credits from the Federal Reserve System.

The Discount Rate By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

Open-Market Operations Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

Open-Market Operations Open-market operations are designed to affect portfolio decisions and the decision to hold money or bonds.

Portfolio Decisions Where should idle funds be held – in cash or some other asset?

Hold Money or Bonds The Fed attempts to influence whether individuals hold idle funds in transaction accounts or government bonds. Changes in bond prices alter portfolio choices.

Open Market Activity Open market operations — the Federal Reserve purchases and sells government bonds to alter bank reserves. Fed buys bonds — it increases bank reserves. Fed sells bonds — it reduces bank reserves.

An Open-Market Purchase Federal Open Market Committee Regional Federal Reserve bank Private bank Public Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check Step 3: Bank deposits check at Fed bank, as a reserve credit Step 2: Bond seller deposits Fed check

Powerful Levers To summarize, there are three policy levers of monetary policy: Reserve requirements Discount rates Open-market operations

Powerful Levers The Fed has effective control of the nation’s money supply.

Shifting Aggregate Demand The ultimate goal of all macro policy is to stabilize the economy at its full-employment capacity. Monetary policy may be used to shift aggregate demand.

Shifting Aggregate Demand Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Expansionary Policy Monetary policy can be used to move the economy to its full-employment potential.

Expansionary Policy The Fed can increase AD by increasing the money supply by: Lowering reserve requirements. Dropping the discount rate. Buying more bonds to increase bank lending capacity.

Expansionary Policy Banks make more loans so AD shifts to the right reflecting increased purchasing power.

Demand-Side Focus AS E2 E1 AD2 AD1 Q1 QF PRICE LEVEL (average price) RATE OF OUTPUT (real GNP per time period) PRICE LEVEL (average price) AS E2 E1 AD2 AD1 Q1 QF

Restrictive Policy Monetary policy can be used to cool an overheating economy.

Restrictive Policy Fed can reduce money supply and decrease AD by: Raising reserve requirements Increasing discount rate Selling bonds

Price vs. Output Effects The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

Aggregate Demand Increases in the money supply shift AD to the right.

Aggregate Supply Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

Aggregate Supply The shape of the AS curve determines the effectiveness of expansionary monetary policy.

Aggregate Supply Horizontal AS — output increases without any inflation. Vertical AS — inflation occurs without changing output. Upward sloped AS — both prices and output are affected by monetary policy.

Aggregate Supply With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

Contrasting Views of Aggregate Supply (a) The Keynesian view RATE OF OUTPUT (real GDP per time period) (average price per unit of output) PRICE LEVEL Aggregate supply P3 P1 AD3 AD2 AD1 Q1 QF

Contrasting Views of Aggregate Supply (b) The Monetarist view Aggregate supply (average price per unit of output) PRICE LEVEL P5 P4 AD5 AD4 QN RATE OF OUTPUT (real GDP per time period)

Contrasting Views of Aggregate Supply (c) An eclectic view Aggregate supply (average price per unit of output) PRICE LEVEL P7 P6 AD7 AD6 Q6 Q7 RATE OF OUTPUT (real GDP per time period)

Policy Perspectives The shape of the aggregate supply curve spotlights a central policy debate.

Fixed Rules or Discretion? Should the Fed try to fine-tune the economy with constant adjustments of the money supply?

Fixed Rules or Discretion? Or should the Fed instead simply keep the money supply growing at a steady pace?

Discretionary Policy The economy is constantly beset by expansionary and recessionary forces. There is a need for continual adjustments to money supply.

Fixed Rules Critics of discretionary monetary raise objections linked to the shape of the AS curve. AS curve could be vertical or at least upward sloping.

Fixed Rules With an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.

Fixed Rules Fixed rules for money-supply management are less prone to error than discretionary policy.

Fixed Rules The money supply should increase by a constant (fixed) rate each year.

The Fed’s Eclecticism The Fed currently uses a pragmatic, eclectic approach. Flexible rules Limited discretion

The Fed’s Eclecticism Mixes money-supply and interest-rate adjustments to do whatever is necessary to promote price stability and economic growth.

Monetary Policy End of Chapter 14