MONETARY POLICY AND THE DEBATE ABOUT MONETARY POLICY Chapter 28 MONETARY POLICY AND THE DEBATE ABOUT MONETARY POLICY

Today’s lecture will: Summarize the structure and duties of the Fed. Explain the three tools of monetary policy. Define the Federal funds rate and discuss how the Fed uses it as an intermediate target. Explain the Taylor rule and its relevance to monetary policy. Demonstrate how monetary policy works in the AS/AD model. Discuss six problems often encountered in conducting monetary policy.

Monetary Policy Price Level Expan-sionary Contrac-tionary SAS P1 P0 AD1 P2 AD0 AD2 Y2 Y0 Y1 Real output

Monetary Policy and the AS/AD Model Monetary policy, controlled by the Fed, influences the economy through changes in the money supply and credit availability. Expansionary monetary policy shifts the AD curve to the right. Contractionary monetary policy shifts the AD curve to the left.

Expansionary Policy Beyond Potential Output LAS Price Level SAS1 B P1 SAS0 A AD1 P0 AD0 YP Real output

Monetary Policy and the AD/AS Model Expansionary monetary policy increases nominal income. Its effect on real income depends on where the economy is in relation to potential output and how the price level responds. %ΔReal Income = % ΔNominal Income - % ΔPrice Level

Central Banks A central bank conducts monetary policy and acts as a financial adviser to the government. Central bank – a type of bankers’ bank. The central bank’s ability to create money gives it the power to control the money supply.

Structure of the Fed Board of Governors of the Federal Reserve System 7 members appointed by the president and confirmed Chairman and vice chairman designated by the president and confirmed by the Senate Regional Reserve Banks and Branches 12 regional Federal Reserve banks 25 branches of Federal Reserve banks Oversees Federal Open Market Committee 7 members of the Board of Governors 5 Federal Reserve bank presidents Chief policymaking body of the Federal Reserve System Open market operations Provides services Financial institutions Federal government

Structure of the Fed The Fed is a semiautonomous organization composed of 12 regional banks. The Fed has much more independence than most government agencies. The Fed does not rely on Congress for appropriations. Its governors serve 14 year terms and cannot be reappointed.

Federal Reserve Districts San Francisco Kansas City Minneapolis Chicago . Boston Richmond Atlanta St. Louis *Alaska and Hawaii are under the jurisdiction of the Federal Reserve Bank of San Francisco Dallas New York Philadelphia Cleveland Washington DC

Duties of the Fed Conducts monetary policy Supervises and regulates financial institutions Lender of last resort to financial institutions Provides banking services to the U.S. government Issues coin and currency Provides financial services such as check clearing to commercial banks, savings and loan associations, savings banks, and credit unions.

The Importance of Monetary Policy The Federal Open Market Committee (FOMC) makes actual monetary policy decisions. The FOMC is composed of: The 7 members of the Board of Governors The president of the New York Fed A rotating group of 4 of the presidents of the other regional banks

The Conduct of Monetary Policy The Fed influences the amount of money in the economy by controlling the monetary base. Monetary base – vault cash, deposits of the Fed, and currency in circulation. Reserves – vault cash or deposits at the Fed Monetary policy affects the amount of reserves in the banking system. Reserves and interest rates are inversely related.

Tools of Monetary Policy Changing the reserve requirement Changing the discount rate Executing open market operations (buying and selling government securities) and thereby affecting the Federal funds rate

Changing the Reserve Requirement The reserve requirement is the percentage the Fed sets as the minimum amount of reserves a bank must have. The amount banks keep in reserve for checking accounts (demand deposits) depend on: The reserve requirement How much they think they need for customer withdrawals

Changing the Reserve Requirement Banks hold as little in reserves as possible since they earn no interest on them. In the late 2000s, the reserve requirement for demand deposits was around 10%. The Fed can increase the money supply by decreasing the reserve requirement, which increases the money multiplier. The Fed can decrease the money supply by increasing the reserve requirement, which decreases the money multiplier.

Changing the Reserve Requirement The approximate real-world money multiplier in the economy is: r = the percentage of deposits banks hold in reserve, around 10% c = the ratio of money people hold in cash to the money they hold as deposits, around 40%

Changing the Reserve Requirement If there is a shortage of reserves a bank can: Borrow reserves from another bank in the Federal funds market Stop making new loans and keep the proceeds of loans that are paid off as reserves Sell Treasury bonds

Changing the Discount Rate In case of a shortage, a bank can borrow reserves directly from the Fed. The discount rate is the interest rate the Fed charges for those loans it makes to banks. An increase in the discount rate makes it more expensive to borrow from the Fed and may decrease reserves and the money supply. A decrease in the discount rate makes it less expensive for banks to borrow from the Fed and may increase reserves and the money supply.

Open Market Operations Changes in the discount rate and reserve requirement are used for major changes. For day-to-day operations the Fed uses open market operations – the Fed’s buying and selling government securities. To expand the money supply, the Fed buys bonds. To decrease the money supply, the Fed sells bonds.

An Open Market Purchase An open market purchase is expansionary monetary policy that tends to reduce interest rates and increase income. When the Fed buys bonds, it deposits money in federal government accounts at banks. Bank reserves increase, and when banks loan out the excess reserves, the money supply increases.

An Open Market Sale An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income. When the Fed sells bonds, it receives checks drawn against banks. The bank’s reserves are reduced and the money supply decreases.

An Open Market Purchase, Bond Price, and Interest Rates Price of a bond Quantity of bonds S When the Fed buys bonds, the demand for bonds increases, the price of bonds increases, and interest rates fall. B A D1 D0

An Open Market Sale, Bond Prices, and Interest Rates Price of a bond Quantity of bonds S0 S1 When the Fed sells bonds, the supply increases and the price of bonds decreases, and interest rates increase. A C D0

The Fed Funds Market Bankers with surplus reserves can lend them overnight to banks with a reserve shortage in the Fed funds market. Fed funds – loans of reserves banks make to each other. Fed funds rate – the interest rate banks charge each other for Fed funds. By selling (buying) bonds, the Fed decreases (increases) reserves, causing the Fed funds rate to increase (decrease).

The Fed Funds Rate and the Discount Rate since 1990

Offensive and Defensive Actions Defensive actions are designed to maintain the current monetary policy. The Fed buys bonds during emergencies such as storms. Reserves would otherwise decrease because individuals and businesses don’t get to the bank with their cash. Offensive actions are designed to have expansionary or contractionary effects on the economy.

The Fed Funds Rate as an Operating Target The Fed looks at the Federal funds rate and other targets to determine whether monetary policy is tight or loose. If the Fed funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate. If the Fed funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate.

The Complex Nature of Monetary Policy The Fed’s ultimate target is price stability, acceptable employment, sustainable growth, and moderate long-term interest rates. These targets are indirectly affected by changes in the Fed funds rate. The Fed watches intermediate targets to measure progress on its ultimate goals.

The Complex Nature of Monetary Policy Fed tools Operating target Open market operations Discount rate Reserve requirement Fed funds Intermediate targets Ultimate targets Consumer confidence Stock prices Interest rate spreads Housing starts Stable prices Sustainable growth Acceptable employment Moderate long-term interest rates

The Taylor Rule The Taylor rule is a useful approximation for predicting Fed policy. Fed funds rate = 2% + Current inflation +0.5 x (actual inflation less desired inflation) +0.5 x (percent deviation of aggregate output from potential)

Fed Response to September 11 In defensive actions, the Fed: Doubled its holdings of repurchase agreements Increased discount window lending Established “swap lines” with foreign banks to temporarily exchange currencies to ensure foreign currency liquidity In offensive actions the Fed bought bonds to reduce the Fed funds rate.

Contractionary Monetary Policy in the AS/AD Model Real output Price level Y1 P1 P0 Y0 AD0 AD1 M i I Y Short-run aggregate supply

Expansionary Monetary Policy Price level P1 P0 AD1 AD0 Y0 Y1 Real output

Monetary Policy in the Circular Flow Expansionary monetary policy tries to expand the economy by channeling more saving into investment. Contractionary monetary policy tries to reduce inflationary pressures by restricting demand for consumer loans and investment,

Monetary Policy in the Circular Flow Expenditures Consumptio Households Government expenditures fiscal policy Firms Exports Imports Consumption Monetary policy Financial sector borrowing Taxes Savings Investment Wages, rents, interest, profits

Emphasis on the Interest Rate A rising interest rate indicates a tightening of monetary policy. A falling interest rate indicates a loosening of monetary policy. There is a problem in using interest rates as an indication of monetary policy because of the difference in real and nominal interest rates.

Real and Nominal Interest Rates Nominal interest rate = Real interest rate + Expected inflation rate The real interest rate cannot be observed since it depends on expected inflation, which cannot be directly observed. Making a distinction between nominal and real rates adds another uncertainty to the effect of monetary policy. If expansionary policy leads to expectations of increased inflation, nominal rates will increase and leave real rates unchanged.

Real and Nominal Interest Rates and Monetary Policy Most economists believe that a monetary regime, not a monetary policy, is the best approach to policy. A monetary regime is a predetermined statement of the policy that will be followed in various situations. A monetary policy is a policy response to events which is chosen without a predetermined framework.

Problems in the Conduct of Monetary Policy Knowing what policy to use The potential level of income must be known in order to determine whether to use expansionary or contractionary policy. Understanding the policy you’re using Since the amount of cash people want to hold and bank lending processes vary, the money multiplier is not stable. If interest rates increase, it could be due to expected inflation or because the real interest rate has increased.

Problems in the Conduct of Monetary Policy Lags in monetary policy The Fed must recognize the problem. Then it must develop a consensus for action. Then businesses and individuals have to react to the policy. Liquidity trap – a situation in which increasing reserves does not increase the money supply, but simply leads to excess reserves. Low interest rates do not necessarily mean that people will go out and borrow money.

Problems in the Conduct of Monetary Policy Political pressure The Fed is not totally insulated from political pressure. Presidents place great pressure on the Fed to use expansionary policy, especially in an election year. Conflicting international goals Monetary policy should be coordinated with other nations.

Summary Monetary policy influences the economy through changes in the banking system’s reserves that affect the money supply and credit availability. The Fed is the central bank of the U.S; it conducts monetary policy and regulates financial institutions. The tools of monetary policy are: Changing reserve requirements Changing the discount rate Open market operations

Summary A change in reserves changes the money supply by the change in reserves times the money multiplier. Open market operations are the Fed’s most important policy tool. To expand the money supply, the Fed buys bonds, which increases their price and decreases interest rates. To decrease the money supply, the Fed sells bonds, which decreases their price and increases interest rates.

Summary The Taylor rule states: Set the Fed funds rate at 2 plus current inflation plus half the difference between actual and desired inflation plus half the percent difference between actual and potential output. Contractionary monetary policy works as follows: Expansionary monetary policy works as follows:

Summary The interest rate is an indication of the direction of monetary policy. A higher (lower) interest rate indicates contractionary (expansionary) policy. Because monetary policy can affect inflation expectations as well as nominal interest rates, the effect of monetary policy on interest rates can be uncertain. This uncertainty has led the Fed to follow monetary regimes.

Summary Problems of monetary policy are: Knowing what policy to use Understanding the policy you are using Lags Liquidity traps Political pressure Conflicting international goals

Review Question 28-1 Suppose that the Fed needs to conduct expansionary policy. Explain how it would use each of its three policy tools. The Fed should decrease reserve requirements, decrease the discount rate, and/or buy government bonds in open market operations. Review Question 28-2 Explain how expansionary policy works in the AS/AD model. For an expansionary policy, the Fed would increase the money supply by buying government bonds or lowering the reserve requirement or the discount rate. An increased money supply will decrease the interest rate, which will increase investment and equilibrium income.