Monetary Policy zThis chapter looks at Monetary Policy, the most frequent use of policy to correct the economy. zMonetary Policy -- The Federal Reserve changing bank loaning conditions to affect the supply of financial capital, investment, and aggregate demand.

The Federal Reserve (1913) zOriginal Roles -- Provider of Discount Window -- “Lender of Last Resort” -- Regulate Banks (e.g. Reserve Ratios) zManages Monetary Policy

Structure of the Federal Reserve

Board of Governors (BOG) z7 members zappointed by the President, with the consent of the Senate zonce approved, independent of the President zImportant Chairs of the BOG -- Paul Volcker Alan Greenspan

The Federal Open Market Committee (FOMC) z12 voting members -- 7 Board of Governors + 5 District Bank Presidents zmeet 8 times per year (more, if needed) zdesigns monetary policy, by specifying Federal Funds rate target.

Federal Reserve District Banks zEach private bank exists within one of 12 districts within the US. zEach district has a Federal Reserve District Bank.

District Banks -- Administer Monetary Policy zconducts Discount Loans with banks within district zenforces reserve requirements for banks within district zholds reserves of banks within district

The Basic Strategy of Monetary Policy zExpansionary (Y* < Y F ) -- Federal Reserve seeks to increase the supply of financial capital by encouraging bank loaning. zContractionary (Y* > Y F ) -- Federal Reserve seeks to decrease the supply of financial capital by discouraging bank loaning.

Monetary Policy Tools zInstruments that initiate monetary policy (1) The Discount Rate (2) Reserve Ratio (3) Open Market Operations

Changing The Discount Rate zThe Discount Rate -- the rate of interest charged to banks that borrow from the Federal Reserve. zExpansionary -- Fed lowers discount rate. zContractionary -- Fed raises discount rate.

Changing the Reserve Ratio zDesigned to change the amount of required reserves. zExpansionary Policy -- Fed lowers the reserve ratio. zContractionary Policy -- Fed raises the reserve ratio.

Open Market Operations zOpen Market Operations -- the buying or selling of bonds by the Federal Reserve in the open market (the Fed’s predominant policy tool). zExpansionary -- Fed buys bonds (gives banks new reserves) zContractionary -- Fed sells bonds (drains reserves from banks)

Open Market Operations: An Example zExample -- Federal Reserve buys a $1000 bond from Chase. Chase  B -$1000  R +$1000 zChase can make a new loan -- start the loaning process (increasing the supply of financial capital).

The Federal Funds Rate zThe Federal Funds Rate (i FF ) -- the market determined interest rate paid by one bank to borrow reserves from another bank. zThe cost to banks of obtaining reserves “in the market”. zThe “thermostat” of monetary policy -- changes in target prompt open market operations.

The Market For Bank Reserves zDemand for Reserves -- Banks wishing to borrow reserves in the Federal Funds market, in response to loan opportunities. zDemand curve downward sloping when plotted against the Federal Funds rate (i FF ).

zSupply of Reserves -- Banks offering reserves to the Federal Funds market + the Federal Reserve changing bank reserves using open market operations. zSupply curve upward sloping when plotted against the Federal Funds rate (i FF ).

Equilibrium in the Market for Bank Reserves zMarket for Bank Reserves determines an equilibrium Federal Funds rate (i FF *). zWhen FOMC changes its target Federal Funds rate for monetary policy purposes, it shifts the supply of reserves curve so that the new equilibrium i FF equals its desired target rate.

The Process of Monetary Policy -- Expansionary zThe FOMC lowers the target Federal Funds Rate. zTo achieve this target, the Fed buys bonds from banks, supplying more reserves to the system. zGreater reserves implies an increase in the supply of financial capital, shifting the supply of capital curve rightward.

zThe Fed does this until the new equilibrium i FF equals its newly set target rate. zThe shift in the supply of financial capital implies that Investment (I*) increases and the interest rate (r*) decreases. zThe increase in I* shifts the AD curve rightward, increasing Y* and P*.

The Process of Monetary Policy -- Contractionary zThe FOMC raises the target Federal Funds Rate. zTo achieve the FOMC’s new target, the Fed sells bonds to banks, thereby removing reserves from the system. zThe Fed does this until the equilibrium i FF equals its target.

zLess reserves implies a decrease in the supply of financial capital, shifting the supply of capital curve leftward. zAs a result, Investment (I*) decreases and the interest rate (r*) increases. zThe decrease in I* shifts the AD curve leftward, decreasing Y* and P*.

Monetary Policy and the Short-Run Perspective zMonetary policy is interventionist – believes that the short-run is the relevant period. zIn formal terms, policy works with the AD and AS curves. zLong-run perspective (AD and LAS curves) – no need for monetary policy “medicine”, economy will cure itself.

Obstacles to Monetary Policy Effectiveness zWhen does monetary policy have difficulty in changing Y* to improve the economy? zParticularly applies to expansionary monetary policy -- getting the economy out of sluggishness or recession.

Two Potential Obstacles zBanks don’t want to loan the added reserves (pessimism about prospects of loan default or fears of inflation). zFirms and consumers don’t want to borrow the funds (pessimism about state of economy).

The Volcker Recession: Ending a Wage-Price Spiral z1970s in US -- Wage-Price Spiral zStarted as overly expansionary government and monetary policies of the 1960s, with progressively higher wage increases. zContinued in late 1970s as expansionary monetary responses to increase in price of energy. Continued high wage increases.

The Volcker Recession of zVery contractionary monetary policy (i FF over 17%) -- Supply of financial capital decreases, I* falls, AD curve shifts leftward. zHigh nominal wage increases continue, big leftward shift in AS curve. zMajor recession, lower inflation eventually eases inflation fears.

The Volcker Recession and Recovery zConvinced of Federal Reserve’s intent to solve inflation problem, lower wage increases occur, smaller leftward shifts in AS curve. zFederal Reserve gradually practices cautious expansionary monetary policy, shifts AD curve rightward, Y* returns to Y F.

Monetary Policy in the Greenspan Era z recession -- similar to Volcker, but on a smaller scale. z“Soft Landing” strategy in 1990s -- small monetary policy changes designed not to arouse inflation fears, overly large wage increases. zContractionary in 2000 (Y* > Y F ), zIn 2001, has experienced difficulty in expanding economy back to Y F.