Managing Aggregate Demand: Monetary Policy Chapter 13 Managing Aggregate Demand: Monetary Policy Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it meant. But they knew that it was an act of extreme wisdom. JOHN KENNETH GALBRAITH

Outline Fed as a central bank Monetary policy Tools Mechanism

Money and Income: Difference At one point in time (stock) E.g.: money stock (M1) Income Over a period of time (flow) E.g.: nominal GDP per year

The Federal Reserve System

The Federal Reserve System The Federal Reserve System, “The Fed” U.S. central bank Bank for banks Origins 1873-1907: four severe banking panics Established in 1914 by the Congress to regulate commercial banks Discussion: Why do we need a central bank?

Dow-Jones Industrial Average

Bank Run on Wall Street, 1907

The Federal Reserve System Organization of the Fed Board of Governors FOMC 12 Regional Banks Member Banks

The Federal Reserve System Board of Governors (7 members) Main governing body of the Fed Appointed by U.S. President Chairman (4-year term) Advice & consent of Senate 14-year term Oversees System operations, makes regulatory decisions, and sets reserve requirements

The Federal Reserve System The Fed has 12 regional banks Each independently incorporated with a 9-member board of directors Set discount rate, subject to approval by Board of Governors Monitor economy and financial institutions in their districts and provide financial services to the U.S. government and depository institutions

The Federal Reserve System Federal Open Market Committee (FOMC) 12 members 7 governors of the Fed President of the Fed – New York 4 (of 11) district banks presidents on a rotating basis Meet eight times a year in DC Determine short-term interest rates (FFR) Size of U.S. money supply

FOMC Meeting

The Federal Reserve System 3400 member banks Private banks Hold stock in their local Federal Reserve Bank Elect six of the nine members of Reserve Banks’ boards of directors

The Federal Reserve System Central bank independence Make decisions without political interference (without prior approval from Congress or the President) Institutional arrangement guarantees the independence Unique structure provides internal checks and balances, not dominated by one part of the system Help control inflation Discussion: Why do we need CBI?

Central bank independence

Tools of Monetary Policy Open market operations Discount rate Reserve requirements

Implementing Monetary Policy Open-market operations (OMOs) Fed’s purchase / sale Short-term government securities (T-bills) Transactions: Open market The Fed uses OMOs to affect market interest rates Purchase: Treasury bills Pays: newly created bank reserves Put pressure on market interest rate The most frequently used tool

Implementing Monetary Policy Market for bank reserves Supply curve Determined by Federal Reserve policy Upward-sloping Demand curve Banks – required to hold reserves Reflects Demand for transaction deposits – banks Depends on real GDP & price level Downward-sloping (Why?)

Figure 1 The market for bank reserves S For given Fed policy Interest Rate D For given Fed policy E For given Y and P Quantity of Bank Reserves

Implementing Monetary Policy Market for bank reserves Federal funds rate (FFR) Interest rate Borrow/lend reserves among banks The Fed – lower federal funds rate Purchase T-bills Additional reserves to market Supply curve – shift outward Lower interest rates More bank reserves

Figure 2 The effects of an open-market purchase S0 S1 Interest Rate E D E A Quantity of Bank Reserves

Implementing Monetary Policy Federal Reserve Wants lower interest rates Purchases U.S. government securities In the open market Pays - creating new bank reserves Required reserve – no change Actual reserves – increased Excess reserves Multiple expansion process Increase money supply by 1/m times

Federal Reserve System Table 1 Effects of an open-market purchase of securities on the balance sheets of banks and the Fed Banks Assets Liabilities Federal Reserve System Assets Liabilities Reserves +$100 million U.S. government securities +$100 million Bank Reserves +$100 million U.S. government securities -$100 million Bank gets Reserves Addendum: Changes in Reserves Actual Reserves +$100 million Required Reserves No Change Excess Reserves Fed gets securities

Implementing Monetary Policy OMOs might not be perfect accurate People - hold cash Banks - hold excess reserves However, Fed can always achieve the FFR it wants FFR is observable in the open market every minute Fed can always adjust the volume of T-bills it needs to buy/sell OMOs is very flexible, fine tune policy

Implementing Monetary Policy Federal Reserve Wants to increase interest rates Sells U.S. government securities In the open market Banks pay: reserves (deposits at the Fed) Multiple contraction process Decrease money supply by 1/m times

Implementing Monetary Policy Another way to look at OMO (via bond market) Expansionary monetary policy Fed buys T-bills T-bill prices – increase Demand – unchanged Supply (available to private investors) Inward shift Interest rates – fall Interest rate = fixed dividend / bond price Bond price ↑ → interest rate ↓

Figure 3 Open-market purchases and treasury bill prices S1 S0 Price of a Treasury Bill S1 S0 D B P1 A P0 Quantity of Treasury Bills

Implementing Monetary Policy Summary of OMO: Open-market purchase-T-bills Raises the money supply Drives up T-bill prices Pushes interest rates down Open-market sale - T- bills Reduces the money supply Lowers T-bill prices Raises interest rates

Effective FFR

Nearly Zero FFR Discussion: In the current recession, Fed already set FFR close to zero. Does this mean the effect of OMOs is limited? What should Fed do if OMOs do not work?

Other Methods of Monetary Control The Fed – lender of last resort Lending to member banks Discount rate Interest rate charged by Fed for overnight loans that member banks borrow via “Discount Window” generally set at a rate close to 1% above the target FFR Discount rate – decrease Banks – borrow more Increase excess reserves

Federal Reserve System Table 2 Balance sheet changes for borrowing from the Fed Banks Assets Liabilities Federal Reserve System Assets Liabilities Reserves +$5 million Loan from Fed +$5 million Loan to Bank +$5 million Bank Reserves +$5 million Addendum: Changes in Reserves Actual Reserves +$5 million Required No Change Excess Reserves Bank borrows $5 million And the proceeds are credited to its reserve account

Other Methods of Monetary Control Minimum required reserve ratio (m) Decrease Increase excess reserves Money expansion Lower interest rates Increase Decrease excess reserves Money contraction Higher interest rates 10% since 1992

How Monetary Policy Works Expansionary monetary policy Open-market purchase Lower interest rates Contractionary monetary policy Open-market sale Raise interest rates

Expansionary Monetary Policy Contractionary Monetary Policy Figure 4 The effects of monetary policy on interest rates S0 S2 S1 S0 Interest Rate D Interest Rate D E B A E Bank Reserves Bank Reserves (a) Expansionary Monetary Policy (b) Contractionary Monetary Policy

How Monetary Policy Works Sensitive to monetary policy Investment (depends on r) Net exports (via exchange rate, Chp. 18) AD = C +I +G +(X-IM) is thus affected Reminder: fiscal policy affects AD through G (directly) and C an I (indirectly via tax) Discussion: fiscal policy vs. monetary policy, pros and cons

(higher interest rate) Figure 5 The effect of interest rates on total expenditure 45° Real Expenditure C+I+G+(X-IM) (lower interest rate) C+I+G+(X-IM) C+I+G+(X-IM) (higher interest rate) Real GDP

How Monetary Policy Works Expansionary monetary policy Lower interest rates (r) Encourage investment (I) Higher total spending Higher expenditure schedule Multiplier effect on aggregate demand

How Monetary Policy Works Contractionary monetary policy Higher interest rates (r) Lower investment spending (I) Lower total spending [C+I+G+(X-IM)] Lower expenditure schedule Lower aggregate demand through multiplier

Mechanism of Mon. Policy (P constant)

Figure 6 The effect of expansionary monetary policy on total expenditure 45° Real Expenditure C+I1+G+(X-IM) E1 C+I0+G+(X-IM) E0 6,500 6,000 Real GDP 5,500 7,000

How Monetary Policy Works Effect of monetary policy On aggregate demand Depends on Sensitivity of interest rates To open-market operations Responsiveness of investment spending To interest rate Size of basic expenditure multiplier

Money & Price Level in Keynesian Model Expansionary monetary policy Increases aggregate quantity demanded At any given price level Causes some inflation Depends on slope of aggregate supply curve

Money & Price Level in Keynesian Model

Figure 7 Inflationary effects of expansionary monetary policy S D1 Price Level S D0 $500 billion B 103 E 6,400 100 6,000 Real GDP

Money & Price Level in Keynesian Model Aggregate demand – slopes downward Higher price level (caused by expansionary monetary policy) Reduce purchasing power Depress exports, Stimulate imports Increase quantity of bank deposits demanded Demand curve (bank reserves) – shift outward Increase federal funds rate Higher interest rate Discourage investment Lower aggregate quantity demanded

Figure 8 The effect of a higher price level on the market for bank reserves S Interest Rate D0 D1 E1 Effect of a higher P E0 Bank Reserves

Summary Fed: Origin and structure Central bank independence Tools of monetary policy OMO Discount rate Reserve requirement Mechanism of the monetary policy Interest rate → Investment → AD → Y and P