Monetary Independence Rationale –“gain then pain scenario” –Kelly M. showed Tom C. time inconsistency political business cycle –government borrowing from central bank How is independence achieved? –Long terms of governors (14 years!) –chair’s term does not coincide with POTUS –district Fed presidents not appointed by POTUS 30_01 Potential GDP OldADI SR NewADI PA(LR) PA(SR) REAL GDP INFLATION RATE LR Real GDP rises above potential GDP in the short run.

Arthur Burns, Fed chair under Richard Nixon, was criticized for letting money grow too quickly, raising inflation, despite what he said here in congressional testimony

30_02 AVERAGE INFLATION (PERCENT, ) New Zealand Spain Italy United Kingdom Belgium Denmark United States Switzerland Germany Netherlands Japan Canada MORE INDEPENDENTLESS INDEPENDENT

Two old tools of monetary policy Discount rate: interest rate Fed charges on loans to commercial banks –Borrowing is part of lender of last resort role of the Fed, aim is to discourage bank runs Bank runs occur when many depositors want cash at the same time--scene from It’s a Wonderful Life –Discount rate is now a side show Fed holds discount rate below federal funds rate Changes in reserve ratio: used rarely –last changed in 1991 to raise bank profits Now the federal funds rate is the main focus

How the Fed changes the federal funds rate Example, what does it do to cut the rate from 5.0 % to 4.75 % as it did last week? A “short-cut” explanation is that it buys bonds which raises bond prices and lowers the interest rate For a fuller explanation we look at money demand, money supply and the interest rate that gives equilibrium between them

Money Demand Money demand is a negative relationship between the interest rate and the quantity of money people are willing to hold To derive money demand consider the choice between two things –money or a financial asset that pays interest –interest rate on the other asset is opportunity cost of holding money Thus, when interest rate rises people want to hold less money

Graph showing money demand 30_0 3 MONEY Money demand INTEREST RATE

Money Supply (Review) M = Currency plus deposits Fed controls M by controlling monetary base (MB= currency plus reserves) example, M = 4 times MB, where 4 is the money multiplier (1+k)/(r+k) = (1+.2)/(.1+.2) = (1.2)/(.3) = 4 Buy bonds to raise reserves, MB, and M Sell bonds to cut reserves, MB, and M

30_04 Money supply Interest rate is determined by the intersection of the money supply line and the money demand curve. MONEY Money demand INTEREST RATE

Illustration of a cut in the federal funds rate by increasing supply of money 30_05 Money supply MONEY Money demand INTEREST RATE Interest rate falls. By increasing the supply of money, the Fed lowers the interest rate.

Illustration of an increase in the federal funds rate through a decrease in the money supplyiIllustration of an increase in the federal funds rate through a decrease in the money supplyi Illustration of an increase in the federal funds rate by decreasing the supply of money 30_05 By decreasing the supply of money, the Fed raises the interest rate. Money supply MONEY Money demand INTEREST RATE Interest rate rises.

Alternative monetary policies Recall the monetary policy rule we used  Alternatives –Constant money growth rule (Milton Friedman) not used now hard to define and measure money –Interest rate responds to real GDP and inflation closer to reality

Questions for Alan Greenspan Dr. Greenspan, we’ve heard a lot about the Fed How does the Fed conduct monetary policy? Does it set interest rates? What about the money supply? Is there any systematic framework?

Key buzz words in Greenspan’s statement we have been setting the funds rate directly money demand has become too difficult to predict inflation is fundamentally a monetary phenomenon--determined by the growth rate of money there are lags in the effect of money we have a firm commitment to control inflation

END OF LECTURE