Monetary Policy Chapter 13

2 OMO: What can go wrong? Credit easier to get Fed increases banking system reserves Fed buys bonds from the public or banks Loans Increase Banks increase loans Deposits Increase Money Supply Increases Interest Rates decrease Banks may not want to lend Public may not want to borrow Loans are not deposited in the banking system Fed Controls Reserves but not the M s

Supply Demand Reserves ffr o Federal Funds Rate Reserves MsMs  $ MdMd 00 Money Supply Demand P0P0 Bonds AD Price Level GDP AS P0P0 GDP 0 Goods and Services

MsMs  $ MdMd 00 Money

Rest of World National Income GDP Households Firms Stocks, Funds Bonds, CD’s, Life Insurance Stocks, Funds Bonds, CD’s, Life Insurance =300 Consumption Investment Pay taxes Circular Flow Diagram pay to Imports Government Government Spending

National Income Buy goods and services Households Firms Stocks, Funds Bonds, CD’s, Life Insurance Stocks, Funds Bonds, CD’s, Life Insurance Circular Flow Diagram pay to Need in liquid form Deposits and Cash MdMd

GDP= Total Income Buy Stocks, Funds Bonds, CD’s, Life Insurance Buy Stocks, Funds Bonds, CD’s, Life Insurance Not earning interest in checking accounts Earning interest Buy Goods and Services = Price x Quantity Buy Goods and Services = Price x Quantity Demand for money (liquidity) depends on Prices and Quantity purchased How much money is saved depends on the interest rate on savings

National Income Buy goods and services Households Firms Circular Flow Diagram pay to Deposits and Cash Prices and Quantity Purchased Interest Rate MdMd

What Determines How Much Liquidity the Public needs? Prices + + We need more cash for more expensive transactions Real Income + + We need more cash for more transactions. Interest rate - - The higher the interest rate the less cash we want to hold. The higher prices and Income, the higher the need for cash/deposits The higher prices and GDP, the higher Deposits are. The higher the interest rate, the lower Deposits are. The higher the interest rate, the lower the demand for cash/deposits

Checking Account Deposits Larger when we engage in more transactions Real GDP is used as an indicator of the number of transactions (Q) Larger when transactions are more expensive Price Index is used as indicator of the average price per transaction (P) Smaller when the opportunity cost of holding idle cash increases Interest rate (  ) is used as the indicator of opportunity cost of holding cash balances

MONEY MARKET Interest Rate Amount the public actually holds in liquid form: Deposits & Cash Amount the public wants to hold in liquid form: Deposits & Cash MdMd MsMs

MdMd i $ Cash and checking accounts The higher the interest rate, the less money the public WANTS to hold in checking accounts   =3%   =5% 700b500b A movement up along M d

M0dM0d Amount the public wants to hold in liquid form: Deposits & Cash i $ Cash and checking accounts The higher prices/real incomes, the more money the public WANTS to hold in checking accounts   =3% 700b500b M d shifts right M1dM1d

Amount the public actually holds in liquid form: Deposits & Cash i $ Cash and checking accounts Expansionary Monetary Policy: More Loans, More Deposits, Money Supply increases   =3% 500b M s shifts right MsMs 700b MsMs

MARKET FOR RESERVES Federal Funds Rate Supply Demand Reserves ffr o Federal Funds Rate Reserves

Demand for Reserves Supply: banks + Fed Demand: Banks short of reserves Money ioio Federal Funds Rate As fed funds rate rises bank’s want to borrow less A movement up ( down ) along the demand for funds resulting from higher ( lower ) interest rates

Moving along Demand For Reserves Banks borrow more ( less ) from other banks when ffr drops ( rises ) Shifting Demand for Reserves Banks borrow more (less) from other banks even though ffr is the same: Deposits increase, banks need to hold more reserves Deposits decrease, banks need to hold less reserves As ffr drops borrowing is cheaper and more reserves are demanded ffr 0 ffr 1 Borrow more Reserves when deposits increase ffr 0 Movement Along: Caused by a change In interest rates Change in Quantity Demanded of reserves.

Demand for Reserves Supply= excess reserves + Fed changes Demand: Banks + Public Money ioio Federal funds Rate Banks need more reserves when Deposits increase

Demand for Reserves depends on dollar value of transactions Demand for Reserves depends on size of Deposits: R = r*D Size of Deposits depend on dollar value of transactions: P*Q Demand for Reserves depends on dollar value of transactions: P*Q

Shifts in Demand for Reserves Supply= excess reserves + Fed changes Demand = Banks in need of reserves Money ioio Federal funds Rate Banks need more reserves when Deposits increase Deposits/ Demand for reserves increase with more transactions When Prices or GDP increase Demand for reserves shift to the right When Prices or GDP increase Demand for reserves shift to the right Deposits/ Demand for reserves increase when GDP or Prices increase

Moving along Demand For Reserves Banks borrow more (less) from other banks when ffr drops (rises) Shifting Demand for Reserves Banks borrow more (less) from other banks even though ffr is the same when: Deposits increase, banks need to hold more reserves Deposits decrease, banks need to hold less reserves Borrow more Reserves when ffr drops ffr 0 ffr 1 Borrow more Reserves when deposits increase ffr 0 Shift: Caused by a change In prices or incomes Change in Demand for Reserves

MARKET FOR RESERVES Federal Funds Rate Supply Demand Reserves ffr o Federal Funds Rate Reserves When GDP or Prices increase, Demand for Reserves shifts right and ffr increases ffr 1

MARKET FOR RESERVES Federal Funds Rate Supply Demand Reserves ffr o Federal Funds Rate Reserves Decrease in GDP or Prices Demand for Reserves shifts left, ffr drops ffr 1

Reserves ioio Federal Funds Rate Banks increase lending as interest rates rise because it is more profitable Banks lend more when the fed funds rate increases Supply: banks with excess reserves A movement up ( down ) along the supply of funds resulting from higher ( lower ) interest rates Moving Along Supply of Reserves

Reserves ioio Federal Funds Rate The Fed manipulates the amount of reserves in the system. Supply increases when the Fed injects reserves A rightward ( leftward ) shift in the supply of funds resulting from Fed injecting ( destroying ) reserves into ( from ) the system Supply: banks, Fed Shifting Supply of Reserves

Market for Reserves: Fed Buys Bonds Supply= excess reserves + Fed changes Demand: Banks + Public Money ffr o Federal funds Rate ffr 1

27 Open Market Operations: Fed Buys Bonds Credit easier to get Fed increases banking system reserves Fed buys bonds from the public or banks Loans Increase Banks increase loans Deposits Increase Money Supply Increases Interest Rates decrease

The Money Market: Fed Buys Bonds i $ Ms0Ms0 Ms1Ms1 Reserves, Loans, Deposits and the M s increase Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when  0 =3%   =3% Md0Md0 Amount of Money the Public holds in deposit accounts > Amount the public wants to hold when  0 =3%   =2% Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when  0 =2% Ms1Ms1 Money plentiful: Everyone needs to lend money: willing borrowers only found at lower interest rate Money out of checking accounts and into interest bearing asset: look for willing borrowers who would pay interest

GOODS AND SERVICES Price Level AD Price Level GDP AS P0P0 GDP 0 Goods and Services AD = C + I + G + NX

30 Open Market Operations: Fed Buys Bonds Credit easier to get Fed increases banking system reserves Fed buys bonds to the public or banks Interest Rates decrease Banks increase loans Investment increases Aggregate demand Increase

Goods and Services Market: Fed Buys Bonds GDP Increase Prices Rise AD 0 = C 0 + I 0 =G 0 +NX 0 Price Level GDP AS AD 1 = C 0 + I 1 =G 0 +NX 0

Inverse Relationship Between Price of Bonds and Interest Rate Amount you get at maturity Price you paid for Bond - = Interest rate $100 $90 11% $80 25% The lower the price on the bond, the higher the interest rate.

MARKET FOR BONDS Price of Bonds Supply: Government and Fed Demand: Public P0P0 Bonds

When the fed buys bonds it decreases the supply of bonds available to the public…. Bond Market: Fed Buys Bonds

Supply of bonds Demand for bonds P0P0 P1P1 Bond Price rises: Interest Rates Decrease  0 =8%  1 =4%

Market for Reserves: Fed Sells Bonds Supply= excess reserves + Fed changes Demand: Banks + Public Money Federal funds Rate ffr o ffr 1

37 Open Market Operations: Fed Sells Bonds Credit harder to get Fed reduces banking system reserves Fed sells bonds to the public or banks Loans Decrease Banks decrease loans Deposits Decrease Money Supply Decreases Interest Rates increase

The Money Market: Fed Sells Bonds i $ Ms0Ms0 Ms1Ms1 Reserves, Loans, Deposits and the M s decrease Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when  0 =3%   =3% Md0Md0 Amount of Money the Public holds in deposit accounts < Amount the public wants to hold when  0 =3% Ms1Ms1   =5% Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when  0 =5% Money scarce: Everyone needs to borrow cash: willing lenders can be found only at higher interest rate. Money into checking accounts: look for willing lenders

39 Open Market Operations: Fed Sells Bonds Credit harder to get Fed reduces banking system reserves Fed sells bonds to the public or banks Interest Rates increase Banks decrease loans Investment Decrease Aggregate demand Drops

Fed Sells Bonds GDP Decrease Prices Drop Price Level Real GDP AS AD 0 = C 0 + I 0 =G 0 +NX 0 AD 1 = C 0 + I 1 =G 0 +NX 0

Bond Market: Fed Sells Bonds Supply of bonds: Fed, government Demand for bonds P 0 =90 P 1 =80 Bond Price falls: Interest Rates Increase  =11%  =25%

When the Fed Wants to Reduce Unemployment Use Expansionary Monetary Policy Increase Reserves and Money Supply Decrease the interest rate. Increase Investment Increase Aggregate Demand for goods and services Buy Bonds Decrease  Decrease r Buy Bonds Decrease  Decrease r

When the Fed Wants to Reduce Inflation Use Contractionary Monetary Policy Decrease the Money Supply Increase the interest rate. Decrease Investment and Consumption? Decrease Aggregate Demand for goods and services Sell Bonds Increase  Increase r Sell Bonds Increase  Increase r

Interest Rate and Velocity of Money Velocity = Nominal GDP/M s Velocity of money: Number of times a dollar bill is used Dollar value of what we buy M s = Deposits + currency Contractionary Policy: interest rate rise, public holds less cash and deposits (M s ):Velocity increases As interest rate rise, public holds less cash for transactions: each dollar is used more times.

Price = $100  =10% Get at maturity = $110 Amount you get at maturity Price you paid for Bond - = Interest rate %

Price = $100  =10% Get at maturity = $110 Amount at maturityBond Price - = % Interest rates drop to 8% Bond Price P? 8% P?

- = % P? 8% P? - = 110 P? 0.08 P? = P = 110/1.08 P = $ P Interest rates drop to 8% Bond Price rises P P = 110

Supply Demand Quantity Bank Reserves ffr o Federal Funds Rate MsMs i $ MdMd Supply of bonds Demand for bonds P0P0 i0i0 AD Price Level GDP AS P0P0 GDP 0

Monetary Policy Actions Demand for Reserves Supply of Reserves Federal Funds Rate LoansDeposits Ms Ms Interest Rate Supply of Bonds Bond PriceGDP Price Level Increase in Required Reserve Ratio (r) : Banks need more Reserves; can make fewer loans Increase: more banks short of R IncreaseDecrease M s Decrease Increase I, AD, GDP drop falls Decrease in Required Reserve Ratio (r): Banks need less Reserves; can make more loans Decrease: Fewer banks short of reserves DecreaseIncrease M s Increase Decrease I, AD, GDP rise rise Buy Bonds: inject reserves into the system IncreaseDecreaseIncrease M s Increase Decrease Increase I, AD, GDP rise rise Sell Bonds: erase reserves from the system DecreaseIncreaseDecrease M s Decrease Increase Decrease I, AD, GDP drop falls Increase in Discount Rate: Fed loans more expensive, banks borrow less from Fed Decrease: Banks hold instead of lending excess reserves Increase Decrease : Banks beef up resesrves instead of lending Decrease M s Decrease Increase I, AD, GDP drop falls Decrease in Discount Rate: Fed loans cheaper, banks borrow more from the fed Increase: Banks lend instead of holding excess reserves Decrease Increase: Banks hold less excess reserves increase lending Increase M s Increase Decrease I, AD, GDP rise rise

Public’s Actions Demand for Reserves Supply of Reserves Federal Funds Rate Deposits MdMd Interest Rate GDP Price Level Increase in Prices: Public needs more cash & Deposits for more expensive transactions Increase: More reserves are needed when Deposits increase: R = r*D same Increase M d Increase Increase I, AD, GDP drop falls Decrease in Prices: Public needs less cash & Deposits for less expensive transactions Decrease: Less reserves are needed when Deposits decrease: R = r*D sameDecrease M d Decrease Decrease I, AD, GDP rise rise Increase in Incomes (GDP) An economic Expansion Public needs more cash & Deposits for more transactions Increase: More reserves are needed when Deposits increase: R = r*D same Increase M d Increase Increase I, AD, GDP drop falls Decrease in Incomes (GDP) Economic Recession Public needs less cash & Deposits for fewer transactions Decrease: Less reserves are needed when Deposits decrease: R = r*D same Decrease M d Decrease Decrease I, AD, GDP rise rise

EventDemand for Reserves Supply of Reserves Federal Funds Rate LoansDepositsMd/Ms Interest Rate Supply of Bonds Bond PriceGDP Price Level Increase in Required Reserve Ratio (r) : Banks need more Reserves; can make fewer loans Increase: more banks short of R IncreaseDecrease M s DecreaseIncrease Decrease in Required Reserve Ratio (r): Banks need less Reserves; can make more loans Decrease: Fewer banks short of reserves DecreaseIncrease M s IncreaseDecrease Buy Bonds: inject reserves into the system IncreaseDecreaseIncrease M s IncreaseDecrease Increase Sell Bonds: erase reserves from the system DecreaseIncreaseDecrease M s DecreaseIncrease Decrease Increase in Discount Rate: Fed loans more expensive, banks borrow less from Fed Decrease: Banks hold instead of lending excess reserves Increase Decrease: Banks beef up resesrves instead of lending DecreaseM s DecreaseIncrease Decrease in Discount Rate: Fed loans cheaper, banks borrow more from the fed Increase: Banks lend instead of holding excess reserves Decrease Increase: Banks hold less excess reserves increase lending Increase M s IncreaseDecrease Increase in Prices: Public needs more cash&Deposits for more expensive transactions Increase: More reserves are needed when Deposits increase: R = r*D same Increase M d IncreaseIncrease Decrease in Prices: Public needs less cash&Deposits for less expensive transactions Decrease: Less reserves are needed when Deposits decrease: R = r*D sameDecrease M d Decrease Decrease Increase in Incomes (GDP) An economic Expansion Public needs more cash&Deposits for more transactions Increase: More reserves are needed when Deposits increase: R = r*D same Increase M d IncreaseIncrease Decrease in Incomes (GDP) Economic Recession Public needs less cash&Deposits for fewer transactions Decrease: Less reserves are needed when Deposits decrease: R = r*D same Decrease M d Decrease Decrease

Questions to prepare for the test Use a diagram to show the effect on reserves, the money supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step. 1. The fed increases/decreases the required reserve ratio 2. The fed buys/sells bonds in the open market 3. Fed increases/decreases the (discount) primary credit rate. 4. Prices increase/decrease 5. Incomes increase/decrease

Supply Demand Reserves ffr o Federal Funds Rate Reserves Supply Demand Reserves ffr o Federal Funds Rate Reserves Supply Demand Reserves ffr o Federal Funds Rate Reserves Supply Demand Reserves ffr o Federal Funds Rate Reserves A B C D

MsMs  $ MdMd 00 Money MsMs  $ MdMd 00 MsMs  $ MdMd 00 MsMs  $ MdMd 00 A B C D

Supply Demand P0P0 Bonds Supply Demand P0P0 Bonds Supply Demand P0P0 Bonds Supply Demand P0P0 Bonds D C A B

AD Price Level GDP AS P0P0 GDP 0 Goods and Services AD Price Level GDP AS P0P0 GDP 0 Goods and Services AD Price Level GDP AS P0P0 GDP 0 Goods and Services AD Price Level GDP AS P0P0 GDP 0 Goods and Services AB CD