Chapter 16: Monetary Policy Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy Monetary policy consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy. The goal is to achieve and maintain price- level stability, full employment, and economic growth. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Interest Rates There are many types of interest rates in the U.S. economy that vary by purpose, size, risk, maturity, and taxability. For simplicity, economists speak of a single interest rate. The interest rate results from the interaction of money demand and money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Selected U.S. Interest Rates, April 2005

The Demand for Money People demand money for two main reasons: to make purchases with it and to hold it as an asset. The demand for money as a medium of exchange is called the transactions demand for money (D t ). The amount of money people want to hold as a store of value is called the asset demand for money (D a ). Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Demand for Money The main determinant of the amount of money demanded for transactions is the level of nominal GDP. The transactions demand for money is vertical. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Demand for Money Holding money incurs an opportunity cost; therefore, the amount of money demanded as an asset varies inversely with the rate of interest, which is the opportunity cost of holding money. The asset demand for money is negatively sloped. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Demand for Money The sum of the transactions demand and assets demand for money equals the total demand for money (D m ). D m = D t + D a Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Equilibrium Interest Rate In the money market, the demand for money and the supply of money determine the equilibrium rate of interest. The money supply, S m, is a vertical line because the monetary authorities and financial institutions have provided the economy with some particular stock of money. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Equilibrium Interest Rate The intersection of demand and supply in the money market determines equilibrium price, or the real interest rate (i c ) – the inflation-adjusted price that is paid for the use of money over some time period. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Money Market Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Tools of Monetary Policy The Federal Reserve can change the money supply and therefore alter interest rates in the economy. The three tools of monetary control are: Open-market operations Reserve ratio Discount rate Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Open Market Operations Open market operations consists of the buying and selling of U.S. government securities by the Fed for the purpose of carrying out monetary policy. Open market operations are the most important instrument for influencing the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Open Market Operations Buying securities increases the reserves of commercial banks. Excess reserves allow the banking system to expand the money supply through loans. Selling securities reduces the reserves of commercial banks. Lower reserves result in a multiple contraction of the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Reserve Ratio Changing the reserve ratio is a powerful technique of monetary control, although it is seldom used by the Fed. Manipulation of the reserve ratio influences the ability of the commercial banks to lend. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Reserve Ratio If the Fed raises the reserve ratio, the amount of required reserves that banks must keep increases. Banks will either lose excess reserves, diminishing their ability to create money by lending, or reduce its checkable deposits due to deficient reserves, and therefore the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Reserve Ratio If the Fed lowers the reserve ratio, the banks’ required reserves will decrease. Banks with more excess reserves are able to create new money by lending. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Discount Rate The discount rate is the interest rate the Federal Reserve Banks charge on the loans they make to commercial banks and thrifts. Occasionally, Federal Reserve Banks makes short-term loans to commercial banks in their district; the Fed is considered the “lender of last resort.” Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Discount Rate In providing loans, the Federal Reserve Bank increases the reserves of the borrowing bank, enhancing its ability to extend credit. From the commercial banks’ perspective, the discount rate is the cost of acquiring reserves. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Discount Rate Increasing the discount rate discourages commercial banks from obtaining additional reserves through borrowing from the Federal Reserve Banks. When the Fed raises the discount rate, it wants to restrict the money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Easy Money Policy Easy money policy (or expansionary monetary policy) are Fed actions designed to increase the money supply, lower interest rates, and expand real GDP. These include buying securities, lowering the reserve ratio and lowering the discount rate. Its purpose is to make loans less expensive and more available and thereby increase aggregate demand, output and employment. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Tight Money Policy The Fed can try to reduce aggregate demand by limiting or contracting the money supply. These actions are called a tight money policy (or restrictive monetary policy). These include selling securities, increasing the reserve ratio and raising the discount rate. The objective is to tighten the money supply in order to reduce spending and control inflation. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy, Real GDP, and the Price Level Monetary policy achieves its goals by affecting the market for money, investment, and equilibrium GDP. The cause-effect chain in Figure 16.2 illustrates how monetary policy works. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy, Real GDP, and the Price Level Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of an Easy Money Policy If real output in the economy is below the full-employment output, the economy must be experiencing a recession (a negative GDP gap) and unemployment; therefore, the Fed should institute an easy money policy. To increase the money supply, the Fed can buy government securities, lower the legal reserve ratio, and lower the discount rate. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of an Easy Money Policy Increasing the money supply will reduce interest rates and will boost investment. This will cause the aggregate demand curve to shift rightward, eliminating the negative GDP gap. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of a Tight Money Policy If real output in the economy is above the full-employment output, the economy has a positive GDP gap and demand-pull inflation; the Fed should institute a tight money policy. The Fed will direct Federal Reserve Banks to undertake some combination of the following actions: (1) Sell government securities, (2) increase the legal reserve ratio, (3) increase the discount rate. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Effect of a Tight Money Policy Decreasing the money supply will raise interest rates and cause investment to decline. The decrease in investment will shift the aggregate demand curve leftward, eliminating the excessive spending and halt demand-pull inflation, closing the positive GDP gap. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy in Action Monetary policy, a dominant component of U.S. national stabilization policy, has two key advantages over fiscal policy: Speed and flexibility Isolation from political pressure Monetary policy can be quickly altered and is a more subtler and more politically neutral measure. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Focus on the Federal Funds Rate Because the Fed can control the supply of reserves in the banking system and thus the Federal funds rate, it currently focuses monetary policy on altering the this interest rate as a need to stabilize the economy. The Federal funds rate is the interest rate banks and thrifts charge one another on overnight loans made out of their excess reserves. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Focus on the Federal Funds Rate If the Fed wants to increase the Federal funds rate, it sells securities in the open market to reduce bank reserves, and vice versa. The Fed can target the Federal funds rate because it knows that interest rates in general (including the economy’s prime interest rate) typically rise and fall with that rate. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Focus on the Federal Funds Rate The prime interest rate is the benchmark interest rate that banks and thrifts use as a reference point for a wide range of loans to businesses and individuals. A change in the Federal funds rate will cause a similar change to the prime rate and other short-term interest rates. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Problems and Complications Monetary policy has certain limitations and real-world complications. One problem is that monetary policy faces recognition lag and operational lag. The Fed must be able to recognize and respond to changes in economic activity. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Problems and Complications Another problem is monetary policy suffers from cyclical asymmetry. Cyclical asymmetry is the potential problem of monetary policy successfully controlling inflation during the expansionary phase of the business cycle but failing to expand spending and real GDP during the recessionary phase of the cycle. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

“Artful Management” or “Inflation Targeting”? Alan Greenspan, in his role and Chairman of the Fed, has artfully managed the money supply to avoid escalating inflation or deep recession and deflation. Some economists are concerned that this “artful management” may be a unique quality of Greenspan and that someone less insightful may not be as successful. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

“Artful Management” or “Inflation Targeting”? Because of this, some feel the Fed should replace or combine the artful management of monetary policy with so-called inflation targeting—the annual statement of a target range of inflation for future years. Some countries have already adopted inflation targeting as it increases the “transparency” of monetary policy and the central bank’s accountability. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.