1 Monetary Policy Ch 15

2 Introduction Fed’s Board of Governor formulates policy, 12 Federal Reserve Banks implement policy Fundamental objective of monetary policy is to aid the economy in achieving full- employment output with stable prices –Do this with changes in Ms –To change Ms, Fed manipulates size of excess reserves held by banks

3 Introduction Monetary policy has a very powerful impact on the economy, and the Fed chairman is sometimes called the second most powerful person in the U.S.

4 Consolidated Balance Sheet of the Fed Banks Assets of the Fed’s balance sheets –Securities which are federal government bonds purchased by the Fed –Loans to commercial banks

5 Consolidated Balance Sheet of the Fed Banks Liability of the Fed –Reserves of Banks held as deposits at Federal Reserve Banks –U.S. Treasury deposits of tax receipts and borrowed funds –Federal Reserve Notes outstanding, aka paper currency

6 Tools of Monetary Policy #1 Open Market Operations Open Market Operations –Buying and selling of govt bonds –Buy securities will increase bank reserves and money supply If Fed buys directly from banks, bank reserves go up by value of securities If Fed buys from general public, people receive checks from Fed and deposit those in bank. Bank checkable deposits rise, as do bank reserves

7 Tools of Monetary Policy #1 Open Market Operations Banks lending ability increases Money supply rises directly with increased deposits by public When Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits

8 Tools of Monetary Policy #1 Open Market Operations –Conclusion: When Fed buys securities banks reserves increase and money supply potentially can rise by a multiple of these reserves Note: When Fed sells securities, all above will be reversed. Bank reserves will decrease, and eventually Ms will go down by a multiple of decrease in reserves

9 Tools of Monetary Policy #1 Open Market Operations –When Fed sells, it soaks up Ms –When Fed purchases, it pumps up Ms

10 Tools of Monetary Policy #1 Open Market Operations How does the Fed get buyers? –When the Fed buys, it raises demand and price of bonds which in turn lowers effective interest rate on bonds. The higher price and lower interest rate makes selling bonds attractive –When Fed sells, Bond supply increases and prices fall, which raises effective interest rate on yield bonds. The lower price and higher interest rate buying bonds from Fed attractive

11 Tools of Monetary Policy #2 Reserve Ratio Reserve Ratio is the fraction of reserves required to their customer deposits –Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks the banks’ lending ability and, therefore, the potential Ms by a multiple amount of the change in excess reserves

12 Tools of Monetary Policy #2 Reserve Ratio –Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves

13 Tools of Monetary Policy #2 Reserve Ratio –Changing the reserve ratio has two effects Affects the size of excess reserves Changes the size of the money multiplier –Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so the Fed rarely changes it.

14 Tools of Monetary Policy #3 Discount Rate Discount rate is the interest rate that the Fed charges commercial banks that borrow money from the Fed –Increase in discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves –Decrease in discount rate signals borrowing reserves will be easier and will tend to expand excess reserves

15 Tools of Monetary Policy “Easy” monetary policy occurs when the Fed tries to increase the Ms by expanding excess reserves in order to stimulate the economy. –Buying securities –Reduce reserve ratio, rare because of powerful impact –Reduce discount rate, has little direct effect on MS

16 Tools of Monetary Policy “Tight” monetary policy occurs when Fed tries to decrease Ms by decreasing excess reserves in order to slow spending in the economy –Sell securities –Raise reserve ratio, rare because of powerful impact –Raise discount rate, has little direct effect on Ms

17 Monetary Policy, RGDP, and Price Level Cause-effect Chain –Demand for money is comprised of two things Transaction Demand directly tied to GDP Asset demand inversely related to interest rate –Ms set by Fed –Interaction of supply and demand determines market rate of interest –Interest Rate determines amount of investment businesses will be willing to make. Investment demand is inversely related to interest rate

18 Monetary Policy, RGDP, and Price Level Effect of interest changes on level of investment is great because interest cost of large, long-term investment is sizable part of investment As investment rises or falls, equilibrium GDP rises or falls by a multiple amount because of the investment spending multiplier (1/mps)

19 Monetary Policy, RGDP, and Price Level Expansionary or easy policy: Fed tries to increase excess reserves, which lowers interest rate and increases investment, which increases GDP by a multiple amount Contractionary or Tight policy: Fed tries to reduce excess reserves, which raise interest rates, which decrease investment, which decreases GDP by a multiple amount

20 Monetary Policy, RGDP, and Price Level AS and Monetary Policy –Easy monetary policy may be inflationary if initial equilibrium is at or near full-employment –If economy is below full employment, easy monetary policy can shift AD and GDP toward full-employment –Tight monetary policy can reduce inflation if economy is near full-employment, but can make unemployment worse in a recession

21 Effectiveness of Monetary Policy Strengths –Quicker and more flexible than fiscal policy since Fed can buy and sell securities on a daily basis –Less political, since changes are more subtle, easier to make unpopular decisions –80’s & 90’s, Fed is given credit for the low inflation and high employment

22 Effectiveness of Monetary Policy Shortcomings –Control is weakening as technology makes it possible to shift money assets to other types; global finance gives nations less control –Cyclical asymmetry may exist; Tight policy works against inflation, but easy policy is not always effective in stimulating economy

23 Effectiveness of Monetary Policy –Velocity of money (number of times money is spent in a year) may be unpredictable, esp. in the short run and can offset the desired impact of changes in Ms. Tight policy may cause people to spend faster, velocity rises. –Impact on investments may be less than traditionally thought

24 Effectiveness of Monetary Policy Currently Fed communicates changes in monetary policy through changes in its target Federal Funds Rate –Fed does not set either the Federal Funds rate or the prime rate, each is est. by the interaction of lenders and borrowers, but generally follow Fed Rate –Fed acts through open market operations, selling bonds to raise interest rates and buying bonds to lower rates

25 Links between monetary policy and international economy Net export effect occurs when foreign financial investors respond to a change in interest rates –Tight policy and higher rates lead to an appreciation of dollar value in foreign exchange markets; easy policy and lower rates lead to dollar depreciation

26 Links between monetary policy and international economy –When dollar appreciates, American goods are costly to foreigners, and this lowers demand for American goods, which can lower GDP. When dollar depreciates, American goods are cheaper to foreigners, increases demand, raises GDP.

27 Links between monetary policy and international economy Monetary policy works to correct both trade balance and GDP problems together. An easy policy leads to increased domestic spending and increased GDP, but it depreciates dollar, higher demand for U.S. exports, which enhances GDP and erases trade deficit. Reverse is true for tight policy

28 Interrelationships Fiscal and monetary policy are interrelated. Impact of increase of government spending will depend on whether it is accommodated by monetary policy. If govt spending comes from money borrowed from general public, it may be offset by a decline in private spending, but if govt borrows from the Fed or if the Fed increases the Ms, then the initial increase in govt spending may not be counteracted by a decline in private spending.