1. Chapter 12 Monetary Policy
Issues In Economics Today, 4e
Guell
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline GOALS, TOOLS AND A MODEL OF MONETARY POLICY
CENTRAL BANK INDEPENDENCE
MODERN MONETARY POLICY

3. You Are Here

4. The Federal Reserve Nicknamed “The Fed”.
Established in 1913 by Congress primarily as the authority for bank regulation.
The power to “coin money” was granted to Congress by Article 1 Section 8 of the US Constitution but this power was delegated to the Federal Reserve.
The power to regulate the amount that exists in the economy was granted to the Federal Reserve in an attempt to avoid the boom and bust periods of the late 1800s.
This power allows the Federal Reserve to alter interest rates without political interference.
There are 12 regional Federal Reserve Banks
Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, St. Louis, Kansas City, Chicago, Dallas, Minneapolis, and San Francisco

5. Goals of Monetary Policy
Provide sufficient money to the economy so that it may grow at a sustainable rate.
Dampen the impact of the business cycle.
Control Inflation

6. Measures of the Amount of Money in the Economy
Monetary Aggregate: a measure of the quantity of money in the economy
The commonly used ones are
M1 =cash+coin and checking accounts
M2=M1+saving accounts+ small CDs

7. The Banking System
When a bank takes a deposit into an account on which a check can be written, it must place a percentage of that deposit on reserve at a Federal Reserve bank. That percentage is called the reserve ratio.

8. The Tools of Monetary Policy
Open Market Operations
A relatively fine tool that can be used to make small adjustments. These adjustments can be daily and often occur without much fanfare.
Targeted Interest Rates
A relatively blunt tool that can be used to make large adjustments. In typical years, changes in targeted interest rates a few times per year.
Reserve Ratio
A rather blunt tool that is only used when very large adjustments are in order.

9. Tools of Monetary Policy: Open Market Operations
The Fed buys US government debt in order to get cash into the economy.
The Fed sells US government Debt in order to get cash out of the economy.
More money in the economy puts downward pressure on interest rates.

10. Tools of Monetary Policy: Targeted Interest Rates
The Fed seeks to influence the Federal Funds Rate (the rate at which banks borrow from one another to meet reserve requirements)
Fed Loans Directly to Banks
Banks with good credit pay the primary credit rate and can borrow unlimited amounts.

11. Tools of Monetary Policy: The Reserve Ratio
The Fed directly controls the percentage of deposits that banks must have at their regional Fed bank.

12. Money Creation
The banking system can create more “money” than physically exists in the form of coin and cash.
The banking system creates money by a series of loans.
Person 1 makes a $1000 deposit at Bank 1
Bank 1 loans Person 2 $900 who buys something from Person 3
Person 3 makes a $900 deposit in Bank 2.
Bank 2 loans $810 to Person 4 who buys something from Person 5….. and so on.
In the end there are deposits totaling $10,000 ($1,000+$900+$810+$ ) that resulted from that initial $1000.

13. Modeling Monetary Policy
If the Fed wants to expand the economy it can
buy bonds
decrease the Federal Funds or Discount Rate
lower the reserve ratio.
This increases the supply of loanable funds. This lowers interest rates which increases aggregate demand.
If the Fed wants to contract the economy it can
sell bonds
increase the Federal Funds or Discount Rate
raise the reserve ratio.
This decreases the supply of loanable funds. This raises interest rates which decreases aggregate demand.

14. Expansionary Monetary Policy
RGDP
Interest Rates
Price Level
Loanable Funds S AS
AD1 D r S’ r’
AD2

15. Contractionary Monetary Policy
Loanable Funds
Interest rate
Price Level
RGDP S AS
AD1 D r S’ r’
AD2

16. Central Bank Independence
Countries with Central Banks (the general name for institutions like the US Federal Reserve) that are more independent of political control have higher rates of economic growth.
This is because political influences tend to create inflationary tendencies which raises interest rates and lowers long-term investment.

17. Fed History
In the late 1970s, the Fed battled the slow growth caused by high oil prices by increasing loanable funds so as to lower interest rates.
The result was high inflation and even higher interest rates.
The Fed induced the 1982 recession with contractionary policy. Once inflation fell below 6% in 1983 it engaged in expansionary policy.

18. Fed History
The Fed battled high deficits (expansionary fiscal policy) by keeping real interest rates fairly high.
The Fed chose not to react to the 1990 recession hoping to persuade Congress and the first President Bush to compromise on deficit reduction.

19. Fed History
The Fed steered a stabilization course through the 1990’s.
A fear of inflation led to a rapid increase in interest rates in 2000.
A fear of recession led to a rapid decrease in interest rates in 2001.
The Fed tried to dampen the economic impact of the Sept 11, 2001 terrorist attacks with quick and deep rate cuts.
Rate cutes left the Federal Funds rate at 1% though 2003

20. Fed History 2004-2007 Began raising interest rates in 2004
Raised interest rates 17 times until the Fed Funds rate was at 5.25%
Maintained that rate for several months.

21. Key Interest Rates

22. The Inflation/Deflation debate
The Fed is often criticized by economists but primarily by politicians for being more concerned about inflation than preventing recession or getting the most out of the US economy.
There was little the Fed could have done to stimulate the economy after the final cut to 1%. There was an active concern on 2003 that deflation was possible

23. Aggressive Fed Action on the Federal Funds Rate (1999-2007)

24. Inflation Targeting
The European Central Bank currently targets inflation rather than a monetary aggregate or interest rate.
Inflation targeting: involves publishing a desired range of a specified inflationary measure and then using the tools of monetary policy to bring that measure of inflation into that desired range.
The Fed’s target is the core PCE deflator.
Target range 1-2%

25. Yield Curves in Recent History