1. Monetary Policy and the Debate about Macro Policy
Chapter 28

2. Laugher Curve
A caveman points to two of his hairy relatives carrying clubs over their shoulders and says:
“OK—you hunt, you gather, and I’ll fine tune the economy.”

3. Introduction
Monetary policy influences the economy through changes in the money supply and availability of credit.
Monetary policy is controlled by the Federal Reserve Bank (the Fed), the U.S. central bank.

4. Effect of Monetary Policy on the Macro Policy Model
Expansionary monetary policy shifts the AD curve to the right.
Contractionary monetary policy shifts the AD curve to the left.

5. Effect of Monetary Policy on the Macro Policy Model
Expansionary monetary policy increases nominal income.
Its effect on real income depends on how the price level responds.
% Real Income =
% Nominal Income – % Price Level

6. Monetary Policy Real output Price Level Contrac-tionary Expan-sionary
SAS P1 P0
AD1 P2
AD0
AD2 Y2 Y0 Y1

7. Expansionary Monetary Policy Beyond Potential Output
Real output
Price Level
LAS
SAS1 B P1
SAS0 A
AD1 P0
AD0 YP

8. Duties and Structure of the Fed
A central bank conducts monetary policy and acts as financial adviser to the government.
Central bank – a type of bankers’ bank.

9. Duties and Structure of the Fed
It is the bank’s ability to create money that gives the central bank the power to control the money supply.

10. Structure of the Fed
The Fed is a semiautonomous organization composed of 12 regional banks.
It is run by a Board of Governors appointed by the President with the advice and consent of the Senate.

11. Structure of the Fed
The Fed has much more independence than most government agencies.
The Fed does not rely on Congress for appropriations.
Its governors serve 14 year terms and cannot be reappointed.

12. Structure of the Fed
The President appoints one of the seven members of the Board of Governors to be chairman for a four-year term.
The chairman is often called the second most powerful official in government.

13. Federal Reserve Districts
San Francisco
Kansas City
Minneapolis
Chicago .
Boston
Richmond
Atlanta
St. Louis
*Alaska and Hawaii are under the jurisdiction of the Federal Reserve Bank of San Francisco
Dallas
New York
Philadelphia
Cleveland
Washington DC

14. Federal Reserve Structure
Chief policymaking body of the Federal Reserve System
Open market operations
Provides services
Financial institutions
Federal government
Board of Governors of the Federal Reserve System
7 members appointed by the president and confirmed
Chairman and vice chairman designated by the president and confirmed by the Senate
Regional Reserve Banks and Branches
12 regional Federal Reserve banks
25 branches of Federal Reserve banks
Oversees
Federal Open Market Committee
7 members of the Board of Governors
5 Federal Reserve bank presidents
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© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

15. Duties of the Fed
Congress gave the Fed six explicit functions.

16. Duties of the Fed
Conducting monetary policy is the most important job the Fed has to do.
Monetary policy – influencing the supply of money and credit in the economy.

17. Duties of the Fed
The Fed supervises and regulates financial institutions.
It serves as a lender of last resort to financial institutions.
It provides banking services to the U.S. government.

18. Duties of the Fed The Fed issues coin and currency.
It provides financial services such as check clearing to commercial banks, savings and loan associations, savings banks, and credit unions.

19. The Importance of Monetary Policy
Monetary policy is the Fed’s most important job, and the most-used policy in macroeconomics.
The Fed conducts and controls monetary policy.

20. The Importance of Monetary Policy
Actual decisions about monetary policy are made by the Federal Open Market Committee.
Federal Open Market Committee (FOMC) – the Fed’s chief policymaking body.

21. The Importance of Monetary Policy
The FOMC is made up of:
The seven members of the Board Of Governors.
The president of the New York fed.
A rotating group of four of the presidents of the other regional banks.

22. The Conduct of Monetary Policy
Monetary base – vault cash, deposits of the Fed, plus currency in circulation.
Allowable reserves – either vault cash or deposits at the Fed.
Bank reserves are IOUs of the Fed

23. The Conduct of Monetary Policy
The Fed influences the amount of money in the economy and the activities of commercial banks by controlling the monetary base.

24. The Conduct of Monetary Policy
Monetary policy affects the amount of reserves in the banking system.
The amount of reserves affect interest rates.

25. The Conduct of Monetary Policy
Other things being equal, as reserves decline, interest rates rise.
As reserves increase, interest rates fall.

26. Tools of Monetary Policy
The three tools of monetary policy are:
Changing the reserve requirement
Changing the discount rate.
Executing open market operations (buying and selling bonds) and thereby affecting the Fed funds rate.

27. Changing the Reserve Requirement
The reserve requirement is the percentage the Federal Reserve System sets as the minimum amount of reserves a bank must have.

28. Required Reserves and Excess Reserves
The amount banks keep in reserve for checking accounts (also called demand deposits) depend:
Partly on the reserve requirement.
Partly on how much they think they need for safety.

29. Required Reserves and Excess Reserves
Banks hold as little in reserves as possible since they earn no interest on them.
In the late 2000s, required reserves for demand deposits were about 10 percent, and zero for all other accounts.

30. The Reserve Requirement and the Money Supply
The Fed can increase or decrease the money supply by changing the reserve requirement.

31. The Reserve Requirement and the Money Supply
If the Fed decreases the reserve requirement, it expands the money supply.
Banks have more money to lend out.
The money multiplier increases.

32. The Reserve Requirement and the Money Supply
If the Fed increases the reserve requirement, it contracts the money supply.
Banks have less money to lend out.
The money multiplier increases.

33. The Reserve Requirement and the Money Supply
The approximate real-world money multiplier in the economy is:
1/(r +c)
r = the percentage of deposits banks hold in reserve
c = the ratio of money people hold in cash to the money they hold as deposits

34. The Reserve Requirement and the Money Supply
In reality, banks keep 10% in reserves (r = 0.1) and the cash-to-deposits ratio is 40% (c = 0.4).
The realistic approximation of the money multiplier for demand deposits is:
1/( ) = 1/0.5 = 2

35. What If There Is a Shortage of Reserves
The bank can borrow reserves from another bank in the Federal funds market and pay the Federal Funds rate.
It can stop making new loans and keep as reserves the proceeds of loans that are paid off.

36. What If There Is a Shortage of Reserves
The bank can sell Treasury bonds in order to get reserves.
The bonds themselves cannot be used as reserves (they are sometimes called secondary reserves) but the cash that comes from their sales does.

37. Changing the Discount Rate
A bank can borrow reserves directly from the Fed, if it experiences a shortage of reserves.
The discount rate is the rate of interest the Fed charges for those loans it makes to banks.

38. Changing the Discount Rate
By changing the discount rate, the Fed can expand or contract the level of bank reserves and the money supply.

39. Changing the Discount Rate
An increase in the discount rate makes it more expensive for banks to borrow from the Fed.
A decrease in the discount rate makes it less expensive for banks to borrow from the Fed.

40. Changing the Discount Rate
In practice, the discount rate is generally a slightly higher than other rates banks would have to pay to borrow reserves.

41. Executing Open Market Operations
Changes in the discount rate and reserve requirements are not used in day-to-day operations of the Fed.
These tools are used for major changes.

42. Executing Open Market Operations
For day-to-day operations the Fed uses a third tool, open market operations.
Open market operations are the Fed’s buying and selling of government securities.

43. Executing Open Market Operations
To expand money supply, the Fed buys bonds.
To contract money supply, the Fed sells bonds.

44. An Open Market Purchase
An open market purchase is an example of expansionary monetary policy.
Expansionary monetary policy is a monetary policy that tends to reduce interest rates and raise income.

45. An Open Market Purchase
When the Fed buys bonds, it deposits the money in federal government accounts at a bank.
Bank cash reserves rise, encouraging banks to lend out the excess.
The money supply rises.

46. An Open Market Sale
An open market sale is an example of contractionary monetary policy.
Contractionary monetary policy is a monetary policy that tends to raise interest rates and lower income.

47. An Open Market Sale Here, the Fed sells bonds.
In return for the bond, the Fed receives a check drawn against a bank.
The bank’s reserve assets are reduced and money supply falls.

48. Bond Prices and Interest Rates
The Fed raises the demand for bonds when it buys bonds in an open market purchase.
Bond prices rise and interest rates fall.

49. Bond Prices and Interest Rates
The Fed increases the supply of bonds when it sells bonds in the open market.
Bond prices fall and interest rates rise.

50. Open Market Purchase
Price of a bond
Quantity of bonds S D1 D0 B A

51. Open Market Sale
Price of a bond
Quantity of bonds S0 S1 D0 A C

52. The Fed Funds Market
Banks with surplus reserves can lend them to banks with a reserve shortage.
They are lent overnight as Fed funds.

53. The Fed Funds Market
Fed funds – loans of reserves banks make to each other.
Federal funds rate – the interest rate banks charge each other for Fed funds.
Federal funds market – the market in which banks lend and borrow reserves.

54. The Fed Funds Market
By selling bonds, the Fed reduces reserves and increases the Fed funds rate.
When the Fed buys bonds, it increases reserves, causing the Fed funds rate to fall.

55. The Fed Funds Rate and the Discount Rate since 1990
1992
1994
1996
1998
2000
2002 9 8 7 6 5 4 3 2 1
Percent
Fed funds rate
Discount rate

56. Offensive and Defensive Actions
The Fed steps in to buy or sell bonds during emergencies, such as floods or earthquakes.
Reserves would fall because it is impossible for businesses or individuals to get to the bank with their cash.

57. Offensive and Defensive Actions
Defensive actions are designed to maintain the current monetary policy.
Offensive actions are designed to have expansionary or contractionary effects on the economy.

58. The Fed Funds Rate as an Operating Target
The Fed looks at the Federal funds rate to determine whether monetary policy is tight or loose.

59. The Fed Funds Rate as an Intermediate Target
If the Federal funds rate is above the Fed’s target range, it buys bonds.
This increases reserves and lowers the Federal funds rate.

60. The Fed Funds Rate as an Intermediate Target
If the Federal funds rate is below the Fed’s target range, it sells bonds.
This decreases reserves and raises the Federal funds rate.

61. The Complex Nature of Monetary Policy
The Fed’s ultimate target is price stability, acceptable employment, sustainable growth, and moderate long-term interest rates.
These targets are indirectly affected by changes in the Fed funds rate.

62. The Complex Nature of Monetary Policy
The Fed watches intermediate targets to see if it is on track.
Intermediate targets include consumer confidence, stock prices, interest rate spreads, housing starts, and a host of others.

63. The Complex Nature of Monetary Policy
Fed tools
Open market operations
Discount rate
Reserve requirement
Operating target
Fed funds
Intermediate targets
Consumer confidence
Stock prices
Interest rate spreads
Housing starts
Ultimate targets
Stable prices
Sustainable growth
Acceptable employment
Moderate long-term interest rates
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© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

64. The Taylor Rule
Set the Fed funds rate at 2 percent plus current inflation if the economy is at desired output and desired inflation.

65. The Taylor Rule
If the inflation rate is higher than desired, increase the Fed funds rate by 0.5 times the difference between desired and actual inflation.

66. The Taylor Rule
If output is higher than desired increase the Fed funds rate by 0.5 times the percentage deviation.

67. The Taylor Rule Formally the Taylor rule is:
Fed funds rate = 2% + Current inflation
+ 0.5 X (actual inflation less desired inflation)
+ 0.5 X (percent deviation of aggregate output from potential)

68. Fed Response to September 11
In defensive actions, the Fed:
Doubled its holdings of repurchase agreements.
Increased discount window lending.
Established “swap lines” with foreign banks to temporarily exchange currencies to ensure foreign currency liquidity.

69. Fed Response to September 11
In offensive actions:
The open market desk reduced the Fed funds rate.

70. Monetary Policy in the AS/AD Model
In AS/AD model, monetary policy is seen working primarily through its effect on interest rates.

71. Contractionary Monetary Policy
The Fed decreases the money supply.
The interest rates go up.
As interest rates go up, the quantity of investment goes down.

72. Contractionary Monetary Policy
As investment goes down, aggregate demand goes down.
Aggregate equilibrium demand and income go down by a multiple of decrease in investment.

73. Contractionary Monetary Policy
The AD curve shifts to the left by a multiple of the shift in investment.
Income and output decrease.
M i I Y

74. Expansionary Monetary Policy
Expansionary monetary policy works in the opposite direction.
M i I Y

75. Contractionary Monetary Policy
Real output
Price level
Short-run aggregate supply P0 P1
AD0
AD1 Y1 Y0

76. Expansionary Monetary Policy
Real output
Price level
Short-run aggregate supply P1 P0
AD1
AD0 Y1 Y0

77. Monetary Policy in the Circular Flow
Expansionary monetary policy tries to expand the economy by channeling more saving into investment.
Contractionary monetary policy tries to reduce inflationary pressures by restricting demand for consumer loans and investment

78. Monetary Policy in the Circular Flow
Expenditures
Consumptio
Households
Government
expenditures
fiscal policy
Firms
Exports
Imports
Consumption
Monetary policy
Financial sector
borrowing
Taxes
Savings
Investment
Wages, rents, interest, profits

79. Emphasis on the Interest Rate
A rising interest rate indicates a tightening monetary policy.
A falling interest rate indicates a loosening of monetary policy.

80. Emphasis on the Interest Rate
A natural conclusion is that the Fed should target interest rates in setting monetary policy.

81. Real and Nominal Interest Rates
There is a problem in using interest rates as a measure of the tightness or looseness of monetary policy.
That problem is the real/nominal interest rate problem.

82. Real and Nominal Interest Rates
Nominal interest rates are those you actually see and pay.
Real interest rates are those adjusted for expected inflation.

83. Real and Nominal Interest Rates
The real interest rate cannot be observed since it depends on expected inflation, which cannot be directly observed.
Nominal interest rate = Real interest rate + Expected inflation rate

84. Real and Nominal Interest Rates and Monetary Policy
Making a distinction between nominal and real interest rates adds another uncertainty to the effect on monetary policy.

85. Real and Nominal Interest Rates and Monetary Policy
Most economists believe that a monetary regime, not a monetary policy, is the best approach to policy.
Expansionary monetary policy will lead to expectations of increased inflation.
Increased inflation expectations will lead to higher nominal interest rates, leaving real interest rates unchanged.

86. Real and Nominal Interest Rates and Monetary Policy
A monetary regime is a predetermined statement of the policy that will be followed in various situations.
A monetary policy is a policy response to events which is chosen without a predetermined framework.

87. Real and Nominal Interest Rates and Monetary Policy
The Fed is currently following a monetary regime that the involves feedback rules that center on the Federal funds rate.
If inflation is above its target, the Fed raises the Fed funds rate.

88. Problems in the Conduct of Monetary Policy
The five problems of monetary policy:
Knowing what policy to use.
Understanding the policy you're using.
Lags in monetary policy.
Liquidity traps
Political pressure.
Conflicting international goals.

89. Knowing What Policy to Use
The potential level of income must be known.
Otherwise you don’t know whether to use expansionary or contractionary monetary policy.

90. Understanding the Policy You’re Using
You must know whether the policy being used is expansionary or contractionary in order to use monetary policy effectively.

91. Understanding the Policy You’re Using
The money multiplier is influenced by both the amount of cash people hold as well as the lending process at the bank.
Neither of these are stable numbers.

92. Understanding the Policy You’re Using
Then there are interest rates.
If interest rates rise, is it because of expected inflation or is it that the real interest rate is going up?

93. Lags in Monetary Policy
Monetary policy takes time to work.
The Fed must recognize what the situation in the economy is.
Then it must develop a consensus for action.
Then businesses and individuals have to react to the policy change.

94. Liquidity Trap
Just because the Fed drops interest rates, that does not necessarily mean that people or businesses will go out and borrow money.

95. Liquidity Trap
Liquidity trap – a situation in which increasing reserves does not increase the money supply, but simply leads to excess reserves.

96. Political Pressure
The Fed is not totally insulated from political pressure.
Presidents place great pressure on the Fed to loosen the purse strings, especially during an election year.

97. Conflicting International Goals
Monetary policy is conducted in an international arena.
It must be coordinated with other nations.

98. Monetary Policy and the Debate about Macro Policy
End of Chapter 28