1. Monetary Policy

2. Monetary Policy
The Federal Reserve’s control over the supply of money is the key mechanism to monetary policy.
Monetary policy is the use of money and credit controls to influence macroeconomic activity.

3. Monetary Policy DETERMINANTS OUTCOMES Jobs Internal market AS forces
Output
Jobs
Prices
Growth
International
balances
Internal market
forces
External shocks AD AS
Policy levers:
Fiscal policy
Monetary policy

4. The Federal Reserve System
Control of the U.S. money supply starts with the Federal Reserve System (the Fed).

5. Federal Reserve Banks
The core of the Federal Reserve system consists of 12 Federal Reserve banks.

6. Functions of Regional Fed Banks
Clear checks between private banks
Hold bank reserves
Provide currency
Provide loans (discounting)

7. The Board of Governors Key decision-maker for monetary policy.
Seven members appointed by President of U.S. for 14 year terms.

8. Structure of the Federal Reserve System
Private banks
(depository institutions)
Federal Reserve banks
(12 banks, 24 branches)
Board of
Governors
(7 members)

9. The Federal Chairman Most visible member of the Fed system.
Selected by the President for a four year term — can be re-appointed.

10. The Federal Chairman
Alan Greenspan was appointed by President Reagan, re-appointed by Presidents Bush, Clinton, and Bush.

11. Monetary Tools The Fed has the power to alter the money supply.
The money supply (M1) consists of currency held by the public, plus balances in transaction accounts.

12. Monetary Tools The Fed has three basic tools of monetary policy:
Reserve requirements
Discount rates
Open-market operations

13. Reserve Requirements
The Fed directly alters the lending capacity of the banking system by changing the reserve requirement.
Required reserves are the minimum amount of reserves a bank is required to hold by government regulation.

14. Reserve Requirements
The ability of the banking system to create deposits is determined by the money multiplier and the amount of excess reserves.

15. Reserve Requirements
A decrease in required reserves increases excess reserves.

16. Reserve Requirements
Excess reserves are bank reserves in excess of required reserves.

17. A Decrease in Required Reserves
A change in the reserve requirement causes:
A change in excess reserves.
A change in the money multiplier.

18. A Decrease in Required Reserves
A lower reserve requirement increases the size of the money multiplier.
The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

19. A Decrease in Required Reserves
A lower reserve requirement increases the size of the money multiplier.
Money multiplier = 1
required reserve ratio

20. The Impact of Reduced Reserve Requirement

21. The Discount Rate
Discounting is Federal Reserve lending of reserves to private banks.
The discount rate is the rate of interest charged by Federal Reserve banks for lending reserves to private bank.

22. The Discount Rate
Sometimes banks reserves run low and they must replenish their reserves temporarily.

23. The Discount Rate There are three sources of last-minute reserves:
Fed funds market – borrow from a reserve-rich bank.
Sell securities.
Discounting – obtaining reserve credits from the Federal Reserve System.

24. The Discount Rate
By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

25. Open-Market Operations
Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

26. Open-Market Operations
Open-market operations are designed to affect portfolio decisions and the decision to hold money or bonds.

27. Portfolio Decisions
Where should idle funds be held – in cash or some other asset?

28. Hold Money or Bonds
The Fed attempts to influence whether individuals hold idle funds in transaction accounts or government bonds.
Changes in bond prices alter portfolio choices.

29. Open Market Activity
Open market operations — the Federal Reserve purchases and sells government bonds to alter bank reserves.
Fed buys bonds — it increases bank reserves.
Fed sells bonds — it reduces bank reserves.

30. An Open-Market Purchase
Federal Open Market Committee
Regional Federal Reserve bank
Private bank
Public
Step 1: FOMC purchases government bonds; pays for bonds with Federal Reserve check
Step 3: Bank deposits check at Fed bank, as a reserve credit
Step 2: Bond seller deposits Fed check

31. Powerful Levers
To summarize, there are three policy levers of monetary policy:
Reserve requirements
Discount rates
Open-market operations

32. Powerful Levers
The Fed has effective control of the nation’s money supply.

33. Shifting Aggregate Demand
The ultimate goal of all macro policy is to stabilize the economy at its full-employment capacity.
Monetary policy may be used to shift aggregate demand.

34. Shifting Aggregate Demand
Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

35. Expansionary Policy
Monetary policy can be used to move the economy to its full-employment potential.

36. Expansionary Policy
The Fed can increase AD by increasing the money supply by:
Lowering reserve requirements.
Dropping the discount rate.
Buying more bonds to increase bank lending capacity.

37. Expansionary Policy
Banks make more loans so AD shifts to the right reflecting increased purchasing power.

38. Demand-Side Focus AS E2 E1 AD2 AD1 Q1 QF PRICE LEVEL (average price)
RATE OF OUTPUT (real GNP per time period)
PRICE LEVEL (average price) AS E2 E1
AD2
AD1 Q1 QF

39. Restrictive Policy
Monetary policy can be used to cool an overheating economy.

40. Restrictive Policy Fed can reduce money supply and decrease AD by:
Raising reserve requirements
Increasing discount rate
Selling bonds

41. Price vs. Output Effects
The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.

42. Aggregate Demand
Increases in the money supply shift AD to the right.

43. Aggregate Supply
Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

44. Aggregate Supply
The shape of the AS curve determines the effectiveness of expansionary monetary policy.

45. Aggregate Supply
Horizontal AS — output increases without any inflation.
Vertical AS — inflation occurs without changing output.
Upward sloped AS — both prices and output are affected by monetary policy.

46. Aggregate Supply
With an upward-sloping AS curve, expansionary policy causes some inflation and restrictive policy causes some unemployment.

47. Contrasting Views of Aggregate Supply
(a) The Keynesian view
RATE OF OUTPUT
(real GDP per time period)
(average price per unit of output)
PRICE LEVEL
Aggregate supply P3 P1
AD3
AD2
AD1 Q1 QF

48. Contrasting Views of Aggregate Supply
(b) The Monetarist view
Aggregate supply
(average price per unit of output)
PRICE LEVEL P5 P4
AD5
AD4 QN
RATE OF OUTPUT
(real GDP per time period)

49. Contrasting Views of Aggregate Supply
(c) An eclectic view
Aggregate
supply
(average price per unit of output)
PRICE LEVEL P7 P6
AD7
AD6 Q6 Q7
RATE OF OUTPUT
(real GDP per time period)

50. Policy Perspectives
The shape of the aggregate supply curve spotlights a central policy debate.

51. Fixed Rules or Discretion?
Should the Fed try to fine-tune the economy with constant adjustments of the money supply?

52. Fixed Rules or Discretion?
Or should the Fed instead simply keep the money supply growing at a steady pace?

53. Discretionary Policy
The economy is constantly beset by expansionary and recessionary forces.
There is a need for continual adjustments to money supply.

54. Fixed Rules
Critics of discretionary monetary raise objections linked to the shape of the AS curve.
AS curve could be vertical or at least upward sloping.

55. Fixed Rules
With an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.

56. Fixed Rules
Fixed rules for money-supply management are less prone to error than discretionary policy.

57. Fixed Rules
The money supply should increase by a constant (fixed) rate each year.

58. The Fed’s Eclecticism
The Fed currently uses a pragmatic, eclectic approach.
Flexible rules
Limited discretion

59. The Fed’s Eclecticism
Mixes money-supply and interest-rate adjustments to do whatever is necessary to promote price stability and economic growth.

60. Monetary Policy
End of Chapter 14