1. Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 12 Managing the Economy: Monetary Policy

2. 12-2 Chapter Objectives The uses of money The structure of the Fed The goals of monetary policy Effect of money policy on the economy Effect of money policy on inflation Policy tools The practice of monetary policy

3. 12-3 The Uses of Money Money is an asset that serves three purposes: –First, it is a medium of exchange. You can use money to buy goods and services and accept it in exchange for the goods and services that you provide. A market economy depends on money. –Second, money is a store of value. –Finally, money is a standard of value.

4. 12-4 The Federal Reserve The Federal Reserve (Fed) is the country’s central bank. It was created by Congress in 1913 in response to the financial panic of 1907. The Federal reserve has the power to issue currency, set interest rates, and lend directly to the banks.

5. 12-5 The Structure of the Federal Reserve The Federal Reserve is a system of banks. It is headed by the Federal Reserve board, located in Washington, and consists of seven members, including the Chairman. There are also 12 regional Federal Reserve banks located around the country. The Federal Reserve was designed to have considerable independence in making policy decisions.

6. 12-6 The Goals of Monetary Policy The original goal of the Federal Reserve was to maintain the stability of the financial system. The Humphrey-Hawkins Act in 1978 specified a broader set of goals. The main goals of the Fed today are controlling inflation, smoothing out the business cycle, and ensuring financial stability.

7. 12-7 Controlling Inflation The top goal of the Federal Reserve is to keep inflation under control. –Prior Chairmen of the Fed have argued that a low and stable inflation is the best way to achieve strong economic growth. –The question is, how low should inflation be? It is generally believed that a rate anywhere between zero and 2% is acceptable.

8. 12-8 Smoothing Out the Business Cycle The Federal Reserve also has a goal of fighting recessions. –When the economy slows and unemployment rises, the Federal Reserve is expected to act. –To boost the economy, the Federal Reserve should cut interest rates. This will stimulate purchases of goods that require financing, such as autos and homes.

9. 12-9 Ensuring Financial Stability Another goal of the Federal Reserve is to serve as lender of last resort in the event of a financial crisis. –Financial markets are subject to occasional bouts of panic and fear. –If this happens, the Fed will calm things down by making sure that banks and Wall Street firms have the money they need to function.

10. 12-10 Policy Tools There are three main tools of monetary policy: –Control over short-term interest rates through open market operations. –Direct lending to banks and other financial institutions in times of crisis. –Changes in the reserve requirement and other financial regulations.

11. 12-11 Open Market Operations The Fed’s most-used policy tool is its ability to control short-term interest rates. The rate the Fed controls is the federal funds rate. The federal funds rate is the rate that banks charge each other for lending reserves or cash to each other overnight.

12. 12-12 Open Market Operations The Federal Reserve can directly control the fed funds rate via open market operations, which increase or decrease the amount of money available to banks to lend out. To cut the fed funds rate, the Fed executes an open market operation that makes more money available for the banks. –This shifts the supply curve for loans to the right, and interest rates fall.

13. 12-13 Open Market Operations Demand curve for loans Q1Q1 r1r1 Supply curve for loans after Fed makes more money available for banks to lend Short-term interest rate Q Quantity of funds borrowed/lent Supply curve for loans r

14. 12-14 Federal Open Market Committee The fed funds rate is set by a vote of the Federal Open Market Committee (FOMC) based on conditions in the economy. The FOMC consists of all seven members of the Board of Governors and presidents of five of the twelve Reserve banks, on a rotating basis. The FOMC meets eight times a year to discuss the economy and set the direction for monetary policy.

15. 12-15 Effect on Other Interest Rates The Fed’s control over the fed funds rate affects all other short-term interest rates, including credit cards, auto loans, adjustable rate mortgages, and rates on money market funds. In general, most short-term rates move together.

16. 12-16 Effect of Monetary Policy on the Economy Fed policy actions impact the interest- sensitive sectors of the economy. –These sectors, such as housing and auto sales, depend on borrowing. In general, a decrease in the fed funds rate will boost spending and GDP, while an increase in the fed funds rate will push spending and GDP down.

17. 12-17 Effect of Lower Rates on Car Sales Demand curve for cars with lower interest rates Q1Q1 P1P1 Original demand curve for cars Price per car Q Quantity of cars bought/sold Supply curve for cars P A B

18. 12-18 Effect of Monetary Policy on the Economy It’s important to note here that monetary stimulus requires about 12 to 18 months to have its full effect. These monetary policy lags have a big influence on the way monetary policy is conducted. While the Fed controls short-term rates, its influence on long-term rates is limited.

19. 12-19 Effect of Monetary Policy on Inflation In general, decreases in the fed funds rate will put upward pressure on prices. Increases in the fed funds rate puts downward pressure on prices. But exact impact depends on where the economy is in terms of actual and potential GDP. –If actual GDP is below potential, rate cuts are likely to boost GDP. –If actual GDP is above potential, rates cuts may lead to higher inflation.

20. 12-20 Fed Funds Rate, Historical

21. 12-21 The Discount Window During a financial crisis, the Fed needs to lend vulnerable financial institutions as much as they need. The Fed does this using the discount window. The discount window allows the Fed to lend money to financial institutions that are running short of funds. The interest cost of borrowing from the Fed is called the discount rate.

22. 12-22 The Housing Boom and Bust

23. 12-23 Reserve Requirements and Other Regulations Fed plays a key role in regulating the financial institutions. Through the regulations, the Fed can exert control over the economy. Two of the important regulations that the Fed controls are the reserve requirement and the margin requirement.

24. 12-24 Reserve Requirements and Other Regulations Reserve requirements require banks to keep a portion of their deposits either in cash in their vaults, or on reserve with the Fed. For most banks, this reserve requirement is 10% of deposits (less for smaller banks). Raising the reserve requirement means banks must keep more money as reserves, so they have less money to lend. –Less lending by banks means less spending by borrowers, which slows the economy.

25. 12-25 Reserve Requirements and Other Regulations Alternatively, cutting the reserve requirement gives banks more money to lend and helps boost the economy. The margin requirement determines how much people can borrow when they buy stock. The higher the margin requirements (now at 50% for most stock purchases), the more cash investors must use to buy stocks.

26. 12-26 Practice of Monetary Policy Monetary policy has certain advantages over fiscal policy: –Monetary policy is more flexible and less political than fiscal policy. –Monetary policy can be conducted in small steps (raising or lowering rates a little bit at a time). –If the economy recovers, the Fed can take back a stimulus more easily than Congress can rescind a tax cut or spending increase.

27. 12-27 Discretion versus Rules A debate exists within the Fed about whether it should use a rules-based approach or a discretionary approach to policy. The rules-based approach is based on the idea that the Fed should state ahead of time the rules it should follow. –The rules are followed no matter what the state of the economy.

28. 12-28 Discretion versus Rules –One example of a rules-based approach is inflation targeting. In this case, the Fed sets an inflation target and conducts policy to hit the target. Discretionary policy is based on the notion that as the economy changes, monetary policy needs to adjust as well. –So if inflation is rising, the Fed must raise interest rates. –Alternatively, if unemployment is rising, the Fed should cut rates.

29. 12-29 Long-term Effects of Monetary Policy Most economists agree that monetary policy affects long-term inflation. But monetary policy has little or no direct impact on long-term growth or on the rate of unemployment. Indirectly, it can have a favorable impact on long-term growth through lower inflation and by smoothing out the business cycle.