1. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ■describe the mechanics of monetary policy ■explain the tradeoffs involved in monetary policy ■describe how financial market participants respond to the Fed’s policies 1 5 Monetary Policy Chapter Objectives

2. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Mechanics of Monetary Policy Monitoring Indicators of Economic Growth: The Fed monitors indicators of economic growth:  GDP - measures the total value of goods and services produced during a specific period  National Income - the total income earned by firms and individual employees during a specific period  Unemployment rate - maintain a low of unemployment rate in the U.S.  Other indexes - Industrial production index, a retail sales index, and a home sales index, and others. 2

3. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Mechanics of Monetary Policy Monitoring Indicators of Inflation  Producer and consumer price indexes: Producer price index represents prices at the wholesale level, and the consumer price index represents prices paid by consumers (retail level).  Other inflation indicators  Wage rates are periodically reported in various regions.  Oil prices can signal future inflation because they affect the costs of some forms of production as well as transportation costs and the prices paid by consumers for gasoline.  The price of gold is closely monitored because gold prices tend to move in tandem with inflation. 3

4. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Once the Federal Open Market Committee assesses economic conditions, it can identify its main concerns about the economy and determine the proper monetary policy that would alleviate its concerns. Monetary policy changes the money supply in order to influence interest rates. 4

5. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Effects of a Stimulative Monetary Policy  With a stimulative monetary policy, the Fed increases the supply of funds in the banking system, which can increase the level of business investment, and hence aggregate spending in the economy. 5

6. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5.2 Effects of an Increased Money Supply 6

7. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Effects of a Stimulative Monetary Policy (cont.)  Impact on interest rates - The quantity of loanable funds supplied exceeds the quantity of loanable funds demanded. The interest rate will decline to equilibrium.  Logic behind the impact on interest rates - The depository institutions experience an increase in supply of funds. Therefore, they borrow less funds or provide more short-term loans at lower interest rates. 7

8. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Effects of a Stimulative Monetary Policy (cont.)  Logic behind the effects of business cost of debt - As business cost of debt decreases, firms implement more projects and spend more money. This results in more income to individuals or other firms which allows more people to invest in the original company.  Effects on business cost of equity - The firms cost of equity is positively related to the risk-free rate. Lower risk-free rate = Lower cost of equity 8

9. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Effects of a Stimulative Monetary Policy (cont.)  Summary of Effects  Effects on the Treasury (risk-free) rate influences cost of debt and cost of equity. (Exhibit 5.3)  Cost of capital is reduced, reducing required return on cost of products.  Encourages firms to spend more money, higher more employees. 9

10. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5.3 How the Fed Can Stimulate the Economy 10

11. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Effects of Restrictive Monetary Policy (Exhibit 5.5)  Increasing risk-free interest rate, increases corporate cost of financing, therefore decreasing the level of business investment.  As economic growth is slowed, inflationary pressure may be reduced. 11

12. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5.5 Effects of a Reduced Money Supply 12

13. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Implementing Monetary Policy Summary of Monetary Policy Effects  Fed can affect economic conditions through its influence on the supply of loanable funds. (Exhibit 5.6)  Lagged Effects of Monetary Policy:  Recognition lag - lag between the time a problem arises and the time it is recognized  Implementation lag - lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve that problem  Impact lag - lag until the policy has its full impact on the economy 13

14. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5.6 How Monetary Policy Can Affect Economic Conditions 14

15. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tradeoff in Monetary Policy Ideally, the Fed would like to achieve both a very low level of unemployment and a very low level of inflation in the United States.  Inverse relationship between inflation and unemployment.  Strong economic conditions: high inflation, low unemployment  Weak economic conditions: low inflation, high unemployment  Historical data on annual inflation and unemployment rates show that when one of these problems worsens, the other does not automatically improve. 15

16. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5.7 Trade-off between Reducing Inflation and Unemployment 16

17. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monitoring the Impact of Monetary Policy Impact on Financial Institutions  When interest rates rise, the cost of funds for financial institutions rises faster than the return they receive.  Financial institutions such as commercial banks, bond mutual funds, insurance companies, and pension funds maintain large portfolios of bonds, so their portfolios are adversely affected when the Fed raises interest rates.  Stock mutual funds, insurance companies, and pension funds maintain large portfolios of stocks, and their stock portfolios are also indirectly affected by changes in interest rates. 17

18. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Homework Assignment 4 Chapter 4: Questions and Applications 2, 3, 9. Chapter 5: Questions and Applications 3, 8, 18