Chapter 13

1. Chapter 13 Managing Aggregate Demand: Monetary Policy Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it meant. But they knew that it was an act of extreme wisdom. JOHN KENNETH GALBRAITH

3. Outline Fed as a central bank Monetary policy Tools Mechanism

4. Money and Income: Difference • Money • At one point in time (stock) • E.g.: money stock (M1) • Income • Over a period of time (flow) • E.g.: nominal GDP per year

5. The Federal Reserve System

6. The Federal Reserve System • The Federal Reserve System, “The Fed” • U.S. central bank • Bank for banks • Origins • 1873-1907: four severe banking panics • Established in 1914 by the Congress to regulate commercial banks Discussion: Why do we need a central bank?

7. Dow-Jones Industrial Average

8. Bank Run on Wall Street, 1907

9. The Federal Reserve System Organization of the Fed Board of Governors FOMC 12 Regional Banks Member Banks

10. The Federal Reserve System • Board of Governors (7 members) • Main governing body of the Fed • Appointed by U.S. President • Chairman (4-year term) • Advice & consent of Senate • 14-year term • Oversees System operations, makes regulatory decisions, and sets reserve requirements

11. The Federal Reserve System The Fed has 12 regional banks Each independently incorporated with a 9-member board of directors Set discount rate, subject to approval by Board of Governors Monitor economy and financial institutions in their districts and provide financial services to the U.S. government and depository institutions

12. The Federal Reserve System • Federal Open Market Committee (FOMC) • 12 members • 7 governors of the Fed • President of the Fed – New York • 4 (of 11) district banks presidents on a rotating basis • Meet eight times a year in DC • Determine short-term interest rates (FFR) • Size of U.S. money supply

13. FOMC Meeting

14. The Federal Reserve System 3400 member banks Private banks Hold stock in their local Federal Reserve Bank Elect six of the nine members of Reserve Banks’ boards of directors

15. The Federal Reserve System • Central bank independence • Make decisions without political interference (without prior approval from Congress or the President) • Institutional arrangement guarantees the independence • Unique structure provides internal checks and balances, not dominated by one part of the system • Help control inflation Discussion: Why do we need CBI?

16. Central bank independence

17. Tools of Monetary Policy Open market operations Discount rate Reserve requirements

18. Implementing Monetary Policy • Open-market operations (OMOs) • Fed’s purchase / sale • Short-term government securities (T-bills) • Transactions: Open market • The Fed uses OMOs to affect market interest rates • Purchase: Treasury bills • Pays: newly created bank reserves • Put pressure on market interest rate • The most frequently used tool

19. Implementing Monetary Policy • Market for bank reserves • Supply curve • Determined by Federal Reserve policy • Upward-sloping • Demand curve • Banks – required to hold reserves • Reflects • Demand for transaction deposits – banks • Depends on real GDP & price level • Downward-sloping (Why?)

20. Figure 1 The market for bank reserves S D For given Fed policy E Interest Rate For given Y and P D S Quantity of Bank Reserves

21. Implementing Monetary Policy • Market for bank reserves • Federal funds rate (FFR) • Interest rate • Borrow/lend reserves among banks • The Fed – lower federal funds rate • Purchase T-bills • Additional reserves to market • Supply curve – shift outward • Lower interest rates • More bank reserves

22. Figure 2 The effects of an open-market purchase S0 S1 D E A Interest Rate D S0 S1 Quantity of Bank Reserves

23. Implementing Monetary Policy • Federal Reserve • Wants lower interest rates • Purchases U.S. government securities • In the open market • Pays - creating new bank reserves • Required reserve – no change • Actual reserves – increased • Excess reserves • Multiple expansion process • Increase money supply by 1/m times

24. Table 1 Effects of an open-market purchase of securities on the balance sheets of banks and the Fed Reserves +$100 million Bank Reserves +$100 million U.S. government securities +$100 million U.S. government securities -$100 million Bank gets Reserves Addendum: Changes in Reserves Actual Reserves +$100 million Required Reserves No Change Excess Reserves +$100 million Fed gets securities

25. Implementing Monetary Policy • OMOs might not be perfect accurate • People - hold cash • Banks - hold excess reserves • However, Fed can always achieve the FFR it wants • FFR is observable in the open market every minute • Fed can always adjust the volume of T-bills it needs to buy/sell • OMOs is very flexible, fine tune policy

26. Implementing Monetary Policy Federal Reserve Wants to increase interest rates Sells U.S. government securities In the open market Banks pay: reserves (deposits at the Fed) Multiple contraction process Decrease money supply by 1/m times

27. Implementing Monetary Policy Another way to look at OMO (via bond market) • Expansionary monetary policy • Fed buys T-bills • T-bill prices – increase • Demand – unchanged • Supply (available to private investors) • Inward shift • Interest rates – fall • Interest rate = fixed dividend / bond price • Bond price ↑ → interest rate ↓

28. Figure 3 Open-market purchases and treasury bill prices S1 S0 D A B P1 Price of a Treasury Bill P0 S1 D S0 Quantity of Treasury Bills

29. Implementing Monetary Policy Summary of OMO: • Open-market purchase-T-bills • Raises the money supply • Drives up T-bill prices • Pushes interest rates down • Open-market sale - T- bills • Reduces the money supply • Lowers T-bill prices • Raises interest rates

30. Effective FFR

31. Nearly Zero FFR Discussion: In the current recession, Fed already set FFR close to zero. Does this mean the effect of OMOs is limited? What should Fed do if OMOs do not work?

32. Other Methods of Monetary Control • The Fed – lender of last resort • Lending to member banks • Discount rate • Interest rate charged by Fed for overnight loans that member banks borrow via “Discount Window” • generally set at a rate close to 1% above the target FFR • Discount rate – decrease • Banks – borrow more • Increase excess reserves

33. Table 2 Balance sheet changes for borrowing from the Fed Reserves +$5 million Loan from Fed +$5 million Loan to Bank +$5 million Bank Reserves +$5 million Addendum: Changes in Reserves Actual Reserves +$5 million Required Reserves No Change Excess Reserves +$5 million Bank borrows $5 million And the proceeds are credited to its reserve account

34. Other Methods of Monetary Control • Minimum required reserve ratio (m) • Decrease • Increase excess reserves • Money expansion • Lower interest rates • Increase • Decrease excess reserves • Money contraction • Higher interest rates • 10% since 1992

35. How Monetary Policy Works • Expansionary monetary policy • Open-market purchase • Lower interest rates • Contractionary monetary policy • Open-market sale • Raise interest rates

36. Figure 4 The effects of monetary policy on interest rates S0 S0 S2 S1 D D E E A B Interest Rate Interest Rate D D S2 S1 S0 S0 Bank Reserves Bank Reserves (b) Contractionary Monetary Policy (a) Expansionary Monetary Policy

37. How Monetary Policy Works • Sensitive to monetary policy • Investment (depends on r) • Net exports (via exchange rate, Chp. 18) • AD = C +I +G +(X-IM) is thus affected • Reminder: fiscal policy affects AD through G (directly) and C an I (indirectly via tax) • Discussion: fiscal policy vs. monetary policy, pros and cons

38. Figure 5 The effect of interest rates on total expenditure 45° C+I+G+(X-IM) (lower interest rate) C+I+G+(X-IM) (higher interest rate) C+I+G+(X-IM) Real Expenditure Real GDP

39. How Monetary Policy Works • Expansionary monetary policy • Lower interest rates (r) • Encourage investment (I) • Higher total spending • Higher expenditure schedule • Multiplier effect on aggregate demand

40. How Monetary Policy Works Contractionary monetary policy Higher interest rates (r) Lower investment spending (I) Lower total spending [C+I+G+(X-IM)] Lower expenditure schedule Lower aggregate demand through multiplier

41. Mechanism of Mon. Policy (P constant)

42. Figure 6 The effect of expansionary monetary policy on total expenditure 45° C+I1+G+(X-IM) C+I0+G+(X-IM) E1 E0 Real Expenditure 0 5,500 7,000 6,000 6,500 Real GDP

43. How Monetary Policy Works • Effect of monetary policy • On aggregate demand • Depends on • Sensitivity of interest rates • To open-market operations • Responsiveness of investment spending • To interest rate • Size of basic expenditure multiplier

44. Money & Price Level in Keynesian Model • Expansionary monetary policy • Increases aggregate quantity demanded • At any given price level • Causes some inflation • Depends on slope of aggregate supply curve

45. Money & Price Level in Keynesian Model

46. Figure 7 Inflationary effects of expansionary monetary policy D1 D0 S E B $500 billion Price Level 100 103 S D0 D1 0 6,000 6,400 Real GDP

47. Money & Price Level in Keynesian Model • Aggregate demand – slopes downward • Higher price level (caused by expansionary monetary policy) • Reduce purchasing power • Depress exports, Stimulate imports • Increase quantity of bank deposits demanded • Demand curve (bank reserves) – shift outward • Increase federal funds rate • Higher interest rate • Discourage investment • Lower aggregate quantity demanded

48. Figure 8 The effect of a higher price level on the market for bank reserves S D0 D1 E1 E0 Interest Rate Effect of a higher P S D0 D1 Bank Reserves

49. Summary Fed: Origin and structure Central bank independence Tools of monetary policy OMO Discount rate Reserve requirement Mechanism of the monetary policy Interest rate → Investment → AD → Y and P