Monetary Policy
chapter sixteen
monetary policy
CHAPTER OVERVIEW
The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around five major topics: (1) the determination of interest rates; (2) the tools of monetary policy; (3) the causeeffect chain of monetary policy, including a graphic representation of the process; (4) a survey of the advantages and disadvantages of monetary policy; and (5) the dilemma of the appropriate scope of the Fed in policy making; whether they should be constrained by an inflation target, or given wider discretion to respond to prevailing macroeconomic conditions.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Identify the goals of monetary policy.
2. Identify some of the different types of interest rates in the economy.
3. Identify two types of demand for money and the main determinant of each.
4. Describe the relationship between GDP and the interest rate and each type of money demand.
5. Explain what is meant by equilibrium in the money market and the equilibrium rate of interest.
6. Explain how each of the three tools of monetary policy may be used by the Fed to expand and to contract the money supply.
7. Describe three monetary policies the Fed could use to reduce unemployment.
8. Describe three monetary policies the Fed could use to reduce inflationary pressures in the economy.
9. Explain the causeeffect chain between monetary policy and changes in equilibrium GDP.
10. Demonstrate graphically the money market and how a change in the money supply will affect the interest rate.
11. Show the effects of interest rate changes on investment spending.
12. Graph and describe the impact of changes in investment on aggregate demand and equilibrium GDP.
13. Contrast the effects of an easy money policy with the effects of a tight money policy.
14. Identify the federal funds rate, its relation to the prime interest rate, and its importance for monetary policy.
15. Describe the actions and results of recent U.S. monetary policy.
16. List strengths and shortcomings of monetary policy.
17. Describe the arguments for and against “inflation targeting” versus a more discretionary “artful management” approach to monetary policy.
18. Define and identify terms and concepts at the end of the chapter.
LECTURE NOTES
I.Introduction to Monetary Policy
A.Reemphasize Chapter 15’s points: The Fed’s Board of Governors formulates policy, and twelve Federal Reserve Banks implement policy.
B.The fundamental objective of monetary policy is to aid the economy in achieving fullemployment output with stable prices.
1.To do this, the Fed changes the nation’s money supply.
2.To change money supply, the Fed manipulates size of excess reserves held by banks.
C.Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s Board of Governors, Alan Greenspan in 2005, is sometimes called the second most powerful person in the U.S.
II.Interest Rates
- There are a variety of interest rates in the economy (Table 16.1)
1.Variation results from differences in purpose, size, risk, maturity, and taxability.
2.Global Snapshot 16.1 compares short term (3 month) rates of selected nations.
3.For discussion purposes, the text assumes a single interest rate determined by the demand for and supply of money.
B.The Demand for Money: Two Components
1.Transactions demand, Dt, is money kept for purchases and will vary directly with GDP (Figure 16.1a).
2.Asset demand, Da, is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, the price of holding idle money (Figure 16.1b).
3.Total demand will equal quantities of money demanded for assets plus that for transactions (Figure 16.1c).
C.The Equilibrium Interest Rate (Figure 16.1c)
1.Money supply is vertical because it is determined by the Fed and financial institutions.
2.Equilibrium interest rate is found at the intersection of money supply and demand.
D.Illustrating the Idea: That is Interest
Irving Fisher illustrated to his anti-interest socialist masseur that if the masseur required additional compensation to wait for payment of his bill, that was interest.
III.Tools of Monetary Policy
A.Monetary authorities have three tools with which they can shift money supply to affect interest rates, which in turn affect investment, consumption and aggregate demand and, ultimately, output, employment, and prices.
B.Openmarket operations refer to the Fed’s buying and selling of government bonds.
1.Buying securities will increase bank reserves and the money supply.
a.If the Fed buys directly from banks, then bank reserves go up by the value of the securities sold to the Fed.
b.If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount.
i.Banks’ lending ability rises with new excess reserves.
ii.Money supply rises directly with increased deposits by the public.
c.As excess reserves are lent out, the money multiplier process begins and the expansion of the money supply exceeds the initial increase in bank reserves.
2.When the Fed sells securities, points ac above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves.
C.The reserve ratio is another tool of monetary policy. It is the fraction of reserves required relative to their customer deposits.
1.Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.
2.Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.
3.Changing the reserve ratio has two effects.
a.It affects the size of excess reserves.
b.It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5.
4.Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so Fed rarely changes it (last time was 1992).
5.Table 16.2 illustrates the effect of different reserve ratios on money creation potential.
D.The third tool is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed.
1.An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves.
2.A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.
3.The Fed is a “lender of last resort” for commercial banks (so a change in the discount rate has more of an “announcement effect” than any significant impact on actual borrowing at the discount rate).
E.“Easy” money policy occurs when the Fed tries to increase money supply by expanding excess reserves in order to stimulate the economy. The Fed will enact one or more of the following measures.
1.The Fed will buy securities.
2.The Fed may lower the reserve ratio, although this is rarely changed because of its powerful impact.
3.The Fed could reduce the discount rate.
F.“Tight” money policy occurs when the Fed tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period. The Fed will enact one or more of the following policies:
1.The Fed will sell securities.
2.The Fed may raise the reserve ratio, although this is rarely changed because of its powerful impact.
3.The Fed could raise the discount rate.
G.Relative Importance
1.Openmarket operations are most important. Decisions are flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response.
2.The reserve ratio is rarely changed since even small changes could destabilize bank’s lending and profit positions.
3.Changing the discount rate has become a passive tool, set at 1 percentage point above the Federal funds rate (covered later in the chapter).
IV.Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy
A.Causeeffect chain:
1.Money market impact is shown in Figure 16.2.
a.Demand for money is comprised of two parts.
i.Transactions demand is directly related to GDP.
ii.Asset demand is inversely related to interest rates, so total money demand is inversely related to interest rates.
b.Supply of money is assumed to be set by the Fed.
c.Interaction of supply and demand determines the market rate of interest, as seen in Figure 16.2a.
2.Interest rate determines amount of investment businesses will be willing to make. Investment demand is inversely related to interest rates, as seen in Figure 16.2b.
a.Interest rate changes may also affect consumer durable spending.
b.Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is sizable part of investment cost.
3.As investment rises or falls, aggregate demand shifts and equilibrium GDP rises or falls by a multiple amount, as seen in Figure 16.2c.
B.Expansionary or easy money policy: The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount. (See Column 1, Table 16.3)
C.Contractionary or tight money policy is the reverse of an easy policy: Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment. (See Column 2, Table 16.3)
V.Monetary Policy in Action
A.Strengths of monetary policy:
1.It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily.
2.It is less political. Fed Board members are isolated from political pressure, since they serve 14year terms, and policy changes are more subtle and not noticed as much as fiscal policy changes. It is easier to make good, but unpopular decisions.
B.Focus on the Federal Funds Rate
1.Currently the Fed communicates changes in monetary policy through changes in its target for the Federal funds rate.
2.The Fed does not set either the Federal funds rate or the prime rate; (see Figure 16.3) each is established by the interaction of lenders and borrowers, but rates generally follow the Fed funds rate.
3.The Fed acts through open market operations, selling bonds to raise interest rates and buying bonds to lower interest rates.
C.Applying the Analysis: Recent monetary policy
1.Easy money policy in the early 1990s helped produce recovery from the 1990-1991 recession and the expansion that lasted until 2001. Tightening in 1994, 1995, and 1997 helped ease inflationary pressure during the expansion.
2.To counter the recession that began in March 2001, the Fed pursued an easy money policy that saw the prime interest rate fall from 9.5 percent at the end of 2000 to 4.25 percent in December 2002.
3.The Fed has been praised for helping the U.S. economy maintain simultaneously full employment, price stability, and economic growth for over four years. They have also received credit for swift and strong responses to the September 11, 2001, terrorist attacks, significant declines in the stock market, and the overall recessionary conditions.
4.In response to expansion, in 2004 the Fed began acting to raise the Federal funds rate to keep aggregate demand growing at a noninflationary pace. (The 10th in the series of quarter-point rate increases occurred on August 9, 2005, with further increases expected.)
D.Problems and complications:
1.Recognition and operational lags impair the Fed’s ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Although policy changes can be implemented rapidly, there is a lag of at least 3 to 6 months before the changes will have their full impact.
2.Cyclical asymmetry may exist: a tight monetary policy works effectively to brake inflation, but an easy monetary policy is not always as effective in stimulating the economy from recession. “You can lead a horse to water, but you can’t make it drink.”
3.The impact on investment may be less than traditionally thought. Japan provides a case example. Despite interest rates of zero, investment spending remained low during the recession.
4.Illustrating the Idea: Pushing on a String
Japan’s ineffective easy money policy illustrates the potential inability of monetary policy to bring an economy out of recession. While pulling on a string (tight money policy) is likely to move the attached object to its desired destination, pushing on a string is not.
E.“Artful Management” or “Inflation Targeting”?
1.The Fed under Alan Greenspan has managed the money supply such that the U.S. economy has enjoyed price stability, high levels of employment, and strong economic growth. This leads some to argue that the Fed should take an active policy role and attempt to pursue all of those objectives in setting policy.
2.Out of concern that the Fed’s success may not be reproducible, some argue for inflation targeting. This narrower policy objective would make monetary policy more predictable and “transparent” to those in the economy making decisions based on Fed action.
3.Opponents of inflation targeting argue that it would unnecessarily limit the discretion of the Fed to adjust to prevailing business cycle conditions.
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