Monetary Policy CHAPTER 31. Will Rogers. There have been three great inventions since the beginning of time: fire, the wheel and central banking.

Transcription

1 CHAPTER 31 Monetary Policy There have been three great inventions since the beginning of time: fire, the wheel and central banking. Will Rogers McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 Monetary Policy Monetary policy: influencing the economy through changes in the banking system s reserves which in turn influence the money supply and credit availability in the economy Controlled by the U.S. central bank (the Fed) 31-2

3 Expansionary Monetary Policy Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment It increases the money supply It decreases interest rates and it tends to increase both investment and output Also called the easy money policy M i I Y M=money supply i=interest rate I=investment Y=output 31-3

4 Draw the Graph: Expansionary Monetary Policy Price level LRAS Monetary policy affects both real GDP and the price level SRAS P 2 P 1 AD 2 Expansionary monetary policy shifts the AD curve to the right AD 1 Y 1 Y 2 Real GDP 31-4

5 Price level P 2 P 1 Expansionary Monetary Policy LRAS Y P SRAS 2 SRAS 1 AD 2 AD 1 Real GDP If the economy is at or above potential output, expansionary monetary policy will cause input costs to rise Rising input costs will eventually shift the SRAS curve up so that real GDP remains unchanged The only long-run effect of expansionary monetary policy when the economy is above potential is to increase the price level 31-5

6 Contractionary Monetary Policy Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment It decreases the money supply It increases the interest rate, and it tends to decrease both investment and output Also called the tight money policy M i I Y M=money supply i=interest rate I=investment Y=output 31-6

7 Draw the Graph: Contractionary Monetary Policy Price level LRAS Monetary policy affects both real GDP and the price level SRAS Contractionary monetary policy shifts the AD curve to the left P 1 P 2 AD 1 Y 2 Y 1 AD 2 Real GDP 31-7

8 Interest Rate Monetary Policy 31 Monetary Policy: The Money Market & Loanable Funds Market Money Market Interest Rate Loanable Funds Market i 1 MS 1 MS 2 Expansionary monetary policy leads to r 1 an increase in loanable funds S LF1 S LF2 i 2 r 2 D M D LF M 1 M Q 2 Q of Money 1 Q 2 Q of Loanable Funds The decline in interest rates increases investment spending, which shifts the aggregate demand curve to the right 31-8

9 How Monetary Policy Works We know monetary policy is conducted by the Fed If commercial banks need to borrow money, they go here If there s a financial panic and a run on banks, the central bank is there to make loans Can we go to the Fed to get a loan? No 31-9

10 Structure of the Fed Board of Governors 7 members appointed by the president and confirmed by the senate Oversees Regional Reserve Banks and Branches 12 regional Federal Reserve banks and 25 branches Federal Open Market Committee (FOMC) Board of Governors plus 5 Federal Reserve bank presidents Open Market Operations Provides Services FINANCIAL SECTOR GOVERNMENT 31-10

11 Six Duties of the Fed 1. Conducts monetary policy (influencing the supply of money and credit in the economy) 2. Supervises and regulates financial institutions 3. Lender of last resort to financial institutions 31-11

12 Six Duties of the Fed 4. Provides banking services to the U.S. government 5. Issues coin and currency 6. Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions McGraw-Hill/Irwin Colander, Economics 12

13 Monetary Policy The Fed influences the amount of money in the economy by controlling the monetary base Monetary base: vault cash, deposits of the Fed, and currency in circulation 31-13

14 Monetary Policy Monetary policy affects the amount of reserves in the banking system Reserves: vault cash or deposits at the Fed Reserves and interest rates are inversely related McGraw-Hill/Irwin Colander, Economics 14

15 Tools of Monetary Policy 1. Reserve Requirement 2. Discount Rate 3. Open market operations These are the 3 shifters of the money supply, and are the tools used by the Fed McGraw-Hill/Irwin Colander, Economics 15

16 The Reserve Requirement and the Money Supply The reserve requirement the percent of deposits that banks must hold in reserve (the percent they can NOT loan out) Banks keep some of the money in reserve and loan out their excess reserves 31-16

17 The Reserve Requirement and the Money Supply The total money supply depends on the reserve requirement By changing the reserve requirement the Fed can increase or decrease the money supply If the Fed increases the reserve requirement it contracts the money supply banks have to keep more reserves and lend out less money (decreases the money multiplier) McGraw-Hill/Irwin Colander, Economics 17

18 The Reserve Requirement and the Money Supply If the Fed decreases the reserve requirement it expands the money supply banks have more money to lend out (increases the money multiplier) McGraw-Hill/Irwin Colander, Economics 18

19 The Money Multiplier Remember from CH 30 that changing the reserve requirement can affect the total money supply through the multiplier The simple money multiplier is 1/r (when banks hold no excess reserves) The money multiplier when people hold cash is (1+c)/(r+c) McGraw-Hill/Irwin Colander, Economics 19

20 Using the Reserve Requirement If there is a recession, what should the Fed do to the reserve requirement? It should decrease the reserve ratio This means banks hold less money and have more excess reserves Banks create more money by loaning out excess reserves The money supply increases, interest rates fall, and AD increases McGraw-Hill/Irwin Colander, Economics 20

21 Using the Reserve Requirement If there is inflation, what should the Fed do to the reserve requirement? Increase the reserve ratio This means banks hold more money and have less excess reserves Banks create less money The money supply decreases, interest rates go up, and AD decreases McGraw-Hill/Irwin Colander, Economics 21

22 The Discount Rate Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks To increase the money supply, the Fed should decrease the discount rate To decrease the money supply, the Fed should increase the discount rate McGraw-Hill/Irwin Colander, Economics 22

23 Open Market Operations The primary way in which the Fed changes the amount of reserves in the system Open market operations occur when the Fed buys or sells government securities To expand the money supply, the Fed buys bonds To decrease the money supply, the Fed sells bonds 31-23

24 Open Market Operations How are you going to remember this? Buy-BIG: Buying bonds increases the money supply Sell-SMALL: Selling bonds decreases the money supply McGraw-Hill/Irwin Colander, Economics 24

25 Open Market Operations There is an inverse relationship between bond prices and interest rates When the Fed buys bonds, the price of bonds rises and interest rates fall When the Fed sells bonds, the price of bonds falls and interest rates rise McGraw-Hill/Irwin Colander, Economics 25

26 Open Market Purchases An open market purchase is expansionary monetary policy that tends to reduce interest rates and increase income When the Fed buys bonds, it deposits money in banks account with the Fed Bank reserves are then increased When banks loan out the excess reserves, the money supply increases 31-26

27 Open Market Sales An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income When the Fed sells bonds, it receives checks drawn against banks The bank s reserves are reduced and the money supply decreases 31-27

28 Applying What You Learned Inflationary and Recessionary Gap What should the Fed do if there is an inflationary gap? Sell bonds on the open market to decrease the amount of money banks can loan out, decreasing the money supply What should the Fed do if there is a recessionary gap? Buy bonds on the open market to increase the amount of money banks can loan out, increasing the money supply McGraw-Hill/Irwin Colander, Economics 28

29 Sample Question: Change in Money Supply vs. Change in Loans The Fed buys bonds equal to $10 million and that the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system? 1/r =1/0.2=5 5 *(10 million)=50 million Fed has to hold 20% though 50 million*(0.2)=10 million Total available for loans: 50 million -10 million =40 million McGraw-Hill/Irwin Colander, Economics 29

30 Sample Question: Change in Money Supply vs. Change in Loans The Fed buys bonds equal to $10 million and that the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system? 1/r =1/0.2=5 5 *(10 million)=50 million McGraw-Hill/Irwin Colander, Economics 30

31 The Federal Funds Market The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves Fed funds are loans of excess reserves banks make to one another 31-31

32 The Federal Funds Market The Fed can increase or reduce reserves by buying or selling bonds By selling bonds, the Fed decreases reserves This causes the fed funds rate to increase By buying bonds, the Fed increases reserves This causes the fed funds rate to decrease McGraw-Hill/Irwin Colander, Economics 32

33 The Fed Funds Rate as an Operating Target If the Fed funds rate is above the Fed s target range, it buys bonds to increase reserves and lower the Fed funds rate If the Fed funds rate is below the Fed s target range, it sells bonds to decrease reserves and raise the Fed funds rate McGraw-Hill/Irwin Colander, Economics 33

34 Maintaining Policy Credibility This is important to prevent inflationary expectations from becoming built into the system Nominal interest rates are the rates you actually see and pay Real interest rates are nominal interest rates adjusted for expected inflation Nominal interest rate = Real interest rate + Expected inflation rate 31-34

35 Maintaining Policy Credibility In the AS/AD model we assume expansionary monetary policies decrease interest rates and contractionary monetary policies increases interest rates If expansionary policy leads to expectations of increased inflation, nominal rates will increase and leave real rates unchanged 31-35

36 Chapter Summary Monetary policy influences the economy through changes in the banking system s reserves that affect the money supply and credit availability Expansionary monetary policy works as follows: M i I Y Contractionary monetary policy works as follows: M i I Y The Federal Open Market Committee (FOMC) makes the actual decisions about monetary policy 31-36

37 Chapter Summary The Fed is the central bank of the U.S; it conducts monetary policy and regulates financial institutions Open market operations are the Fed s most important policy tool To expand the money supply, the Fed buys bonds, which increases their price and decreases interest rates To decrease the money supply, the Fed sells bonds, which decreases their price and increases interest rates 31-37

38 Chapter Summary When the Fed buys bonds, the price of bonds rises and interest rates fall. When the Fed sells bonds, the price of bonds falls and interest rates rise. A change in reserves changes the money supply by the change in reserves times the money multiplier The Federal funds rate is the rate at which one bank lends reserves to another bank It is the Fed s primary operating target 31-38