MONETARY POLICY. 8Topic

Transcription

1 MONETARY POLICY 8Topic

2 The Central Bank: CB The Federal Reserve System, commonly known as the Fed, is the central bank of the United States. A Central Bank (CB) is the public authority that, typically, regulates a nation s depository institutions and controls the quantity of the nation s money. The degree of independence the central bank has from the government of the day varies a great deal from one country to another.

3 The Central Bank: CB The CB s Goals and Targets The CB conducts the nation s monetary policy, which means that, among other things, it adjusts the quantity of money in circulation. The CB s goals are to keep inflation in check, maintain full employment, moderate the business cycle, and contribute to achieving long-term growth. In pursuit of its goals, in the U.S., the Fed pays close attention to interest rates and sets a target for the federal funds rate that is consistent with its goals. The federal funds rate is the interest rate that commercial banks in the U.S. charge each other on overnight loans of reserves [ federal funds ]. In Canada, this rate is called the Overnight lending rate. In Bangladesh, it is called the Call Money Rate.

4 Controlling the Quantity of Money The CB s Policy Tools In theory, the CB could use three monetary policy tools: Required reserve ratios The discount rate Open market operations

5 Controlling the Quantity of Money The CB sets required reserve ratios, which are the minimum percentages of deposits that depository institutions must hold as reserves. The CB does not change these ratios very often. The discount rate is the interest rate at which the CB stands ready to lend reserves to depository institutions. An open market operation is the purchase or sale of government securities Treasury bills and bonds by the CB in the open market.

6 Controlling the Quantity of Money How Required Reserve Ratios Work An increase in the required reserve ratio boosts the reserves that banks must hold, decreases their lending, and decreases the quantity of money. However, this is a sudden discontinuous change, so can be disruptive. How the Discount Rate Works An increase in the discount rate raises the cost of borrowing reserves from the CB and decreases banks reserves, which decreases their lending and decreases the quantity of money. But banks try to avoid borrowing from the CB [why?], so discount rate changes act mainly as a signal.

7 Controlling the Quantity of Money How an Open Market Operation Works When the CB conducts an open market operation by buying a government security, it increases banks reserves. Banks loan the excess reserves. By making loans, they create money. The reverse occurs when the CB sells a government security. Changing the supply of reserves to the banking system changes the interbank lending/borrowing rate, the interest rate at which banks lend and borrow reserves among themselves. So in practice, the CB announces a target rate for the interbank lending rate, and then uses Open Market Operations to get close to its target.

8 The Demand for Money This Figure illustrates the demand for money curve. The demand for money curve slopes downward a rise in the interest rate raises the opportunity cost of holding money and brings a decrease in the quantity of money demanded, which is shown by a movement along the demand for money curve.

9 The Supply of Money This Figure shows the supply of money as a vertical line at the quantity of money that is largely determined by the CB. The money supply is largely but not exclusively determined by the CB because both banks and the public are important players in the money supply process (as explained in earlier chapters). For example, when banks do not lend their entire excess reserves, the money supply is not as large as it is when they do. Money market equilibrium determines the interest rate.

10 Interest Rate Determination An interest rate is the percentage yield on a financial security such as a bond or a stock [or savings account]. The price of a bond and the interest rate are inversely related. If the price of a bond falls, the interest rate on the bond rises. If the price of a bond rises, the interest rate the bond yields falls. We can study the forces that determine the interest rate in the market for money.

11 Money Market Equilibrium This Figure illustrates the equilibrium interest rate.

12 Money Market Equilibrium If the interest rate is above the equilibrium interest rate, the quantity of money that people are willing to hold is less than the quantity supplied. They try to get rid of their excess money by buying financial assets. This action raises the price of these assets and lowers the interest rate.

13 Money Market Equilibrium If the interest rate is below the equilibrium interest rate, the quantity of money that people want to hold exceeds the quantity supplied. They try to get more money by selling financial assets. This action lowers the price of these assets and raises the interest rate.

14 Money Market Equilibrium Changing the Interest Rate This Figure shows how the CB changes the interest rate. If the CB conducts an open market sale, the money supply decreases, the money supply curve shifts leftward, and the interest rate rises.

15 Money Market Equilibrium If the CB conducts an open market purchase, the money supply increases, the money supply curve shifts rightward, and the interest rate falls.

16 Transmission Mechanisms Changes in one market can often ripple outward to affect other markets. The routes, or channels, that these ripple effects travel are known as the transmission mechanism. Monetary policy transmission mechanism: The routes, or channels, traveled by the ripple effects that the money market creates and that affect the goods and services market (represented by the aggregate demand and aggregate supply curves in the AD AS framework). In this chapter we discuss two transmission mechanisms: the Keynesian and the Monetarist.

17 Transmission Mechanisms The Money Market in the Keynesian Transmission Mechanism: Indirect If the CB increases money supply, the interest rate decreases. Then, three events follow: Investment and consumption expenditures increase. The value of the dollar in terms of foreign currency falls and net exports increase. Aggregate demand increases (through a multiplier effect).

18 The final step depends on the shape of the aggregate supply curve Transmission Mechanisms The Keynesian Transmission Mechanism: Indirect This Figure summarizes these ripple effects.

19 Transmission Mechanisms

20 Transmission Mechanisms The Keynesian Mechanism May Get Blocked Interest-Insensitive Investment (a) If investment is totally interest insensitive, a change in the interest rate will not change investment; therefore, aggregate demand and Real GDP will not change.

21 Transmission Mechanisms The Keynesian Mechanism May Get Blocked The Liquidity Trap (b) If the money market is in the liquidity trap, an increase in the money supply will not lower the interest rate. It follows that there will be no change in investment, aggregate demand, or Real GDP.

22 Transmission Mechanisms Bond prices, interest rates, and the liquidity trap Remember that the price of a bond and the interest rate are inversely related. So, when money supply increases, people use the extra money supply to buy bonds, price of bonds increases and interest rate falls. However, when interest rate is very low, this relationship may break down. At a low interest rate, the money supply increases but does not result in an excess supply of money. Interest rates are very low, and so bond prices are very high. Would-be buyers believe that bond prices are so high that they have no place to go but down. So individuals would rather hold all the additional money supply than use it to buy bonds.

23 Transmission Mechanisms The Keynesian View of Monetary Policy

24 Transmission Mechanisms The Monetarist Transmission Mechanism: Direct The monetarist transmission mechanism is short and direct. Changes in the money market directly affect aggregate demand in the goods and services market. For example, an increase in the money supply leaves individuals with an excess supply of money that they spend on a wide variety of goods.

25 Monetary Policy and the Problem of Inflationary and Recessionary Gaps Expansionary Monetary Policy: To reduce unemployment

26 Monetary Policy and the Problem of Inflationary and Recessionary Gaps Contractionary Monetary Policy: To reduce inflation