Introduction Thinking Like an Economist CHAPTER 13 Monetary

Introduction: Thinking Like an Economist CHAPTER 13 Monetary Policy There have been three great inventions since the beginning of time: fire, the wheel and central banking. — Will Rogers Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Monetary Policy 13 1 Monetary Policy Ø Monetary policy is a policy of influencing the economy through changes in the banking system’s reserves that influence the money supply, credit availability, and interest rates in the economy • Fiscal policy is controlled by the government directly • Monetary policy is controlled by the U. S. central bank, the Federal Reserve Bank (the Fed) • Monetary policy works through its influence on credit conditions and the interest rate in the economy 13 -2

Monetary Policy 13 1 How Monetary Policy Works in the Models Price level Monetary policy affects both real output and the price level Expansionary monetary policy shifts the AD curve to the right SAS P 1 P 0 AD 1 P 2 AD 0 AD 2 Y 0 Y 1 Contractionary monetary policy shifts the AD curve to the left Real output 13 -3

Monetary Policy 13 1 Monetary Policy Price level If the economy is at or above potential, expansionary monetary policy will cause input costs to rise LAS SAS 1 P 1 SAS 0 AD 1 P 0 AD 0 YP Rising input costs will eventually shift the SAS curve up so that real output remains unchanged The only long-run effect of expansionary monetary policy when the economy is above potential is to increase the price level Real output 14 -4 13 -4

13 1 Monetary Policy and the Money Market Loanable Funds Market Interest Rate M 0 i 0 Interest Rate M 1 Expansionary monetary policy leads to… i 1 … an increase in loanable funds S 0 S 1 i 0 i 1 D D Q of Money Q of Loanable Funds • The decline in interest rates increases investment spending, which shifts the aggregate demand curve out to the right 14 -5 13 -5

Monetary Policy 13 1 How Monetary Policy Works in the Models Ø Expansionary monetary policy is a policy that increases the money supply and decreases the interest rate and it tends to increase both investment and output M i I Y Ø Contractionary monetary policy is a policy that decreases the money supply and increases the interest rate, and it tends to decrease both investment and output M i I Y 13 -6

Monetary Policy 13 1 Monetary Policy and the Fed Ø A central bank is a type of banker’s bank whose financial obligations underlie an economy’s money supply • The central bank in the U. S is the Fed • If commercial banks need to borrow money, they go to the central bank • If there’s a financial panic and a run on banks, the central bank is there to make loans Ø The ability to create money gives the central bank the power to control monetary policy 13 -7

Monetary Policy 13 1 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 FINANCIAL SECTOR Provides Services GOVERNMENT 14 -8 13 -8

Monetary Policy 13 1 Duties of the Fed Ø Conducts monetary policy (influencing the supply of money and credit in the economy) Ø Supervises and regulates financial institutions Ø Lender of last resort to financial institutions Ø Provides banking services to the U. S. government Ø Issues coin and currency Ø Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions 13 -9

Monetary Policy 13 1 The Tools of Conventional Monetary Policy Ø The Fed influences the amount of money in the economy by controlling the monetary base • Monetary base is vault cash, deposits of the Fed, and currency in circulation Ø Monetary policy affects the amount of reserves in the banking system • Reserves are vault cash or deposits at the Fed • Reserves and interest rates are inversely related 13 -10

Monetary Policy 13 1 The Reserve Requirement and the Money Supply Ø The reserve requirement is the percentage the Fed sets as the minimum amount of reserves a bank must have Ø There are other ways the Fed can impact the banks’ reserves • The Fed can directly add to the banks’ reserves • The Fed can change the interest rate it pays banks’ on their reserves • The Fed can change the Fed funds rate, the rate of interest at which banks borrow the excess reserves of other banks 13 -11

Monetary Policy 13 1 Borrowing from the Fed and the Discount Rate Ø In case of a shortage of reserves, a bank can borrow reserves directly from the Fed Ø The discount rate is the interest rate the Fed charges for those loans it makes to banks • An increase in the discount rate makes it more expensive to borrow from the Fed and may decrease the money supply • A decrease in the discount rate makes it less expensive to borrow from the Fed and may increase the money supply 13 -12

Monetary Policy 13 1 The Fed Funds Market Ø Banks with surplus reserves loan these reserves to banks with a shortage in reserves • Fed funds are loans of excess reserves banks make to each other • Fed funds rate is the interest rate banks charge each other for Fed funds Ø By selling bonds, the Fed decreases reserves, causing the Fed funds rate to increase Ø By buying bonds, the Fed increases reserves, causing the Fed funds rate to decrease 13 -13

Monetary Policy 13 1 The Complex Nature of Monetary Policy While the Fed focuses on the Fed funds rate as its operating target, it also has its eye on its ultimate targets: stable prices, acceptable employment, sustainable growth, and moderate long-term interest rates Fed tools Open market operations, Discount rate, and Reserve requirement Operating target Fed funds rate Intermediate targets Consumer confidence Stock prices Interest rate spreads Housing starts Ultimate targets Stable prices Sustainable growth Acceptable employment Moderate i rates 13 -14

Monetary Policy 13 1 The Taylor Rule Ø The Taylor rule is a useful approximation for predicting Fed policy Ø Formally the Taylor rule is: Fed funds rate = 2% + Current inflation + 0. 5 x (actual inflation less desired inflation) + 0. 5 x (percent deviation of aggregate output from potential) 13 -15

Monetary Policy 13 1 Limits to the Fed’s Control of Interest Rates Ø The Fed may not be able to shift the entire yield curve up or down, but may make it steeper, flatter or inverted Ø A yield curve is a curve that shows the relationship between interest rates and bonds’ time to maturity. Ø An inverted yield curve is one in which the short-term rate is higher than the long-term rate 13 -16

Monetary Policy 13 1 Normal vs. Inverted Yield Curves 13 -17

Monetary Policy 13 1 Limits to the Fed’s Control of the Interest Rate • As financial markets become more liquid, and technological changes occur, the Fed’s ability to control the long-term rate through conventional monetary policy lessens • When faced with a financial crisis, the Fed may use quantitative easing, Fed policy that does not directly affect the interest rate • An example is buying assets other than bonds 14 -18 13 -18