Monetary Policy

Chapter 13and 15

Monetary Policy

Altering the money supply and interest rates to manipulate the economy.

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The Federal Reserve

The FED is the part of the government that determines & enacts monetary policy.

The Fed serves as the central bank for the United States.

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Central Bank Functions: It is the banks’ bank: it accepts deposits from

and makes loans to commercial banks. It acts as banker for the federal government. It controls the money supply. Performs certain regulatory functions for the

financial industry.

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Fed Policy Tools Reserve requirements

How much money a bank must keep on hand Discount rate

The rate the Fed lends money to banks Federal Funds Rate

The interest rate for inter-bank reserve loans – One bank to another

Open market operations Treasury buys & sells government bonds

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Reserve Requirements Legal reserves

The cash a bank holds in its vault plus its deposits at the Fed.

Excess reserves If the Fed lowers reserve requirements, banks

that hold excess reserves can increase lending. Such lending increases the money supply.

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Changing Interest Rates

By altering the money supply the Federal Reserve is able to affect the equilibrium rate of interest.

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Interest Rates & Spending Altering the money supply changes the

equilibrium rate of interest. This changes consumer, investor, government,

and net export spending.

Higher rates less spending & investment

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Open Market Operations The buying and selling of government bonds by the

Fed to control bank reserves, the fed funds rate, and the money supply.

The FOMC Buys bonds: Bonds are replaced by cash Money supply is increased.

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Monetary Stimulus The goal of monetary stimulus is to increase

aggregate demand with lower interest rates. Increases investing Increases larger-ticket consumption

The increase in investment will kick off multiplier effects

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Monetary Stimulus: Tools:

Increase the money supply. Reduce interest rates.

Both lead to increase in aggregate demand which leads to more jobs, etc…

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Monetary Restraint

To lessen inflationary pressures, the Fed will apply a policy of monetary restraint.

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Obstacles to Fed Intervention

1. Reluctant Lenders Banks themselves must expand the money

supply by making new loans. Banks may be unwilling to make new loans

because their returns are lower.

2. Low Expectations

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Obstacles to Fed Intervention

3. Liquidity Trap When interest rates are low, people may

decide to hold all the money they can get – waiting for opportunities to improve.

4. Global Money borrow money from foreigners

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Real vs. Nominal Interest

The real interest rate is: The nominal rate of interest minus anticipated

inflation rate.

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The Equation of Exchange MV = PQ

M = money supply V = velocity of circulation P = Prices of products sold Q = Quantity of products sold

▪ PxQ = nominal GDP

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Stable Velocity Monetarist believe velocity of money (V) is stable. –

change (M) will change spending Some monetarists claim that Q, as well as V, is stable. -

If true, changes in the money supply (M) would affect only prices (P).

A stable Q means that the quantity of goods produced is primarily dependent on production capacity, labor-market efficiency, and other structural forces leads to a “natural” rate of unemployment

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Fighting Unemployment

The Keynesian cure for unemployment is to expand M and lower interest rates.

Monetarists fear that an increase in M will lead to higher P.

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The Policy Levers

What Keynesians and Monetarists argue about is which of the policy levers – (M) or (V) – is likely to be effective in altering aggregate spending.

Monetarists point to the money supply (M) as the principal lever.

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Crowding Out If (V) is constant, changes in total spending can come

about only through changes in the money supply.

If the government raises taxes or borrows more money, it effectively crowds out consumers and investors who would otherwise be spending or borrowing.

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Monetarist Advice

Monetarists favor fixed money supply targets.

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Keynesian Advice

Keynesians reject fixed money supply targets.

Keynesians advocate targeting interest rates, not the money supply.

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Current FED Policy The Fed uses a mixture of monetarist and

Keynesian policies instead of the strict monetarist approach.

Focus on Federal Funds Rate

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