Monetary Policy

Chapter 13

2

OMO: What can go wrong?

Credit easier to get

Fed increases banking system reserves

Fed buys bonds from the public or banks

Loans Increase

Banks increase loans

Deposits Increase

Money Supply Increases Interest Rates decrease

Banks may not want to

lend

Banks may not want to

lend

Public may not want to

borrow

Public may not want to

borrowLoans are not deposited in the banking

system

Loans are not deposited in the banking

system

Fed Controls Reserves but not the Ms

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

Ms

$

Md

0

Money

Supply

Demand

P0

Bonds

AD

Price Level

GDP

AS

P0

GDP0

Goods and Services

Ms

$

Md

0

Money

Rest of World

National

Income

GDP

HouseholdsFirms

=300

Investment

Circular Flow Diagram

Import

s

Government

Government Spending

National

Income

Buy goods and

services

HouseholdsFirms

Circular Flow Diagram

Need in liquid form

Deposits and Cash

Md

GDP= Total Income

Buy Stocks, FundsBonds, CD’s,Life Insurance

Not earning interest in checking accounts

Earning interest

Buy Goods and Services

= Price x QuantityDemand for money (liquidity) depends

on Prices and Quantity purchased

How much money is saved depends on the interest rate on

savings

National Income

Buy goods and

services

HouseholdsFirms

Circular Flow Diagram

Deposits and Cash

Prices and Quantity Purchased

Prices and Quantity Purchased

Interest Rate

Interest Rate Md

What Determines How Much Liquidity the Public needs?

Prices +We need more cash for more expensive transactions

Real Income +We need more cash for more transactions.

Interest rate -The higher the interest rate the less cash we want to hold.

The higher prices and Income, the higher the need for cash/deposits

The higher prices and GDP, the higher Deposits are.

The higher the interest rate, the lower Deposits are.

The higher the interest rate, the lower the demand for cash/deposits

Checking Account DepositsLarger when we engage in more transactions Real GDP is used as an indicator of the number of transactions

(Q)

Larger when transactions are more expensive Price Index is used as indicator of the average price per

transaction (P)

Smaller when the opportunity cost of holding idle cash increases Interest rate () is used as the indicator of opportunity cost of

holding cash balances

MONEY MARKETInterest Rate

Amount the public actually holds in liquid form: Deposits & Cash

Amount the public wants to hold in liquid

form: Deposits & Cash

Md

Ms

Md

Amount the public wants to hold in liquid

form: Deposits & Cashi

$ Cash and checking accounts

The higher the interest rate, the less money the public WANTS to hold in checking accounts

=3%

=5%

700b500b

A movement up along Md

M0d

Amount the public wants to hold in liquid

form: Deposits & Cashi

$ Cash and checking accounts

The higher prices/real incomes, the more money the public WANTS to hold in checking

accounts

=3%

700b500b

Md shifts right

M1d

Amount the public actually holds in

liquid form: Deposits & Cashi

$ Cash and checking accounts

Expansionary Monetary Policy: More Loans, More Deposits,

Money Supply increases

=3%

500b

Ms shifts right

Ms

700b

Ms

MARKET FOR RESERVESFederal Funds Rate

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

Demand for Reserves

Supply: banks + Fed

Demand: Banks short of reservesMoney

io

Federal Funds RateAs fed funds

rate rises bank’s want to borrow

less

A movement up (down) along the demand for funds resulting from higher (lower)

interest rates

Moving along Demand For Reserves

Banks borrow more (less) from other banks when ffr drops (rises)

Shifting Demand for Reserves

Banks borrow more (less) from other banks even though ffr is the same: Deposits increase, banks need

to hold more reserves Deposits decrease, banks need

to hold less reserves

As ffr drops borrowing is cheaper and more

reserves are demanded

ffr0

ffr1

Borrow more Reserves when deposits increase

ffr0

Movement Along:• Caused by a changeIn interest rates• Change in Quantity Demandedof reserves.

Demand for Reserves

Supply= excess reserves + Fed

changes

Demand: Banks + Public

Money

io

Federal funds RateBanks need

more reserves when Deposits

increase

Demand for Reserves depends on dollar value of transactions

Demand for Reserves depends on size of Deposits:

R = r*D

Size of Deposits

depend on dollar value of transactions:

P*Q

Demand for Reserves

depends on dollar value of

transactions: P*Q

Shifts in Demand for Reserves

Supply= excess reserves + Fed

changes

Demand = Banks in need of reserves

Money

io

Federal funds RateBanks need

more reserves when Deposits

increase

Deposits/ Demand for

reserves increase with

more transactions

When Prices or GDP increase Demand for reserves shift to the right

Deposits/ Demand for

reserves increase when GDP or Prices

increase

Moving along Demand For Reserves

Banks borrow more (less) from other banks when ffr drops (rises)

Shifting Demand for Reserves

Banks borrow more (less) from other banks even though ffr is the same when: Deposits increase, banks need

to hold more reserves Deposits decrease, banks need

to hold less reserves

Borrow more Reserves when ffr drops

ffr0

ffr1

Borrow more Reserves when deposits increase

ffr0

Shift:• Caused by a changeIn prices or incomes• Change in Demand for Reserves

MARKET FOR RESERVESFederal Funds Rate

Supply

Demand

Reserves

ffro

Federal Funds Rate

ReservesWhen GDP or

Prices increase, Demand for

Reserves shifts right and ffr increases

ffr1

MARKET FOR RESERVESFederal Funds Rate

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

Decrease in GDP or Prices

Demand for Reserves shifts

left, ffr dropsffr1

Reserves

io

Federal Funds Rate

Banks increase lending as interest rates rise because it is more profitable

Banks lend more when the fed funds

rate increases

Supply: banks with excess reserves

A movement up (down) along the supply of funds

resulting from higher (lower) interest rates

A movement up (down) along the supply of funds

resulting from higher (lower) interest rates

Moving Along Supply of Reserves

Reserves

io

Federal Funds Rate

The Fed manipulates the amount of reserves in the system.

Supply increases

when the Fed injects

reserves

A rightward (leftward) shift in the supply of funds resulting from Fed injecting (destroying)

reserves into (from) the system

Supply: banks, Fed

Shifting Supply of Reserves

Market for Reserves: Fed Buys Bonds

Supply= excess reserves + Fed

changes

Demand: Banks + Public

Money

ffro

Federal funds Rate

ffr1

27

Open Market Operations: Fed Buys Bonds

Credit easier to get

Fed increases banking system reserves

Fed buys bonds from the public or banks

Loans Increase

Banks increase loans

Deposits Increase

Money Supply Increases Interest Rates decrease

The Money Market: Fed Buys Bonds

i

$

Ms0

Ms1 Reserves, Loans,

Deposits and the Ms

increaseAmount of Money the Public holds in deposit

accounts = Amount the public wants to

hold when 0 =3%

=3%

Md0

Amount of Money the Public holds in deposit accounts > Amount the

public wants to hold

when 0 =3% =2%

Amount of Money the Public holds in deposit accounts = Amount the

public wants to hold

when 0 =2%

Ms1

Money plentiful: Everyone needs to lend money: willing borrowers only found at lower interest rate

Money out of checking accounts and into interest

bearing asset: look for willing borrowers who would pay

interest

Money out of checking accounts and into interest

bearing asset: look for willing borrowers who would pay

interest

GOODS AND SERVICESPrice Level

AD

Price Level

GDP

AS

P0

GDP0

Goods and Services

AD = C + I + G + NX

30

Open Market Operations: Fed Buys Bonds

Credit easier to get

Fed increases banking system reserves

Fed buys bonds to the public or banks

Interest Rates decrease

Banks increase loans

Investment increases

Aggregate demand Increase

Goods and Services Market: Fed Buys Bonds

GDP Increase

Prices Rise

AD0 = C0 + I0=G0+NX0

Price Level

GDP

AS

AD1 = C0 + I1=G0+NX0

Inverse Relationship Between Price of Bonds and Interest Rate

Amount you get at maturity

Price you paid for Bond-

Price you paid for Bond

=Interest

rate$100 $90

$90

11%$80

$80

25%

The lower the price on the bond, the higher the interest rate.

MARKET FOR BONDSPrice of Bonds

Supply: Government and Fed

Demand: Public

P0

Bonds

When the fed buys bonds it decreases the

supply of bonds

available to the public….

Bond Market: Fed Buys Bonds

Bond Market: Fed Buys BondsSupply of bonds

Demand for bonds

P0

P1

Bond Price rises: Interest

Rates Decrease

0 =8%0 =8%

1=4%1=4%

Market for Reserves: Fed Sells Bonds

Supply= excess reserves + Fed

changes

Demand: Banks + Public

Money

Federal funds Rate

ffro

ffr1

37

Open Market Operations: Fed Sells Bonds

Credit harder to get

Fed reduces banking system reserves

Fed sells bonds to the public or banks

Loans Decrease

Banks decrease loans

Deposits Decrease

Money Supply Decreases Interest Rates increase

The Money Market: Fed Sells Bonds

i

$

Ms0Ms

1

Reserves, Loans, Deposits and the Ms

decrease

Amount of Money the Public holds in deposit

accounts = Amount the public wants to

hold when 0 =3% =3%

Md0

Amount of Money the Public holds in deposit accounts < Amount the

public wants to hold

when 0 =3%

Ms1

=5% Amount of Money the Public holds in deposit accounts = Amount the

public wants to hold

when 0 =5%

Amount of Money the Public holds in deposit accounts = Amount the

public wants to hold

when 0 =5%

Money scarce: Everyone needs to borrow cash: willing lenders can be found only at higher interest rate.

Money into checking accounts: look for willing

lenders

Money into checking accounts: look for willing

lenders

39

Open Market Operations: Fed Sells Bonds

Credit harder to get

Fed reduces banking system reserves

Fed sells bonds to the public or banks

Interest Rates increase

Banks decrease loans

Investment Decrease

Aggregate demand Drops

Fed Sells Bonds

GDP Decrease

Prices Drop

Price Level

Real GDP

AS

AD0 = C0 + I0=G0+NX0

AD1 = C0 + I1=G0+NX0

Bond Market: Fed Sells BondsSupply of bonds: Fed, government

Demand for bonds

P0=90

P1=80

Bond Price falls: Interest

Rates Increase

=11% =11%

=25% =25%

When the Fed Wants to Reduce Unemployment

Use Expansionary Monetary Policy

Increase Reserves and Money Supply

Decrease the interest rate.

Increase Investment

Increase Aggregate Demand for goods and services

Buy Bonds

Decrease Decrease r

When the Fed Wants to Reduce InflationUse Contractionary Monetary Policy

Decrease the Money Supply

Increase the interest rate.

Decrease Investment and Consumption?

Decrease Aggregate Demand for goods and services

Sell Bonds

Increase Increase r

Interest Rate and Velocity of Money

Velocity = Nominal GDP/Ms

Velocity of money: Number of times a dollar bill is used

Dollar value of what we buy

Dollar value of what we buy

Ms = Deposits + currency

Ms = Deposits + currency

Contractionary Policy: interest rate rise, public holds less cash and deposits

(Ms):Velocity increases

As interest rate rise, public holds less cash for transactions: each dollar is

used more times.

Price = $100

=10%Get at maturity =

$110

Amount you get at maturity

Price you paid for Bond-

Price you paid for Bond

=Interest

rate110 100

100

10%

Price = $100

=10%Get at maturity =

$110

Amount at maturity Bond Price-

=110 100

100

10%

Interest rates drop

to 8%

Bond PriceP?

8%P?

-=

110 10010% P?

8%P?

-=

110 P?0.08

P?= 110

1.08P

= 110/1.08

P = $101.85P

Interest rates drop

to 8%

Bond Price rises

P + 0.08P= 110

Supply

Demand

Quantity Bank Reserves

ffro

Federal Funds Rate Ms

i

$

Md

Supply of bonds

Demand for

bonds

P0

i0

AD

Price Level

GDP

AS

P0

GDP0

Monetary Policy Actions

Demand for Reserves

Supply of Reserves

Federal Funds Rate

Loans Deposits Ms

Interest Rate

Supply of Bonds Bond Price GDP Price

Level

Increase in Required Reserve Ratio (r) : Banks need more

Reserves; can make fewer loans

Increase: more banks short of R Increase Decrease Decrease Ms

Decrease Increase I , AD , GDP drop

falls

Decrease in Required Reserve Ratio (r): Banks need less Reserves; can

make more loans

Decrease: Fewer banks short of

reserves Decrease Increase Increase Ms

Increase Decrease I , AD , GDP rise rise

Buy Bonds: inject reserves into the

system Increase Decrease Increase Increase Ms

Increase Decrease Decrease Increase I , AD , GDP rise rise

Sell Bonds: erase reserves from the

system Decrease Increase Decrease Decrease Ms

Decrease Increase Increase DecreaseI , AD , GDP drop

falls

Increase in Discount Rate: Fed loans more

expensive, banks borrow less from Fed

Decrease: Banks hold instead of

lending excess

reserves

Increase

Decrease: Banks beef up

resesrves instead

of lending

Decrease Ms Decrease Increase

I , AD , GDP drop

falls

Decrease in Discount Rate: Fed loans

cheaper, banks borrow more from the fed

Increase: Banks lend instead of

holding excess

reserves

Decrease

Increase: Banks

hold less excess

reserves increase lending

Increase Ms

Increase Decrease I , AD , GDP rise rise

Public’s Actions

Demand for Reserves

Supply of Reserves

Federal Funds Rate

Deposits Md Interest Rate GDP Price

Level

Increase in Prices: Public needs more cash & Deposits for

more expensive transactions

Increase: More reserves are

needed when Deposits increase:

R = r*D

same Increase Increase Md

Increase IncreaseI , AD , GDP drop

falls

Decrease in Prices: Public needs less cash

& Deposits for less expensive transactions

Decrease: Less reserves are

needed when Deposits decrease:

R = r*D

same Decrease Decrease Md

Decrease DecreaseI , AD , GDP rise

rise

Increase in Incomes (GDP) An economic Expansion Public

needs more cash & Deposits for more

transactions

Increase: More reserves are

needed when Deposits increase:

R = r*D

same Increase Increase Md

IncreaseIncrease

I , AD , GDP drop

falls

Decrease in Incomes (GDP) Economic Recession Public needs less cash & Deposits for fewer

transactions

Decrease: Less reserves are

needed when Deposits decrease:

R = r*D

same Decrease Decrease Md

DecreaseDecrease

I , AD , GDP rise

rise

Event Demand for Reserves Supply of Reserves

Federal Funds Rate

Loans Deposits Md/Ms Interest Rate

Supply of Bonds Bond Price GDP Price

Level

Increase in Required Reserve Ratio (r) : Banks need more Reserves; can make fewer loans

Increase: more banks short of R Increase Decrease Decrease Ms Decrease Increase

Decrease in Required Reserve Ratio (r): Banks need less Reserves; can make more loans

Decrease: Fewer banks short of reserves Decrease Increase Increase Ms Increase Decrease

Buy Bonds: inject reserves into the system Increase Decrease Increase Increase Ms Increase Decrease Decrease Increase

Sell Bonds: erase reserves from the system Decrease Increase Decrease Decrease Ms Decrease Increase Increase Decrease

Increase in Discount Rate: Fed loans more expensive, banks borrow less from Fed

Decrease: Banks hold instead of lending excess reserves

Increase

Decrease: Banks beef up resesrves instead of lending

Decrease Ms Decrease Increase

Decrease in Discount Rate: Fed loans cheaper, banks borrow more from the fed

Increase: Banks lend instead of holding excess reserves

Decrease

Increase: Banks hold less excess reserves increase lending

Increase Ms Increase Decrease

Increase in Prices: Public needs more cash&Deposits for more expensive transactions

Increase: More reserves are needed when Deposits increase: R = r*D

same Increase Increase Md Increase Increase

Decrease in Prices: Public needs less cash&Deposits for less expensive transactions

Decrease: Less reserves are needed when Deposits decrease: R = r*D

same Decrease Decrease Md Decrease Decrease

Increase in Incomes (GDP) An economic Expansion Public needs more cash&Deposits for more transactions

Increase: More reserves are needed when Deposits increase: R = r*D

same Increase Increase Md Increase Increase

Decrease in Incomes (GDP) Economic Recession Public needs less cash&Deposits for fewer transactions

Decrease: Less reserves are needed when Deposits decrease: R = r*D

same Decrease Decrease Md Decrease Decrease

Questions to prepare for the testUse a diagram to show the effect on reserves, the money

supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step.

1. The fed increases/decreases the required reserve ratio

2. The fed buys/sells bonds in the open market

3. Fed increases/decreases the (discount) primary credit rate.

4. Prices increase/decrease

5. Incomes increase/decrease

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

Supply

Demand

Reserves

ffro

Federal Funds Rate

Reserves

A B

C

D

Ms

$

Md

0

MoneyMs

$

Md

0

Money

Ms

$

Md

0

Money

Ms

$

Md

0

Money

A B

C D

Supply

Demand

P0

Bonds

Supply

Demand

P0

Bonds

Supply

Demand

P0

Bonds

Supply

Demand

P0

Bonds

D

C

A B

AD

Price Level

GDP

AS

P0

GDP0

Goods and Services

AD

Price Level

GDP

AS

P0

GDP0

Goods and Services

AD

Price Level

GDP

AS

P0

GDP0

Goods and Services

AD

Price Level

GDP

AS

P0

GDP0

Goods and Services

A B

C D