Monetary Policy The “Fed” Fed Chairman Home of the 7 Board of Governors Ben Bernanke
Monetary Policy [Objectives] • 1. Know the cause-effect of both expansionary [easy] and contractionary [tight] monetary policy. • 2. Three tools of monetary policy. • A. Discount Rate • B. Reserve Requirement • C. Buying and Selling of Government Securities • 3. Know the strengths of monetary policy. [Is monetary policy as effective against depression as it is against inflation?] • 4. Know the “Taylor Rule” for the monetary policy. • 5. Quiz over “Money Creation.”
Expansionary Fiscal Policy Loanable Funds Market [Incr G; Decr T][But we get negative Xn] D2 S D1 r=8% SRAS Real In. Rate PL r=6% Start from a Balanced Budget G & T = $2 Trillion AD2 LRAS F1 F2 AD1 “Now, this is better.” $2.2 tr. “I can’t get a job.” PL2 $2 tr. $2 tr. PL1 E2 GT E1 YR YF Real GDP $2.2 $2.2 G G I.R. AD Y/Empl./PL; LFM $1.8 $1.8 T Y/Emp/PL; DI C AD T LFM IR
Expansionary [Easy] Money Policy DM DI MS1 MS2 Investment Demand 8% 6% 4% 0 8 4 0 Nominal Interest Rate 6% Buy If there is a RECESSION MS will be increased. Money Market QID1 QID2 AS AD1 AD2 PL I want a job as a Rockette PL2 E2 PL1 E1 YR Y* Real GDP Fed Buy Bonds I.R. QID MS Y/Emp/PL AD
Contractionary Fiscal Policy Loanable Funds Market [Decr G; Incr T ] [Again, we get negative Xn] D1 D2 S r=6% PL r=3% SRAS Real In. Rate Start from a Balanced Budget G & T = $2 Trillion LRAS AD2 F2 F1 PL1 $2.2 Ttril. E1 $2 tril. $2 Ttril. $1.8 tril.. PL2 GT AD1 E2 YI YF [like we have “money trees”] Real GDP $1.8 $1.8 G G I.R. AD Y/Empl./PL; LFM $2.2 $2.2 T Y/Emp/PL; DI C AD T LFM IR
Contractionary [Tight] Money Policy Dm MS1 MS2 DI “It’s cheaper to burn money than wood.” Investment Demand 10% 8% 6% 0 10 8 6 0 Nominal Interest Rate Sell If there is INFLATION, MS will be decreased. Money Market QID1 QID2 AS like “money trees” AD1 AD2 PL PL1 E1 PL2 E2 YI Y* Fed Sell Bonds MS I.R. AD Y/Empl./PL QID
Economy’s Speed Limitat Full Employmentis4%,instead of2.5%. Can sustain a much greater increase in AD if the AS curve is also shifting to the right, due to increasing productivity. AD2 In the early 90’s, at FE, 2.5% was the speed limit. AS shifted slowly due to low productivity. AD1 AS1 AS2 PL2 PL3 PL1 So, at FE, the“goldilocks economy”has expanded. Increasing productivity of the late 90’s allowed more growth at FE GDP. Y*1 Y2 Y3 Real GDP under 4% 0 Real GDP 17 increases 4% “Goldilocks Economy” [not too fast or slow]
Monetary Policy – America’s Main Stabilization Tool Nominal Interest Rate Inflation
Monetary Policy – America’s Main Stabilization Tool Nominal Interest Rate Recession Monetary Policy Tools 1. Discount Rate – when banks borrow from the Fed [“symbolic”] 2. Reserve Ratio – currently 10%; the most powerful tool 3. Buying [recession] & selling [inflation] of bonds
BALANCE SHEET OF FED BANKS ASSETS • Securities [90%] • Loans to Commercial Banks LIABILITIES • Reserves of Commercial Banks • Treasury Deposits • Federal Reserve Notes [90%]
Assets[own]Liabilities[owe] Consolidated Balance Sheet of the Federal Reserve Banks[millions] Securities *758,551Reserves of commercial banks $14,923 Treasury deposits 4,463 Loans to Commercial Banks 19,250Federal Reserve Notes*754,567 [when these notes are in circulation, they constitute claims against assets of the Fed] All other assets 59,967All other liabilities & net worth 63,615 Total $837,768Total $837,768 Australia Reserve Bank of Australia [RBA] CanadaBank of Canada Euro ZoneCentral Bank of Europe[CBE] Japan The Bank of Japan [“BOJ”] Russia Central Bank of Russia United Kingdom Bank of England MexicoBanco de Mexico (Mex Bank) Sweden Sveriges Ribsbank [Nobel Pr.] U.S. Federal Reserve System[“Fed”]
The Fed controls the banks’ ability to create new money to ensure the economy doesn’t gettoo much money, nortoo little. Underfed Fed just right Overfed 1983 1980 And – so it is with money. Not too much, not too little. +30% $75.00 $97.50 Money Prices
3 Tools of Monetary Policy 1. Discount Rate – banks borrow from the Fed (symbolic) 2. Required Reserve - % of DD which cannot be loaned. 3. Buy/SellBonds – government debt - 3 mo., 6 mo., & 1 year; purchase price:$10,000 - 2 yr., 3 yr., 5 yr.,($5,000), & 10 yr., ($10,000) - 30 years with purchase of $1,000 Federal Funds Target Rate – overnight lending rate between banks to correct a temporary imbalance in reserves. Inflation Raise Raise Sell Recession Lower Lower Buy AS AS AD LRAS AD AD AD PrimeRate-loan rate to the best (prime)customers. Y*YI YR Y* Real GDP .6% 17 increases 4%
“Easy Money” During Recessions “Students, should the Fed buy or sell bonds to jumpstart this economy?” MS1 MS2 DI Investment Demand 10 8 6 0 10 8 6 0 Nominal Interest Rate Buy DM If there is RECESSION MS will be increased. Money Market QID1 QID2 AD1 [C+Ig+G+Xn] AD2 LRAS “Easy Money” – (Buy/Sell) bonds, which(increase/decrease) MS, which (increase/decrease) interest rates, which (appreciate/depreciate) the dollar, which(increase/decrease) C, Ig, & Xn, which (increase/decrease) AD & therefore, PL, GDP, & emp. AS Jobs are tough to get. Price level P2 E2 P1 E1 YRReal GDP Y*
“Tight Money” To Fight Inflation “Now, should I buy or sell?” DI MS1 MS2 Dm 10 8 6 0 10 8 6 0 Investment Demand Nominal Interest Rate Sell If there is INFLATION, MS will be decreased. QID1 Money Market QID2 AS LRAS “Tight Money” – (Buy/Sell) bonds, which(incr/decr) the MS, which (incr/decr) in. rates, which (apprec/deprec) the dollar, which (incr/decr) C, Ig, & Xn, which (incr/decr) AD, PL,& GDP. AD2 “I’ll get rid of some money.” P1 E1 P2 E2 AD1 YI Y*
Hypothetical Ideal Economy MS2 DI Dm AD2 AS 6% 0 6% 0 I=$60 PL2 Y* $60 120 QID RDO Money Market Investment Demand • Ideal Economy • MS is at 120 billion, putting the • Interest rates at 6%, and • Investment is at $60 billion.
Recessionary Gap DI MS2 MS1 AD2 AD1 AS 9% 0 9% 0 I=$60 I=$50] 6% 6% PL2 PL1 Dm YR Y* $60 $50 RDO $100 $120 QID Money Market Investment Demand Recessionary Gap Increase MS from $100 to$120, which lowers the I.R. from 9%to 6%, which increases QID from$50 to$60,which increases AD fromAD1to AD2.
Inflationary Gap AD3 DI MS2 MS3 Dm I=$70 AD2 AS 3% 0 3% 0 I=$60 6% 6% PL3 PL2 Y* YI $60 $140 $120 $70 RDO QID Money Market Investment Demand Inflationary Gap Decrease MS from $140to $120,whichincreases the I.R. from 3%to6%. which decreases QID from $70to $60,which decreases AD from AD3 toAD2.
3 Tools of Monetary Policy …to assist the economy in achieving a full employment, non-inflationary level of output
3 Tools of Monetary Policy • 1. Discount Rate – when banks borrow from the Fed. [Symbolic] • 2. Reserve Ratio – how much of demand deposits that have to be kept in reserve and can’t be loaned out. [Currently 10%] • 3. Buying [recession gap] and selling [inflation gap] of securities.
3 Tools of Monetary Policy 1.Open Market Operations [at first this was used just to increase bank earnings] - “nuts&bolts”of Monetary Policy[main tool] - $60-$70 billion every day
- most powerful (seldom used) - affects money creation by changing ER andthe multiplier - an increase of½ of 1%would increase bank reserves by over $5 billion - RR was 20% from 1937-1958 2. Reserve Requirement Sledgehammer of Monetary Policy Banks that fail to maintain at least the RR [10%] on average over a two-week period face severe penalties. RR - Atomic Bomb of Monetary Policy
Atomic Bomb of Monetary Policy Reserve Requirement Example Suppose the banking system has $500 billion in DD. The RR is 12% & TR are $60 billion, which is 12%of the$500 billionDD. So, there are no ER. Now, the Fed lowers the RR to 10%. Now banks are required to keep only $50 billionin RR. So, $10 billion more ER is available to loan out. $10 billion X 10 = $100 billion in new DD. So, 20% increase MS [DD] from $500 to $600billion.
Reserve Requirement at 10% - Easy Money [In 1980, the RR was set at 12%; stayed there until 1992; went to 10%] Monetary Expansion [10% RR] [1/.10=10] “Easy Money” $10,000 [$9,000+$1,000] $729 AS AD2 AD1 PL $810 YR Y* $900 [$900x10] $1,000 $1,000 Initial deposit “Easy Money” “Easy Money” – increase the money supply
RR at 20% - Tight Money Monetary Expansion (20% RR) [1/.20=MD of 5] “Tight Money” $5,000 [$4,000+$1,000] AD1 AS $512 AD2 $640 PL $800 Y*YI $1,000 Initial deposit “Tight Money” - decrease the money supply
3. Discount Rate - emergency Fed loans to banks- symbolic (raises Prime Rate)- Discount Rate was 1% from1934-46 and the prime rate was 1.5% FL borrowed $99 million In 1991 Hurricane EarthQuake The Fed tends to change the D.R. in lockstep with the fed funds target rate.
"Easy Money" At Work After the recession, the unemployment rate still increased. During this period, 1990-1992, the Fed did 4 things: 1. Decreased discount rate from 10% to 3%; 2. Decreased the RR from 12% to 10%; 3. Decreased the Fed Funds Rate 24 times, and 4. Bought bonds
Fed Funds Rate 1996-2008 2.00% April, 2008 “Easy” Money “Easy” Money “Tight” Money 08’
Relative Importance of Monetary Policy A. WWII-1979 – Fed targeted theinterest ratenot the growth of MS. B. 1979 - 1982 – Fed targeted thegrowth of the MS not the in. rate. C. 1982 - Present- Fed targetstheinterest rate, not the MS. 1. Discount Rate – not a primary tool of monetary policy. It does have an “announcement effect.” 2. Reserve Requirement (10%)-has changed one time in 2 decades (12% to 10% in 1992). It would affect bank profits so is seldom used. 3. Open-market operations – evolved as the most effective tool of monetary policy because of flexibility. Securities can be bought or sold in large amounts & their impact on reserves is very prompt. Did it work?
Effectiveness of Monetary Policy Strengths of Monetary Policy 1. Speed and flexibility –can quickly be altered (compared to fiscal policy). This can occur on a daily basis and influence interest rates and the MS. 2. Isolation from political pressures – because of the 14 year terms. They can enact unpopular policies which might be best for our economy’s health.
Monetarist ViewofTransmission Mechanismv.Keynesian View DI(K) MS2 Investment Demand MS1 AD2(M) AS 10 8% 6% 0 10% 8% 6% 0 AD1 AD2 DI(M) Dm(K) PL2 PL2 PL1 Dm(M) (K) YRY* YI Money Market QID1QID2 QID2 Mainly, we end up just getting inflation. Dm is more inelastic [I.R. moresensitive] DI is more elastic [or moreresponsive] AS AD2 Keynesian viewis thatDIis rathersteepso monetary policy is not that strong. Fiscal policy is“top banana.” AD1 Also, theKeynesians don’t thinkthe lower interest rateis as important as“profit expectations.”
Strengths of Monetary Policy • Speed and flexibility • Isolation from political pressure • Successes in the 1980s & 1990s Shortcomings and problems Monetary Policy better I may not drink water but I’ll eat spiked brownies. I’d like one of those 1% mortgages, but I don’t have a job. Cyclical asymmetry [better at fighting inflation than fighting depressions] Fiscal Policy better
Shortcomings and Problems of Monetary Policy But – I will also eat spiked muffins. Cyclical Asymmetry (lack of balance) – “Tight money during inflationsis more effective than easy money policy during a depressions.” a. An easy money policy during depression does not guarantee that people will take out loans if they don’t have jobs. [“You can lead a horse to water, but you can’t make him drink.”] b. The cyclical asymmetry has not created a major difficulty for monetary policy except during times of depression. c. Velocity of money may increaseduring inflationwhen the fed is trying to decrease the MS & decrease during recession when the Fed is trying to increase MS. d. The lower interest rates during recession & depreciationof the dollar may cause foreign investors to pull their money out of the U.S. and reduce the MS. e. Banks may hold their ER or the public may hold too much currency. f. Dm curve may be more flatso that interest rate will not drop as much, or the DI curve may be more vertical so that investment will not increase asmuch.
Taylor Rule • The Fed does not adhere to a strict inflationary target or monetary policy rule. It targets the Federal funds rate at the level it thinks is appropriate for the economic conditions. They appear to roughly follow a rule first established by economist John Taylor of Stanford. • The Taylor Rule assumes a 2% target rate of inflation and has three parts. • 1. If real GDP rises by 1% above potential GDP, the Fed should raise the Federal funds rate by ½ a percentage point. • 2. If inflation rises by 1% above its target of 2%, then the Fed should raise the Federal funds rate by ½ a percentage point. • 3. When real GDP is equal to potential GDP and inflation is equal to its target rate of 2%, the Federal funds rate should remain at about 4%, which would imply a real interest rate of 2%. • These rules are reversible for situations in which the real GDP falls below potential GDP and the rate of inflation falls below 2%. • The Fed is free to diverge from the Taylor Rule, like after 9/11.
Fiscal Policy RecessionInflation Increase GDecrease G Decrease TIncrease T Monetary Policy RecessionInflation Lower D. RateRaise D. Rate Lower R. RateRaise R. Ratio Buy BondsSell Bonds “Easy Money”“Tight Money”
Tools of Monetary Policy Discount Rate The Reserve Ratio Open Market Operations “Easy Money” Fed • Easy Money Policy • Lower Discount Rate • Lower Reserve Ratio • Buy Bonds
Tools of Monetary Policy Discount Rate The Reserve Ratio Open Market Operations “Got to decrease the MS.” Fed • Tight Money Policy • Raise Discount Rate • Raise Reserve Ratio • Sell Bonds
NS 48-58(MS=DD+CurrencyofPublic) 48.The 3 tools of monetary policy are open market operations, changes in RR, & (changes in T/changes in G/ changes in discount rate). 49. The main toolof the Fed in regulating the MS is(open-market operations/DR/RR). 50. When the Fed sells securities to thePUBLIC[ ], DD (don’t change/incr/decr) & banking system RR, ER & TR (incr/decr). 51. When the Fed[ ] buys securities from commercial banks, DD (don’t change/increase/decrease) & ER and TR (increase/decrease). 52. When the commercial bankingsystem borrows from theFed, DD (don’t change/increase/decrease) but ER & TR (incr/decr). 53.When commercial banks[ ] sell government bondsto theFed[ ], DD (don’t change/incr/decr) but their ER & TR (do not change/incr/decr). 54. When the PUBLIC[ ] buys securities from the Fed, DD (don’t change/incr/decr) and RR, ER, & TR of banks (don’t change/incr/decr). 55. When a commercial bankgets a loan fromthe Fed, their lending ability(incr/decr). 56. Assume that the RR is 25% & theThunder Bank borrows $100,000 from the Fed., commercial bank ERs are increased $________. PMC in the banking system are increased by $_______. TMS can be as much as $________. 57. The (margin requirement/discount rate) specifies the size of the down payment on stock purchases. 58. If the Fed were to increase the RR [10% to 20%] we would expect (higher/lower) interest rates, a (reduced/expanded) GDP and (appreciation/depreciation) of the dollar. [less “C”, “Ig”, & “Xn”] 100,000 400,000 400,000
59. When the RR is increased [10% to 50%], the ER of member banks are (increased/decreased)and the monetary multiplier is (incr/decr). 60. Assume the RR is 25% & theFed [ ]buys $4 M of bonds from the public[ ]. The MS is increased by ($3/$4/) millionand the PMC is increased by ($16/$12) mil. Potential TMS is ($3/$4/$12/$16) mil. 61. When the Fed lends to commercial banks [ ], this is called the (Fed Funds Rate/discount rate) and when commercial banks make loans to one another, this is the (Fed Funds Rate/ Discount Rate). 62. The Keynesian cause-effect chain of aneasy money policy would be to (buy/sell) bonds; which would (increase/decrease) the MS, which would(lower/raise) interest rates & (incr/decr) Ig, “C”, Xn, & Y. 63. If the Fedwere to buy government securitiesin the open market, we would anticipate(lower/higher) interest rates, an (expanded/contracted) GDP, and (appreciation/depreciation) of the dollar. 64. If the Fedwere reducing demand-pull inflation, the proper policies would be (lower/raise) the discount rate, (lower/raise) the RR and ((buy/sell) government bonds. 65. Monetary policyis thought to be more effective in (controlling inflation/ fighting depressions) andfiscal is more effective(controlling inflation/ fighting depressions). 66.The “net export effect” of an “easy” money policy (strengthens/ weakens) that policy, while the “net export effect” of “expansionary” fiscal policy (strengthens/weakens) that policy. [impact of interest rates] NS 57-66
NS 67-70 AD3 DI MS2 MS1 MS3 I=$70 AD2 AD1 AS 9% 6% 3% 0 9% 6% 3% 0 I=$60 I=$50] PL3 PL2 PL1 Dm YRY* YI $50$60 $100120140 $70 RDO QID Money Market Investment Demand 67. If AD is AD3, what must the Fed do to get to AD2(FE GDP [Y*])? (increase/decrease) the MS from ($120/$140) to ($100/$120). 68. If the MS is MS1, & the goal of the Fed is FE GDP[Y*], they should (increase/decrease) the MS from ($100/$120) to ($120/$140). 69. Which of the following would shift the MS curve from MS3to MS2? (buying/selling) bonds. 70. If the MS is MS2 and the goal of the Fed is FE GDP of Y*, they should (increase/decrease/don’t change) the Ms.
NS 71-72 71. An easy money policy will (apprec/deprec) the dollar & (incr/decr) U.S. Xn. A tight money policy will (apprec/deprec) the dollar & (incr/decr) U.S. Xn. 72. If the economy were in a severe recession, proper monetary policy would call for (lowering/raising) the discount rate, (lowering/raising) the RR, & (buying/selling) bonds. Proper fiscal policy would be to (incr/decr) “G” & (incr/decr) “T”, both of which would result in a bugetary (deficit/surplus).
Money, Banking, &FedTest Review 1-8 1. If yourbank [ ]borrows $50,000 from theFed, does thisautomatically increase the MS? _____ Does this loan increase the amount in RR?_____ ER? ____ With 10% RR, PMC is __________. TMS is __________. 2. If the RR is 50% & theFed buys $100 mil. of securities from thepublic, then:MS is increased by ________. PMC is _________. TMS is ________. 3. What will cause the Dt(& total demand) for money curve to shift right? (increase/decrease) in nominal (money) Y? 4. When the Fedbuys bonds from banks [or gives them a loan], DD are (incr/decr/ unchanged) but their ER & TR both (incr/decr/unchanged). 5. If the Fed buys $10 million of securities from the public, with a RR of 40%, MS is increased by ________ & PMC is _________. TMS is ________. 6. If the Fed decreased the RR from 20% to 10%, we would expect (higher/lower) interest rates, (appreciation/depreciation) of the dollar, and an (increase/decrease) in GDP. 7. DD of $100,000 and RR of 25% in a commercial banking system with TR of $40,000. PMC in the banking system is ($240,000/$60,000). 8. If you are estimating your expensesfor the prom at $3,000, money is functioning as (unit of account/medium of exchange/store of value). No No $500,000 Yes $500,000 $200 mil. $100 mil. $100 mil. $25 mil. $15 mil. $10 mil.
“Easy Money” During Recessions “Students, should the Fed buy or sell bonds to jumpstart this economy?” MS1 MS2 DI Investment Demand 10 8 6 0 10 8 6 0 Nominal Interest Rate Buy DM If there is RECESSION MS will be increased. Money Market QID1 QID2 AD1 [C+Ig+G+Xn] AD2 LRAS 9.“Easy Money” – (Buy/Sell) bonds, which(increase/decrease) MS, which (increase/decrease) interest rates, which (appreciate/depreciate) the dollar, which(increase/decrease) C, Ig, & Xn, which (increase/decrease) AD & therefore, PL, GDP, & emp. AS Jobs are tough to get. Price level P2 E2 P1 E1 YRReal GDP Y*
“Tight Money” To Fight Inflation “Now, should I buy or sell?” DI MS1 MS2 Dm 10 8 6 0 10 8 6 0 Investment Demand Nominal Interest Rate Sell If there is INFLATION, MS will be decreased. QID1 Money Market QID2 AS LRAS 10. “Tight Money” – (Buy/Sell) bonds, which(incr/decr) the MS, which (incr/decr) in. rates, which (apprec/deprec) the dollar, which (incr/decr) C, Ig, & Xn, which (incr/decr) AD, PL,& GDP. AD2 “I’ll get rid of some money.” P1 E1 P2 E2 AD1 YI Y*
RR is 20% AssetsDD(Liabilities) • TR[RR+ER]=$20 mil.$100 million • How much can this bank loan out? $______ • 2. If Pam Andersonputs $1,000 in this • bank(DD), Pam can write a check for as • much as ________; ER will increase by • $_______. • 3. Possible Money Creation in the system could be $_______. • 4. Potential Total Money Supply could be as much as$________. MS = Currency + DD of PUBLIC 0 $1,000 800 4,000 5,000
RR is 20% Assets DD(Liabilities) TR[RR+ER] = $20 mil.$100 million 11. How much can Pam’s bankloan out? $______ 12. If Pam Anderson’s Bankborrows $1,000 from the Fed ER will increase by $_______. 13. Possible Money Creation in the system could be $_______. 14. Potential Total Money Supply could be as much as$________. TR 11-14MS = Currency + DD of PUBLIC 0 1,000 Fed Pam Anderson’s Bank 5,000 5,000
RR is 25% AssetsDD (Liabilities) • TR[RR+ER]=$25 mil.$100 million • How much can thisbankloan out? $______ • 2.If Pam Anderson puts $4,000 in this • bank(DD), Pam can write a check for as much as _______; • ER will increase by $_______. • . • 3.Possible Money Creation in the system could be $________. • 4. Potential Total Money Supply could be as much as$________. MS = Currency + DD of Public 0 $4,000 3,000 12,000 16,000
RR is 40% Assets DD(Liabilities) TR[RR+ER]=$40 mil.$100 million 1. How much can this bank loan out? $______ 2. If Cameron Diaz puts $10,000 in this bank(DD), Pam can write a check [DD] for as much as $__________; ER can increase by $_________. 3. Possible Money Creation in the system could be $________. 4. Potential Total Money Supply could be as much as$_________. Extra PracticeMS = Currency + DD of PUBLIC 0 10,000 6,000 15,000 25,000
RR is 50% Assets DD (Liabilities) TR[RR+ER] = $50 mil.$100 million 11. How much canCameron’s bankloan out? $______ 12. IfCameron Diaz’s Bankborrows $5,000 from theFed ER will increase by $_______. 13. Possible Money Creation in the system could be $________. 14. Potential Total Money Supply could be as much as$________. Extra PracticeMS = Currency + DD of Public 0 5,000 Cameron Diaz’s Bank Fed 10,000 10,000