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Janet Yellen

Monetary Policy. 1%?. 2%?. 1.5%?. The “Fed”. Janet Yellen. Easy (Expansionary) Monetary Policy. MS 1. D I. MS 2. Investment Demand. 8% 6% 4% 0. 8 4 0. nominal Interest Rate. 6%. D M. Buy. If there is a RECESSION MS will be increased. Money Market. QID1.

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Janet Yellen

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  1. Monetary Policy 1%? 2%? 1.5%? The “Fed” Janet Yellen

  2. Easy (Expansionary) Monetary Policy MS1 DI MS2 Investment Demand 8% 6% 4% 0 8 4 0 nominal Interest Rate 6% DM Buy If there is a RECESSION MS will be increased. Money Market QID1 QID2 AS AD1 AD2 I want a job as a Rockette PL2 Price level E2 PL1 E1 YR Y* Real GDP Buy Bonds I.R. QID MS Y/Emp/PL AD

  3. Tight [Contractionary] Monetary Policy DI “It’s cheaper to burn money than wood.” Dm MS1 MS2 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” AD2 AD1 E1 PL1 Price level PL2 E2 YI Y* Sell Bonds MS I.R. AD Y/Empl./PL QID

  4. 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 Increasing productivityof the late 90’s allowed more growth at full employment. PL3 PL1 PL1 So, at FE, the“goldilocks economy”has expanded. Y*1 Y2 Y3 0 Real GDP 2.5%

  5. If The Economy Is Exceeding TheFE GDPSpeed Limit Of 4%

  6. “When the party gets too good, it’s the job of the Fed to take away the punch bowl.” I promise to control inflation… The Fed’s policy is “If you see inflation, its too late. Whip it before it gets out of the box.” During a recession, the Fed is happy to “spike the punch.”

  7. Should The Fed Chairman Show His Hand?

  8. Monetary Policy – America’s Main Stabilization Tool Nominal Interest Rate Inflation Recession • Monetary Policy Tools • Discount Rate – when banks borrow from the Fed [“symbolic”] • Reserve Ratio – currently 10%; the most powerful tool • Buying [recession] & selling [inflation] of bonds

  9. BALANCE SHEET OF FED BANKS ASSETS • Securities [90%] • Loans to Commercial Banks LIABILITIES • Reserves of Commercial Banks • Treasury Deposits • Federal Reserve Notes [90%]

  10. Consolidated Balance Sheet of the Federal Reserve Banks[millions] Assets[own]Liabilities[owe] Securities *647,580Reserves of commercial banks $28,678 Treasury deposits 6,050 Loans to Commercial Banks 59Federal Reserve Notes*549,711 [when these notes are in circulation, they constitute claims against assets of the Fed] All other assets 86,768All other liabilities & net worth 49,723 Total $734,407Total $734,407 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 U.S. Federal Reserve System[“Fed”]

  11. The Fed controls the banks’ ability to create new money to ensure the economy doesn’t get too much money, nor too little. Overfed Fed Right Underfed 1983 1980 +30% $75.00 $97.50 Money Prices

  12. And What Happens If You Feed A Dog too Much

  13. 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 YRY* June, 2006 [5.25%] Real GDP 1.6% 17 increases

  14. “Easy Money” During Recessions MS1 MS2 DI “Students, should the Fed buy or sell bonds to jumpstart this economy?” 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 LRAS AD2 “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*

  15. “Tight Money” during Inflation DI MS1 MS2 Dm “Now, should I buy or sell?” 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 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*

  16. 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 The ideal economy is AD2, with I.R. at 6%& Igat$60 billion.

  17. 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$100to $120,which lowers the I.R. from9%to 6%, which increases QID from$50to $60,which increases AD fromAD1to AD2.

  18. AD3 DI 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. from3%to 6%. which decreases QID from$70 to $60, which decreases AD fromAD3 to AD2.

  19. GOALS OF MONETARY POLICY …to assist the economy in achieving a full employment, non-inflationary level of output

  20. Three Tools Of Monetary Policy 1. Open Market Operations - “nuts and bolts”of Monetary Policy[main tool] - $60-$70 billion every day

  21. 2. Reserve Requirement - 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 Sledgehammer of Monetary Policy RR - Atomic Bomb of Monetary Policy

  22. 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 $600 billion.

  23. Reserve Requirement at 10% - Easy Money [In 1980, the RRwas set at12%; stayed there until 1992; went to10%] Monetary Expansion [10% RR] [1/.10=10] “Easy Money” $10,000 [$9,000+$1,000] $729 AS AD2 AD1 PL $810 YRY* $900 [$900x10] $1,000 $1,000 Initial deposit “Easy Money” “Easy Money” – increase the money supply

  24. 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 suply

  25. 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.

  26. Fed Funds Rate 1996-2006 5.25% June, 2006

  27. Relative Importance of Monetary Policy Relative Importance of Monetary Policy A. WWII-1979–Fed targeted the interest ratenot the growth of MS. B. 1979-1982 – Fed targeted the growth of the MS not the in. rate. C. 1982-Present-Fed targets the interest 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. 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.

  28. 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.”

  29. Strengths of Monetary Policy • Speed and flexibility • Isolation from political pressure • Successes in the 1980s & 1990s Shortcomings and problems Monetary Policy better I’d like one of those 1% mortgages, but I don’t have a job. Cyclical asymmetry [better atfighting inflationthanfighting depressions] Fiscal Policy better

  30. Shortcomings and Problems of Monetary Policy But – I will eat spiked brownies. Cyclical Asymmetry (lack of balance) – “Tight money during inflations is 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.

  31. 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”

  32. Monetary and Fiscal Policy

  33. 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

  34. 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

  35. 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[$$] sells securities to thePUBLIC[T-bills], DD (don’t change/incr/decr) & banking system RR, ER & TR (incr/decr). 51. When the Fed[T-bills] buys securities from commercial banks[$$], DD (don’t change/increase/decrease) & ER and TR (increase/decrease). 52. When the commercial bankingsystem[$$] borrows from the Fed, DD (don’t change/increase/decrease) but ER & TR (incr/decr). 53. When commercial banks[$$] sell government securitiesto theFed[T-bills], DD (don’t change/incr/decr) but their ER & TR (do not change/incr/decr). 54. When the PUBLIC[T-bills] 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

  36. 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% and the Fed buys $4 M of bonds from the public. The MS is increased by ($3/$4/) million and the PMC is increased by ($16/$12) M. Potential TMS is ($3/$4/$12/$16) M. 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

  37. 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.

  38. 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).

  39. Money, Banking, &FedTest Review 1-8 1. If your bank borrows $50,000 from the Fed, does this automatically 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.

  40. NS 9. “Easy Money” During Recessions MS1 MS2 DI “Students, should the Fed buy or sell bonds to jumpstart this economy?” 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 LRAS AD2 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*

  41. NS 10. “Tight Money” during Inflation DI MS1 MS2 Dm “Now, should I buy or sell?” 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 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*

  42. RR is 20% AssetsDD(Liabilities) TR[RR+ER]=$20 mil.$100 million 11. How much can thisbankloan out? $______ 12.IfPam Andersonputs $1,000in this bank(DD),ER will increase by$_______. 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 0 800 4,000 5,000

  43. RR is 25% AssetsDD(Liabilities) • TR[RR+ER]=$25 mil.$100 million • How much can thisbankloan out? $______ • 2. IfPam Andersonputs$4,000in this • bank(DD),ER will increase by$_______. • 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 3,000 12,000 16,000

  44. RR is 20% AssetsDD(Liabilities) TR[RR+ER] = $20 mil.$100 million 11. How much canPam’s bankloan out?$______ 12. If Pam Anderson’s Bank borrows $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 Pam Anderson’s Bank Fed 5,000 5,000

  45. RR is 40% AssetsDD(Liabilities) TR[RR+ER]=$40 mil.$100 million 1. How much can this bank loan out? $______ 2. IfCameron Diazputs $10,000in thisbank(DD), ER will increase by$_________. 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 6,000 Cameron fell in March, 2005 and had to have 19 stitchesin her head but she is OK now. 15,000 25,000

  46. RR is 50% AssetsDD(Liabilities) TR[RR+ER] = $50 mil.$100 million 11. How much can Cameron’s bank loan out? $______ 12. If Cameron Diaz’s Bank borrows $5,000 from the Fed ER will increase by $_______. 13. Possible Money Creation in the system could be $________. 14. Potential Total Money Supply could be as much as$________. Extra PracticeMS = Currency + DD of Public 0 5,000 Cameron Diaz’s Bank Fed 10,000 10,000

  47. Test Review 15-19 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 15. If the goal is F.E., & theinterest rate is9%, a(an) (recess/ inflat) gap exists, the Fed should (incr/decr) the in. rate. 16. If the interest rate is 3%, a(an) (recess/inflat) gap exists, the Fed should (increase/decrease) the interest rate. 17. If the interest rate is 6%,the Fed should (incr/decr/do nothing) to the interest rate. 18. To reduce inflation,the Fed should (lower, lower, buy/raise, raise, sell) 19. To get out ofa recession, the Fed should (lower, lower, buy/raise, raise, sell)

  48. The End

  49. Review of Money Creation, The Fed, & Monetary Policy

  50. Money Creation

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