Monetary Policy

1. Monetary Policy

2. Goals of Monetary Policy • Not profit motivated • “assist in achieving a full-employment, noninflationary level of total output” • 1960s: focus full-employment • Post-1970s: focus inflation • Alters M by altering excess reserves to affect output and prices

3. Consolidated Balance Sheet • Assets: • Securities: Treasury bills (short-term) and Treasury bonds (long-term): public debt; usually bought/sold open market • Loans to Commercial Banks • Liabilities • Reserves of Commercial Banks • Treasury Deposits: gov’t writes checks too • Outstanding Federal Reserve Notes

4. Tools • 1) Open Market Operations • Buying and selling of bonds in open market • Buying • From C. Banks: increases banks’ reserves by amount of purchase (if fully “loaned up” $1000 bond w/20% RR $5000 increase lending + M) • From public: indirectly increases banks’ reserves (less the reserve requirement: $4000 in lending and $1000 in new demand deposit= $5000 increase M) • Selling: just the reverse

5. Why sell/buy to Fed? • Buy D up price up and IR down • Sell S up  price down and IR up

6. Reserve Ratio • Raise RR A) lose excess reserves diminish money creation through lending or B) reserves become deficient contract checkable deposits and therefore M • Lowering has opposite effect • ∆ RR: 1) ∆ excess reserves and 2) ∆ monetary multiplier (1/RR)

7. Discount Rate • C. Bank borrowing from Fed increase reserves extension credit • Discount rate: rate charged to borrow from Fed (cost of acquiring reserves) raise/lower discourages/encourages C. Bank borrowing to increase M

8. Easy vs. Tight • Expand M: buy securities, reduce RR, lower discount rate • Restrict M: sell, raise, raise

9. Relative Importance of Tools • #1 Open market operations (bonds) • Discount rate: 1) C. Banks borrow only 2-3% of reserves from Fed (and OMO changes in borrowing); 2) DR effectiveness dependent on bank decisions (if banks unwilling, Fed unable) • But, discount rate as “announcement effect”; but often to keep in line w/other rates • Reserve ratio: used rarely bc impacts bank profits (reserves earn no interest)

10. OMO: 1) flexible (scalpel > sledgehammer); 2) prompt (timing problems); 3) powerful: total sale could take reserves $22B $0

11. Monetary Policy, Real GDP, Price Level • See board (or p. 314-315)

12. Degree of Policy Effectiveness and Feedback • Steeper Dm larger effect ∆ M on equil I. • Flatter investment demand greater effect ∆ I • Feedback: I eGDP, and eGDP I (transaction demand) • Partial offsets (a la net export or crowding out effects): ∆ M ∆ I  ∆ GDP opposite ∆ I

13. Effectiveness • 1) Speed and flexibility • 2) isolation from political pressure • 3) “Success” in 1980s + 1990s (the “maestro”) monetary policy primary stabilization tool in US

14. Shortcomings and Problems • 1) Less control? ∆ banking + globalization undermine Fed policy power • 2) Cyclical assymetry: easy money only works if willing to loan/borrow: Fed strong in expansions, weaker in recessions (when arguably most needed) • 3) Changes in velocity: total expenditures = M times velocity of money (how often spent) • Asset demand velocity inverse M • 4) Investment Impact: ∆ biz confidence (movement of investment demand curve) may require enormous exertions by Fed to offset • 5) Interest as income: MP based on assumption expenditures inversely related i; but i also income, so direct relationship (probably only partly off-sets)

15. Federal Funds rate • “target”: not set by Fed (supply and demand), but buys/sells bonds to affect rate • Prime rate follows Federal Funds

16. MP in OE • Net Export Effect: opposite of fiscal policy reinforces policy • Macro Stability and the Trade Balance: “pay its own way” (balance trade) • Full-employment goal and off-setting trade deficit goal hand in hand • Anti-inflation and off-setting trade surplus contradictory

17. Real and Nominal Interest • Nominal interest rate= real interest rate + anticipated inflation • or • R=N-A • or • A=N-R