Chapter 16 -- Monetary Policy

1. Chapter 16 -- Monetary Policy • This chapter looks at MonetaryPolicy, the most frequent use of policy to correct the economy. • Monetary Policy -- The Federal Reserve changing bank loaning conditions to affect the supply of financial capital, investment, and aggregate demand.

2. The Banker’s Problem • Fundamental decision -- how to allocate their assets to make reasonable profits and to service depositor withdrawals. • Reserves – do not earn interest (not a source of revenue), are used to back up depositor withdrawals. • Loans – earn interest for the bank (their major source of revenue), but funds committed to loans are not accessible to the bank.

3. The Federal Reserve (1913) • Original Roles -- Provider of Discount Window -- “Lender of Last Resort” -- Regulate Banks (e.g. Reserve Ratios) • Manages Monetary Policy

4. Structure of the Federal Reserve

5. Board of Governors (BOG) • 7 members • appointed by the President, with the consent of the Senate • once approved, independent of the President • Important Chairs of the BOG -- Paul Volcker -- 1979-87 -- Alan Greenspan – 1987-2006 -- Ben Bernanke -- 2006-

6. The Federal Open Market Committee (FOMC) • 12 voting members -- 7 Board of Governors + 5 District Bank Presidents (19 members in all). • meets approximately once a month (more, if needed). • designs monetary policy, communicated by specifying Federal Funds rate target.

7. Federal Reserve District Banks • Each private bank exists within one of 12 districts within the US. • Each district has a Federal Reserve District Bank. • District banks administer monetary policy, regulate the private banks within their district.

8. The Basic Strategy of Monetary Policy • Expansionary (Y* < YF)-- Federal Reserve seeks to increase the supply offinancial capital by encouraging bank loaning. • Contractionary (Y* > YF) -- Federal Reserve seeks to decrease the supplyof financial capital by discouraging bank loaning.

9. Monetary Policy Tools • Instruments that initiate monetary policy. (1) The Discount Rate (2) Reserve Ratio (3) Open Market Operations

10. Changing The Discount Rate • The Discount Rate -- the rate of interest charged to banks that borrow from the Federal Reserve. • ExpansionaryPolicy-- Fed lowers discount rate. • Contractionary Policy -- Fed raises discount rate.

11. Changing the Reserve Ratio • Designed to change the minimum amount of reserves the bank must hold. • ExpansionaryPolicy -- Fed lowers the reserve ratio. • Contractionary Policy-- Fed raises the reserve ratio.

12. Open Market Operations • Open Market Operations -- the buying or selling of bonds by the Federal Reserve in the open market (the Fed’s predominant policy tool). • Expansionary -- Fed buys bonds (gives banks new reserves) • Contractionary -- Fed sells bonds (drains reserves from banks)

13. Open Market Operations: An Example • Example -- Federal Reserve buys a $1000 bond from Chase. • Chase receives new reserves, can make new loans. • Therefore, the potential to increase the supply of financial capital is increased.

14. The Federal Funds Rate • The Federal Funds Rate -- the interest rate paid by one bank to borrow reserves from another bank. • The “thermostat” of monetary policy. Changes in target Federal Funds rate by the FOMC prompt the execution of open market operations. Open market operations stop when new target is achieved.

15. The Process of Monetary Policy -- Expansionary • The FOMC lowers the target Federal Funds Rate. • To achieve this target, the Fed buys bonds from banks, supplying more reserves to the system. • The Fed does this until the new target Federal Funds rate is achieved.

16. Expansionary Monetary Policy, Continued • Increased bank loaning due to having greater reserves implies an increase in the supply of financial capital, shifting the supply of capital curve rightward. • The shift in the supply of financial capital implies that the interest rate (r*) decreases and Investment (I*) increases. • The increase in I* shifts the AD curve rightward, increasing both Y* and P*.

17. The Process of Monetary Policy -- Contractionary • The FOMC raises the target Federal Funds Rate. • To achieve the new target, the Fed sells bonds to banks, thereby removing reserves from the system. • The Fed does this until the new target Federal Funds rate is achieved.

18. Contractionary Monetary Policy, Continued • Decreases in bank loaning due to having less reserves implies a decrease in the supply of financial capital, shifting the supply of capital curve leftward. • As a result, the interest rate (r*) increases and Investment (I*) decreases. • The decrease in I* shifts the AD curve leftward, decreasing both Y* and P*.

19. Monetary Policy and the Short-Run Perspective • Monetary policy is interventionist – believes that the short-run is the relevant period. • In formal terms, policy works with the AD and AS curves. • Long-run perspective (AD and LAS curves) – no need for monetary policy “medicine”, economy will cure itself.

20. Obstacles to Monetary Policy Effectiveness • When does monetary policy have difficulty in changing Y* to improve the economy? • Particularly applies to expansionary monetary policy -- getting the economy out of sluggishness or recession.

21. A Potential Obstacle (1) Banks don’t want to loan the added reserves (pessimism about prospects of loan default or fears of inflation). • No shifts in demand or supply for financial capital.

22. Another Potential Obstacle 2) Banks want to loan, but firms and consumers don’t want to borrow the funds (e.g. pessimism about state of economy). • Described as leftward shift in the demand for financial capital coupled with a rightward shift in the supply of financial capital.

23. The Volcker Recession: Ending a Wage-Price Spiral • 1970s in US -- Wage-Price Spiral • Started as overly expansionary government and monetary policies of the 1960s, with progressively higher wage increases. • Continued in late 1970s as expansionary monetary responses to increase in price of energy. Continued high wage increases.

24. The Volcker Recession of 1981-83 • Very contractionary monetary policy (Federal Funds rate over 17%) -- Supply of financial capital decreases, I* falls, AD curve shifts leftward. • High nominal wage increases continue, big leftward shift in AS curve. • Major recession, lower inflation eventually eases inflation fears.

25. The Volcker Recession and Recovery -- 1981-83 • Convinced of Federal Reserve’s intent to solve inflation problem, lower wage increases occur, smaller leftward shifts in AS curve. • Federal Reserve gradually practices cautious expansionary monetary policy, shifts AD curve rightward, Y* returns to YF.

26. Monetary Policy in the Greenspan Era • 1990-91 recession -- similar to Volcker, but on a smaller scale. • “Soft Landing” strategy beginning in 1990s -- small monetary policy changes designed not to arouse inflation fears, overly large wage increases. • Contractionary in 2000 (Y* > YF),

27. Monetary Policy: From Greenspan to Bernanke • 2001-03: Expansionary (Y* < YF.). Policy experienced difficulty getting economy back to YF. • 2004-06: Contractionary. Economy caught up to YF, concern about overstimulated economy and increased energy prices. • 2007-08: Expansionary. Addressing slowdown and ultimate recession of 2008.