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Page 1: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

33

Monetary Policy

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

15

Page 2: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Interest Rates

• The price paid for the use of money

• Many different interest rates

• Speak as if only one interest rate

• Determined by the money supply and money demand

LO1 33-2

Page 3: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Demand for Money

• Why hold money?

• Transactions demand, Dt

• Determined by nominal GDP

• Independent of the interest rate

• Asset demand, Da

• Money as a store of value

• Varies inversely with the interest rate

• Total money demand, Dm

LO1 33-3

Page 4: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

The Money MarketR

ate

of

inte

rest

, i p

erce

nt

10

7.5

5

2.5

050 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded and supplied

(billions of dollars)

=+

(a)Transactionsdemand formoney, Dt

(b)Asset

demand formoney, Da

(c)Total

demand formoney, Dm

and supply

Dt Da Dm

Sm

5

LO1 33-4

Page 5: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Interest Rates

• Equilibrium interest rate

• Changes with shifts in money supply and money demand

• Interest rates and bond prices

• Inversely related

• Bond pays fixed annual interest payment

• Lower bond price will raise the interest rate

LO1 33-5

Page 6: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

LO2

Federal Reserve Balance Sheet

33-6

Assets Liabilities

• Securities * Reserves of commercial banks

* Loans to commercial banks

* Treasury deposits

* Federal Reserve Notes outstanding

Page 7: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

March 24, 2010 (in Millions)

Source: Federal Reserve Statistical Release, H.4.1, March 24, 2010, http://www.federalreserve.gov

SecuritiesLoans to Commercial BanksAll Other Assets

Total

Reserves of Commercial BanksTreasury DepositsFederal Reserve Notes (Outstanding)All Other Liabilities and Net WorthTotal

$2,017,955

85,659212,911

$2,316,525

$ 1,147,747150,087

893,035125,656

$2,316,525

LO2

Federal Reserve Balance Sheet

Assets Liabilities and Net Worth

33-7

Note: The total amount of securities held by the Fed right now is about $4.2 trillion.

Page 8: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• Open market operations

• Buying government securities (or bonds) increases the money supply.

• From commercial banks and the general public.

• Either way the money supply can increase up to the amount of the purchase times the money multiplier.

LO2 33-9

Page 9: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• Fed buys bonds from commercial banks

Assets Liabilities and Net Worth

Federal Reserve Banks

+ Securities + Reserves of Commercial Banks

(b) Reserves

Commercial Banks

-Securities (a)

+Reserves (b)

Assets Liabilities and Net Worth

LO2

(a) Securities

33-10

Page 10: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Open Market Operations

• Fed buys $1,000 bond from a commercial bank

New Reserves

$5000Bank System Lending

Total Increase in the Money Supply, ($5,000)

$1000Excess

Reserves

LO2 33-11

Page 11: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Open Market Operations

• Fed buys $1,000 bond from the public

Check is DepositedNew Reserves

$1000

Total Increase in the Money Supply, ($5000)

$200RequiredReserves

$800Excess

Reserves

$1000Initial

CheckableDeposit

$4000Bank System Lending

LO2 33-12

Page 12: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• Open market operations

• Selling government securities (or bonds) decreases the money supply.

• To commercial banks and the general public.

• Either way the money supply can decrease up to the amount of the sale times the money multiplier.

LO2 33-13

Page 13: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• Fed sells bonds to commercial banks

Assets Liabilities and Net Worth

Federal Reserve Banks

- Securities - Reserves of Commercial Banks

Commercial Banks

+ Securities (a)

- Reserves (b)

Assets Liabilities and Net Worth

(a) Securities (b) Reserves

LO2 33-14

Page 14: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• The reserve ratio

• Changes the money multiplier

LO2 33-15

Liability Type

Requirement

% of liabilities

Effective date

Net transaction accounts 1

$0 to $13.3 million2

0 1-23-14More than $13.3 million to $89.0 million3

3 1-23-14More than $89.0 million

10 1-23-14Nonpersonal time deposits

0 12-27-90

Page 15: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

The Reserve Ratio

Effects of Changes in the Reserve Ratio

(1)

Reserve

Ratio, %

(2)

Checkable

Deposits

(3)

Actual Reserve

s

(4)

Required Reserves

(5)

Excess Reserves

,

(3) –(4)

(6)

Money-Creating

Potential of

Single Bank, = (5)

(7)

Money-Creating

Potential of Banking System

(1) 10 $20,000 $5000 $2000 $3000 $3000 $30,000

(2) 20 20,000 5000 4000 1000 1000 5000

(3) 25 20,000 5000 5000 0 0 0

(4) 30 20,000 5000 6000 -1000 -1000 -3333

LO2 33-16

Page 16: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• The discount rate

• The Fed is the “lender of last resort.”

• Short term loans

• Lower rate will encourage banks to borrow reserves (increases money supply.)

• Higher rate will discourage banks from borrowing reserves (decreases money supply).

• Mostly set now in response to other interest rates.

LO2 33-17

Page 17: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Tools of Monetary Policy

• Open market operations are the most important

• Reserve ratio last changed in 1992

• Discount rate is a passive tool – the Fed mostly changes it to keep it in line with other short-term interest rates.

LO2 33-18

Page 18: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

The Federal Funds Rate

• Rate charged by banks on overnight loans

• Targeted by the Federal Reserve

• FOMC conducts open market operations to achieve the target

• Demand curve for Federal funds

• Supply curve for Federal funds

LO3 33-19

Page 19: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

The Federal Funds Rate

Fed

eral

Fu

nd

s R

ate,

Per

cen

t

3.5

Quantity of Reserves

Df

Sf 3

4.0

4.5

Sf 1

Sf 2

Qf3 Qf1 Qf2

Using Open Market Operations

LO3 33-20

Page 20: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Monetary Policy

• Expansionary monetary policy

• Economy faces a recession

• Lower target for Federal funds rate

• Fed buys securities

• Expanded money supply

• Downward pressure on other interest rates

LO3 33-21

Page 21: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Monetary Policy

• Restrictive monetary policy

• Periods of rising inflation

• Increases Federal funds rate

• Increases money supply

• Increases other interest rates

LO3 33-22

Page 22: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

10

8

4

6

2

0

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Per

cen

t

Year

Prime interest rate

Federal funds rate

Monetary Policy

33-23

Page 23: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Taylor Rule

• Rule of thumb for tracking actual monetary policy

• Fed has 2% target inflation rate

• If real GDP = potential GDP and inflation is 2%, then targeted Federal funds rate is 4%

• Target varies as inflation and real GDP vary

LO3 33-24

Page 24: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Monetary Policy, Real GDP, Price Level

• Affect on real GDP and price level

• Cause-effect chain

• Market for money

• Investment and the interest rate

• Investment and aggregate demand

• Real GDP and prices

• Expansionary monetary policy

• Restrictive monetary policy

LO4 33-25

Page 25: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Monetary Policy and Equilibrium GDP

10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)

Amount of moneydemanded and

supplied(billions of dollars)

Amount of investment (billions of dollars)

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3$125 $150 $175 $15 $20 $25

P2

P3

Sm1 Sm2 Sm3

Dm

IDAD1

I=$15

AD2

I=$20

AD3

I=$25

(a)The marketfor money

(b)Investment

demand

(c)Equilibrium real

GDP and thePrice level

AS

LO4 33-26

Page 26: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3

P2

P3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(c)Equilibrium real

GDP and thePrice level

AS

Pri

ce

Le

ve

lReal GDP

(billions of dollars)

Q1 Qf Q3

P2

P3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(d)Equilibrium real

GDP and thePrice level

AS

abc

AD4

I=$22.5

Monetary Policy and Equilibrium GDP

LO4 33-27

Page 27: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Expansionary Monetary Policy

Problem: Unemployment and Recession

Fed buys bonds, lowers reserve ratio, lowers the discount rate.

Excess reserves increase

Federal funds rate falls

Money supply rises

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP risesLO4

CA

US

E-E

FF

EC

T C

HA

IN

33-28

Page 28: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Restrictive Monetary Policy

Problem: Inflation

Fed sells bonds, increases reserve ratio, increases the discount rate.

Excess reserves decrease

Federal funds rate rises

Money supply falls

Interest rate rises

Investment spending decreases

Aggregate demand decreases

Inflation declines

CA

US

E-E

FF

EC

T C

HA

IN

LO4 33-29

Page 29: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

Evaluation and Issues

• Advantages over fiscal policy• Speed and flexibility

• Isolation from political pressure

• Monetary policy is more subtle than fiscal policy

LO5 33-30

Page 30: 33 Monetary Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15

The Big Picture

Levels ofOutput,

Employment,Income, and

Prices

AggregateDemand

AggregateSupply

InputResourcesWith Prices

ProductivitySources

Legal-InstitutionalEnvironment

Consumption(Ca)

Investment(Ig)

Net ExportSpending

(Xn)

GovernmentSpending

(G)

33-33


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