Chapter 13

Managing Aggregate Demand:

Monetary Policy

Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it

meant. But they knew that it was an act of extreme wisdom.

JOHN KENNETH GALBRAITH

Outline

• Fed as a central bank• Monetary policy

– Tools

– Mechanism

Money and Income: Difference

• Money– At one point in time (stock)

– E.g.: money stock (M1)

• Income– Over a period of time (flow)

– E.g.: nominal GDP per year

4

The Federal Reserve System

The Federal Reserve System

• The Federal Reserve System, “The Fed”– U.S. central bank

• Bank for banks

– Origins• 1873-1907: four severe banking panics

– Established in 1914 by the Congress to regulate commercial banks

Discussion: Why do we need a central Discussion: Why do we need a central bank?bank? 6

Dow-Jones Industrial Average

Bank Run on Wall Street, 1907

The Federal Reserve System

• Organization of the Fed– Board of Governors

– FOMC

– 12 Regional Banks

– Member Banks

The Federal Reserve System

• Board of Governors (7 members)– Main governing body of the Fed

– Appointed by U.S. President• Chairman (4-year term)

– Advice & consent of Senate

– 14-year term

– Oversees System operations, makes regulatory decisions, and sets reserve reserve requirements requirements

10

The Federal Reserve System

• The Fed has 12 regional banks– Each independently incorporated with a

9-member board of directors

– Set discount ratediscount rate, subject to approval by Board of Governors

– Monitor economy and financial institutions in their districts and provide financial services to the U.S. government and depository institutions

The Federal Reserve System

• Federal Open Market Committee (FOMC)– 12 members

• 7 governors of the Fed• President of the Fed – New York• 4 (of 11) district banks presidents on a

rotating basis

– Meet eight times a year in DC

– Determine short-term interest ratesshort-term interest rates (FFR)

– Size of U.S. money supply

12

FOMC Meeting

The Federal Reserve System

• 3400 member banksmember banks– Private banks

– Hold stock in their local Federal Reserve Bank

– Elect six of the nine members of Reserve Banks’ boards of directors

The Federal Reserve System• Central bank independence

– Make decisions without political interference (without prior approval from Congress or the President)

– Institutional arrangement guarantees the independence

– Unique structure provides internal checks and balances, not dominated by one part of the system

– Help control inflation

Discussion: Why do we need CBI?Discussion: Why do we need CBI? 15

Central bank independence

Tools of Monetary Policy

• Open market operations• Discount rate• Reserve requirements

Implementing Monetary Policy

• Open-market operations (OMOs)– Fed’s purchase / sale

• Short-term government securities (T-bills)• Transactions: Open market

• The Fed uses OMOs to affect market interest rates– Purchase: Treasury bills

– Pays: newly created bank reserves

– Put pressure on market interest rate

• The most frequently used tool 18

Implementing Monetary Policy

• Market for bank reserves– Supply curve

• Determined by Federal Reserve policy• Upward-sloping

– Demand curve• Banks – required to hold reserves• Reflects

– Demand for transaction deposits – banks

• Depends on real GDP & price level• Downward-sloping (Why?)

19

The market for bank reserves

Figure 1

20

Quantity of Bank Reserves

Inte

rest

Rat

e

S

SD

D

E

For given

Fed policy

For given

Y and P

Implementing Monetary Policy

• Market for bank reserves– Federal funds rate (FFR)Federal funds rate (FFR)

• Interest rate• Borrow/lend reserves among banks

• The Fed – lower federal funds rate– Purchase T-bills

• Additional reserves to market

– Supply curve – shift outward• Lower interest rates• More bank reserves

21

The effects of an open-market purchase

Figure 2

22

Quantity of Bank Reserves

Inte

rest

Rat

e

S0

S0

D

D

S1

S1

E

A

Implementing Monetary Policy

• Federal Reserve– Wants lower interest rates

– Purchases U.S. government securities• In the open market• Pays - creating new bank reserves• Required reserve – no change• Actual reserves – increased • Excess reserves

– Multiple expansion process – Increase money supply by 1/m1/m times

23

Effects of an open-market purchase of securities on the balance sheets of banks and the Fed

Table 1

24

Banks

Assets Liabilities

Federal Reserve System

Assets Liabilities

Reserves +$100 million

U.S. government

securities -$100 million

Addendum: Changes

in Reserves

Actual Reserves

+$100 million

Required Reserves

No Change

Excess Reserves

+$100 million

U.S. government

securities +$100 million

Bank Reserves

+$100 million

Bank gets Reserves

Fed gets securities

Implementing Monetary Policy

• OMOs might not be perfect accurate– People - hold cash

– Banks - hold excess reserves

• However, Fed can always achieve the FFR it wants– FFR is observable in the open market

every minute

– Fed can always adjust the volume of T-bills it needs to buy/sell

• OMOs is very flexibleflexible, fine tunefine tune policy 25

Implementing Monetary Policy

• Federal Reserve– Wants to increase interest rates

– Sells U.S. government securities• In the open market• Banks pay: reserves (deposits at the Fed)

– Multiple contraction process – Decrease money supply by 1/m1/m times

Implementing Monetary Policy

Another way to look at OMO (via bond bond marketmarket)

• Expansionary monetary policy– Fed buys T-bills– T-bill prices – increase

• Demand – unchanged• Supply (available to private investorsavailable to private investors)

– Inward shift

– Interest rates – fall• Interest rate = fixed dividend / bond price• Bond price ↑ → interest rate ↓ 27

Open-market purchases and treasury bill prices

Figure 3

28

Quantity of Treasury Bills

Pric

e of

a T

reas

ury

Bill

S0

S0

D

D

S1

S1

P0

P1A

B

Implementing Monetary Policy

Summary of OMO:• Open-market purchase-T-bills

– Raises the money supply

– Drives up T-bill prices

– Pushes interest rates down

• Open-market sale - T- bills– Reduces the money supply

– Lowers T-bill prices

– Raises interest rates29

Effective FFR

Nearly Zero FFR

• Discussion: In the current recession, Discussion: In the current recession, Fed already set FFR close to zero. Fed already set FFR close to zero. Does this mean the effect of OMOs is Does this mean the effect of OMOs is limited? What should Fed do if OMOs limited? What should Fed do if OMOs do not work?do not work?

Other Methods of Monetary Control• The Fed – lender of last resort

– Lending to member banks

• Discount rate– Interest rate charged by Fed for overnight

loans that member banks borrow via “Discount WindowDiscount Window”

– generally set at a rate close to 1% above the target FFR

• Discount rate – decrease– Banks – borrow more

– Increase excessexcess reserves 32

Balance sheet changes for borrowing from the Fed

Table 2

33

Banks

Assets Liabilities

Federal Reserve System

Assets Liabilities

Reserves

+$5 million

Loan from

Fed +$5 million

Addendum:

Changes in

Reserves

Actual Reserves

+$5 million

Required

Reserves

No Change

Excess Reserves

+$5 million

Loan to

Bank +$5 million

Bank Reserves

+$5 million

And the proceeds are credited

to its reserve account

Bank borrows $5 million

Other Methods of Monetary Control

• Minimum required reserve ratio (m)– Decrease

• Increase excess reserves– Money expansion

• Lower interest rates

– Increase• Decrease excess reserves

– Money contraction

• Higher interest rates

– 10% since 199234

How Monetary Policy Works

• Expansionary monetary policy– Open-market purchase

– Lower interest rates

• Contractionary monetary policy– Open-market sale

– Raise interest rates

35

The effects of monetary policy on interest rates

Figure 4

36

Bank Reserves

Inte

rest

Rat

e

S0

S0D

D

S1

S1

E

A

(a)

Expansionary Monetary Policy

Bank Reserves

Inte

rest

Rat

e

S0

S0

D

D

S2

S2

E

B

(b)

Contractionary Monetary Policy

How Monetary Policy Works

• Sensitive to monetary policy– Investment (depends on r)

– Net exports (via exchange rate, Chp. 18)

• AD = C +II +G +(X-IMX-IM) is thus affected• Reminder: fiscal policy affects AD through

GG (directly) and CC an II (indirectly via tax)• Discussion: fiscal policy vs. monetary Discussion: fiscal policy vs. monetary

policy, pros and conspolicy, pros and cons

37

The effect of interest rates on total expenditure

Figure 5

38Real GDP

Rea

l Exp

endi

ture

45°

C+I+G+(X-IM)

C+I+G+(X-IM)

(lower interest rate)

C+I+G+(X-IM)

(higher interest rate)

How Monetary Policy Works

• Expansionary monetary policy– Lower interest rates (r)

– Encourage investment (I)

– Higher total spending

– Higher expenditure schedule

– Multiplier effect on aggregate demand

39

How Monetary Policy Works

• Contractionary monetary policy–Higher interest rates (r)–Lower investment spending (I)–Lower total spending [C+I+G+(X-

IM)]–Lower expenditure schedule–Lower aggregate demand through

multiplier

Mechanism of Mon. Policy (P constant)

GDPIMXGIC 43

321

)(

Ir and MPolicy

Reserve Federal

The effect of expansionary monetary policy on total expenditure

Figure 6

42

Rea

l Exp

endi

ture

45°

C+I1+G+(X-IM)

C+I0+G+(X-IM)

E0

E1

6,5006,0000

Real GDP

5,500 7,000

How Monetary Policy Works

• Effect of monetary policy– On aggregate demand

– Depends on• Sensitivity of interest rates

– To open-market operations

• Responsiveness of investment spending– To interest rate

• Size of basic expenditure multiplier

43

Money & Price Level in Keynesian Model

• Expansionary monetary policy– Increases aggregate quantity demanded

• At any given price level

– Causes some inflation• Depends on slope of aggregate supply curve

44

Money & Price Level in Keynesian Model

PYIMXGIC and )(

Ir and MPolicy

Reserve Federal

43

321

Inflationary effects of expansionary monetary policy

Figure 7

46

Pric

e Le

vel

0

Real GDP

6,4006,000

S

S

D0

D0

100

E103

D1

D1

B$500 billion

Money & Price Level in Keynesian Model

• Aggregate demand – slopes downward– Higher price level (caused by

expansionary monetary policy)• Reduce purchasing power• Depress exports, Stimulate imports• Increase quantity of bank deposits demanded

– Demand curve (bank reserves) – shift outward– Increase federal funds rate– Higher interest rate– Discourage investment– Lower aggregate quantity demanded

47

The effect of a higher price level on the market for bank reserves

Figure 8

48

Bank Reserves

Inte

rest

Rat

e

S

S D0

D0

D1

D1

Effect of a

higher P

E1

E0

Summary

• Fed: Origin and structure• Central bank independence• Tools of monetary policy

– OMO– Discount rate– Reserve requirement

• Mechanism of the monetary policy– Interest rate → Investment → AD → Y and P