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Monetary PolicyChapter 10

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Monetary Policy

• We talked about how the government can use fiscal policy to try to smooth recessions• The other major tool they use is monetary policy-

manipulating inflation and interest rates• This is not done by the federal government itself, but

by the Federal Reserve Bank

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The Federal Reserve

• Nicknamed “The Fed”.• Established in 1913 by Congress primarily as the

authority for bank regulation.• The power to “coin money” was granted to Congress

by Article 1 Section 8 of the US Constitution but this power was delegated to the Federal Reserve.• The power to regulate the amount that exists in the

economy was granted to the Federal Reserve in an attempt to avoid the boom and bust periods of the late 1800s.• This power allows the Federal Reserve to alter

interest rates without political interference.

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• There are 12 regional Federal Reserve Banks• Boston, New York, Philadelphia, Richmond, Atlanta,

Cleveland, St. Louis, Kansas City, Chicago, Dallas, Minneapolis, and San Francisco

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Goals of Monetary Policy

• Provide sufficient money to the economy so that it may grow at a sustainable rate.• Dampen the impact of the business cycle.• Control Inflation

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What is Money?

• First of all what is money and why do we have it?• The alternative is we could just trade apples for

cheeseburgers, but that is pretty inconvenient• Suppose I grow apples• Tim has a coal mine• Joe cuts hair• Laura builds houses• I want to trade my apples for other stuff, but I have to make

a whole series of trades to get it worked out, and some of it may be inconvenient to trade (like houses and hair cuts)

• Money (or cash) makes things much more convenient, we can just trade money for goods and services rather than having to hold goods we don’t want

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How do we Measure Money?

• Monetary Aggregate: a measure of the quantity of money in the economy

• Its not so easy to decide exactly what money is-sort of depends how easy it is to get access to it

• Has become more complicated with electronic transitions

• The commonly used ones are • M1 =cash+coin and checking accounts• M2=M1+saving accounts+ small CDs

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Traditional and Ordinary Tools of Monetary Policy

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• Open Market Operations– A relatively fine tool that can be used to make

small adjustments. These adjustments can be daily and often occur without much fanfare.

• Targeted Interest Rates– A relatively blunt tool that can be used to make

large adjustments. Changes in targeted interest rates typically occur a few times per year.

• Reserve Ratio– A rather blunt tool that is only used when very

large adjustments are in order.

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Tools of Monetary Policy: Open Market Operations

• The Fed buys US government debt in order to get cash into the economy.• The Fed sells US government Debt in order to get cash

out of the economy.• More money in the economy puts downward pressure

on interest rates.

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Tools of Monetary Policy:Targeted Interest Rates

• The Fed seeks to influence the Federal Funds Rate (the rate at which banks borrow from one another to meet reserve requirements)• Fed Loans Directly to Banks• Banks with good credit pay the primary credit rate and can

borrow unlimited amounts.

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Tools of Monetary Policy: The Reserve Ratio

• When a bank takes a deposit into an account on which a check can be written, it must place a percentage of that deposit on reserve at a Federal Reserve bank. That percentage is called the reserve ratio.• The Fed directly controls the percentage of deposits

that banks must have at their regional Fed bank.

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Money Creation

• The banking system can create more “money” than physically exists in the form of coin and cash.

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• The banking system creates money by a series of loans. • Sal makes a $1000 deposit at Chase• Chase loans Mary $900 who buys something

from Sue • Sue makes a $900 deposit in Citibank.• Citibank loans $810 to Bill who buys

something from Allen….. and so on.• In the end there are deposits totaling

$10,000 ($1,000+$900+$810+$729+....) that resulted from that initial $1000.

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Modeling Monetary Policy

• If the Fed wants to expand the economy it can• buy bonds• decrease the Federal Funds or Discount Rate• lower the reserve ratio.• This increases the supply of loanable funds. This

lowers interest rates which increases aggregate demand.

• If the Fed wants to contract the economy it can • sell bonds• increase the Federal Funds or Discount Rate• raise the reserve ratio.• This decreases the supply of loanable funds. This

raises interest rates which decreases aggregate demand. 1

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expantionary MoNetary Policy

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InterestRates

Loanable funds RDGP

PriceLevel

AS

AD

r

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Contractionary MonetaryPolicy

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InterestRates

Loanable funds RDGP

PriceLevel

AS

AD

r

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Monetary Transmission

• The Monetary Transmission Mechanism is the means by which changes in the interest rate impact the overall economy through changes in business investment and consumer spending.• The Fed can impact the interest rate with

monetary policy.• The Fed cannot count on interest rates

changing business investment and consumer spending.• When the Monetary Transmission Mechanism

fails, you have a liquidity trap.

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New Tools of Monetary Policy(Quantitative Easing)

• Purchases of Commercial Paper, short term debt of corporations.• Purchases of longer term Federal Treasuries• Purchases of mortgage backed securities.

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Central Bank Independence

• Countries with Central Banks (the general name for institutions like the US Federal Reserve) that are more independent of political control have higher rates of economic growth.• This is because political influences tend to create inflationary tendencies which raises interest rates and lowers long-term investment.

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Fed History 1975-1983

• In the late 1970s, the Fed battled the slow growth caused by high oil prices by increasing loanable funds so as to lower interest rates. • The result was high inflation and even higher interest rates.• The Fed induced the 1982 recession with contractionary policy. Once inflation fell below 6% in 1983 it engaged in expansionary policy.

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Fed History 1984-1990

• The Fed battled high deficits (expansionary fiscal policy) by keeping real interest rates fairly high.• The Fed chose not to react to the 1990 recession

hoping to persuade Congress and the first President Bush to compromise on deficit reduction.

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Fed History 1990-2003

• The Fed steered a stabilization course through the 1990’s.• A fear of inflation led to a rapid increase in interest rates in 2000.• A fear of recession led to a rapid decrease in interest rates in 2001.• The Fed tried to dampen the economic impact of the Sept 11, 2001 terrorist attacks with quick and deep rate cuts.• Rate cutes left the Federal Funds rate at 1% though 2003

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Fed History 2004-2009

• Began raising interest rates in 2004• Raised interest rates 17 times until the Fed Funds rate was at 5.25%•Maintained that rate for several months.• In 2008, it began cutting interest rates in response to the economic slowdown.• Brought the federal funds rate to zero (to 0.25) percent in late 2008.

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Key Interest Rates

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The Inflation/Deflation debate

• The Fed is often criticized by economists but primarily by politicians for being more concerned about inflation than preventing recession or getting the most out of the US economy.• There was little the Fed could have done to stimulate the economy after the final cut to 1%. There was an active concern on 2003 that deflation was possible

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Aggressive Fed Action on the Federal Funds Rate (1999-2009)

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Inflation Targeting

• The European Central Bank currently targets inflation rather than a monetary aggregate or interest rate.

•Inflation targeting: involves publishing a desired range of a specified inflationary measure and then using the tools of monetary policy to bring that measure of inflation into that desired range. • The Fed’s target is the core PCE deflator. • Target range 1-2%

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European Debt Crisis

• Right now a lot of countries in Europe share a common currency: the Euro• Advantage: Makes international trade much easier as it

makes the Eurozone more like one large economy• Disadvantage: Countries are now limited in using the

central bank to control their own circumstances• More specifically it takes away an important tool: when

government debt becomes bad enough one solution is to print money to pay • In practice the government would issue bonds• the central bank would print money to buy the bonds (and then

tear them up)

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•Now there is a big issue of what happens if an EU member defaults on their debt•One solution for Greece would be to bail on the Euro and use their own currency to pay off their debt another is to default•If either of these happens, confidence in Portugal falls, then maybe Spain, then maybe Italy•Since the whole area is tied together, this is a bad situation for everyone•For example, a lot of Greek debt is held by German banks•For this reason these countries are all tied together•Of course there is a moral hazard problem: if they bail Greece out today how will Portugal behave tomorrow?•Current situation is quite unstable-still not clear exactly how it will be resolved