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

1313

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

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

● Money and Income: The Important Difference

● America’s Central Bank: The Federal Reserve System

● Implementing Monetary Policy: Open Market Operations

● Other Methods of Monetary Control

● Money and Income: The Important Difference

● America’s Central Bank: The Federal Reserve System

● Implementing Monetary Policy: Open Market Operations

● Other Methods of Monetary Control

ContentsContents

Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

● Supply-Demand Analysis of the Money Market

● How Monetary Policy Works

● Money and the Price Level in the Keynesian Model

● From Models to Policy Debates

● Supply-Demand Analysis of the Money Market

● How Monetary Policy Works

● Money and the Price Level in the Keynesian Model

● From Models to Policy Debates

Contents (continued)Contents (continued)


Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

● Stock variables are measured at a moment in time.

● Flow variables are measured over time.

● Stock variables are measured at a moment in time.

● Flow variables are measured over time.

Money and Income: The Important DifferenceMoney and Income: The Important Difference


Money and Income: The Important DifferenceMoney and Income: The Important Difference

● Money is a stock, income a flow.♦ Stock of money influences the rate at which

people earn income.

♦ Money affects GDP.

● Money is a stock, income a flow.♦ Stock of money influences the rate at which

people earn income.

♦ Money affects GDP.


America’s Central Bank: The Federal Reserve SystemAmerica’s Central Bank: The Federal Reserve System

● The Federal Reserve System, established in 1914, is the U.S. central bank.♦ Comprised of twelve district banks

♦ Governed by a seven-member Board of Governors

♦ Decisions on the money supply made by the Federal Open Market Committee

● The Federal Reserve System, established in 1914, is the U.S. central bank.♦ Comprised of twelve district banks

♦ Governed by a seven-member Board of Governors

♦ Decisions on the money supply made by the Federal Open Market Committee



● Central Bank Independence♦ Fed board members:

■Appointed to fourteen-year terms■Independent of political pressures

● Central Bank Independence♦ Fed board members:

■Appointed to fourteen-year terms■Independent of political pressures


● Central Bank Independence♦ In some other countries, the central banks are

less independent.

♦ Countries without independent central banks often have less stable economies.

● Central Bank Independence♦ In some other countries, the central banks are

less independent.

♦ Countries without independent central banks often have less stable economies.



Implementing Monetary PolicyImplementing Monetary Policy

● Market for Reserves♦ Supply of reserves controlled by the Fed

♦ Demand for reserves depends on banks’ need for reserves■Required reserves = m x D■Dollar value of transactions = P x Y

● Market for Reserves♦ Supply of reserves controlled by the Fed

♦ Demand for reserves depends on banks’ need for reserves■Required reserves = m x D■Dollar value of transactions = P x Y



● Market for Reserves♦ Federal funds rate = interest rate banks charge

each other for interbank loans■Banks with excess reserves can loan out funds to

other banks and charge the federal funds rate■Banks with a shortage of reserves can borrow funds

from other banks and pay the federal funds rate

● Market for Reserves♦ Federal funds rate = interest rate banks charge

each other for interbank loans■Banks with excess reserves can loan out funds to

other banks and charge the federal funds rate■Banks with a shortage of reserves can borrow funds

from other banks and pay the federal funds rate


FIGURE 1: The Market for Bank Reserves

FIGURE 1: The Market for Bank Reserves



● Market for Reserves♦ Downward sloping demand:

■↑ federal funds rate →↑ cost of reserves→↓quantity of reserves demanded

♦ Upward sloping supply:■↑ federal funds rate →↑ interest earned from

interbank loans →↑quantity of reserves supplied

♦ Equilibrium: Quantity of reserves demanded = Quantity of reserves supplied:

● Market for Reserves♦ Downward sloping demand:

■↑ federal funds rate →↑ cost of reserves→↓quantity of reserves demanded

♦ Upward sloping supply:■↑ federal funds rate →↑ interest earned from

interbank loans →↑quantity of reserves supplied

♦ Equilibrium: Quantity of reserves demanded = Quantity of reserves supplied:


● Mechanics of an Open-Market Operation ♦ The Fed affect the interest rate by buying

government securities on the open market.■It pays for these securities by creating new bank

reserves.■These additional reserves lower interest rate

♦ To increase the interest rate, the Fed sells securities.

● Mechanics of an Open-Market Operation ♦ The Fed affect the interest rate by buying

government securities on the open market.■It pays for these securities by creating new bank

reserves.■These additional reserves lower interest rate

♦ To increase the interest rate, the Fed sells securities.



FIGURE 2: Effects of an Open-Market Purchase

FIGURE 2: Effects of an Open-Market Purchase

TABLE 1: Effects of an Open-Market Purchase of Securities

TABLE 1: Effects of an Open-Market Purchase of Securities




● Mechanics of an Open-Market Operation

● When the Fed buys bonds: supply of reserves federal funds rate quantity of reserves ♦ deposit creation

● Opposite when Fed sell bonds

● Mechanics of an Open-Market Operation

● When the Fed buys bonds: supply of reserves federal funds rate quantity of reserves ♦ deposit creation




● Open-Market Operations, Bond Prices and Interest Rates

● When the Fed buys bonds: demand for bonds price of bonds

price of bonds = interest rate


● Open-Market Operations, Bond Prices and Interest Rates

● When the Fed buys bonds: demand for bonds price of bonds

price of bonds = interest rate


FIGURE 3: Open-Market Purchases and T-Bill Prices

FIGURE 3: Open-Market Purchases and T-Bill Prices


Quantity of Treasury Bills

P0

P1

S 0

S0

S1

S1

D

D

A

B

Pri

ce

of

a T

reas

ury

Bill


● Lending to Banks♦ The Fed lends to member banks, occasionally

as a “lender of last resort.”

♦ Discount rate = interest rate Fed charges member banks when it makes loans to them

● Lending to Banks♦ The Fed lends to member banks, occasionally

as a “lender of last resort.”

♦ Discount rate = interest rate Fed charges member banks when it makes loans to them

Other Methods of Monetary ControlOther Methods of Monetary Control


● Lending to Banks discount rate

Borrowing by member banks Reserves Money supply

♦ Opposite if Fed raises discount rate

● Lending to Banks discount rate

Borrowing by member banks Reserves Money supply

♦ Opposite if Fed raises discount rate

Other Methods of Monetary ControlOther Methods of Monetary Control

TABLE 2: Balance Sheet Changes, Borrowing from Fed

TABLE 2: Balance Sheet Changes, Borrowing from Fed



● Changing Reserve Requirements Required reserve ratio

Excess reserves Loans Money supply

♦ Opposite if Fed increases reserve requirement

♦ In practice, the Fed seldom changes the reserve requirements.

● Changing Reserve Requirements Required reserve ratio

Excess reserves Loans Money supply

♦ Opposite if Fed increases reserve requirement

♦ In practice, the Fed seldom changes the reserve requirements.

Other Methods of Monetary Control Other Methods of Monetary Control


● Of the four components of aggregate demand, investment and net exports are the most sensitive to monetary policy.

● Assume that net exports (X - IM) are fixed.

● Focus on monetary policy’s influence on investment (I)

● Of the four components of aggregate demand, investment and net exports are the most sensitive to monetary policy.

● Assume that net exports (X - IM) are fixed.

● Focus on monetary policy’s influence on investment (I)

How Monetary Policy WorksHow Monetary Policy Works


● Investment and Interest Rates interest rates investment spending investment multiplier effect

■Lowers GDP

interest rates opposite

● Investment and Interest Rates interest rates investment spending investment multiplier effect

■Lowers GDP

interest rates opposite


FIGURE 5: Effect of Interest Rates on Total Expenditure

FIGURE 5: Effect of Interest Rates on Total Expenditure


C + I + G + (X – IM )

45

Real GDP

Rea

l E

xpen

dit

ure

C + I + G + (X – IM ) (higher interest rate)

C + I + G + (X – IM ) (lower interest rate)



● Monetary Policy and Total Expenditure♦ Fed actions

money supply interest rates

♦ interest rate investment investment AD AD GDP

● Monetary Policy and Total Expenditure♦ Fed actions

money supply interest rates

♦ interest rate investment investment AD AD GDP

How Monetary Policy Affects GDP

How Monetary Policy Affects GDP


Federal Reserve Policy

1

M and r

2

I

3

C + I + G + (X - IM)

4

GDP

FIGURE 6: Expansionary Policy on Total Expenditure

FIGURE 6: Expansionary Policy on Total Expenditure


$200 billion

7,000 6,500 6,000

45

5,500

C + I0 + G + (X – IM)

Re

al

Ex

pe

nd

itu

re

Real GDP

E0

C + I1 + G + (X – IM) E1


● Expansionary monetary policy causes some inflation under normal circumstances.

● How much inflation it causes depends on the state of the economy.♦ Represented by the slope of the AS curve

● Expansionary monetary policy causes some inflation under normal circumstances.

● How much inflation it causes depends on the state of the economy.♦ Represented by the slope of the AS curve

Money and the Price Level in the Keynesian ModelMoney and the Price Level in the Keynesian Model

FIGURE 7: The Inflationary Effects of Expansionary Policy

FIGURE 7: The Inflationary Effects of Expansionary Policy


$500 billion

103

6,400

S

S

D0

D0

6,000

100

Real GDP

Pri

ce

Le

ve

l

E

D1

D1

B



● Fed policy ♦ M & r

♦ AD

♦ Y & P

● Both output and prices are normally affected by monetary policy.

● Fed policy ♦ M & r

♦ AD

♦ Y & P

● Both output and prices are normally affected by monetary policy.

Effect of Monetary Policy on Output and Prices

Effect of Monetary Policy on Output and Prices


Federal Reserve Policy

1

M and r

2

I

3

C + I + G + (X - IM)

4

Y and P



● Application: Why the AD Curve Slopes Downward price level

money demand interest rates investment

● Application: Why the AD Curve Slopes Downward price level

money demand interest rates investment



● Application: Why the AD Curve Slopes Downward investment negative multiplier effect on

GDP

♦ Thus price level GDP

● Application: Why the AD Curve Slopes Downward investment negative multiplier effect on

GDP

♦ Thus price level GDP


From Models to Policy DebatesFrom Models to Policy Debates

● We have done all the theory that is needed.

● The next three chapters of the text turn to policy debates.

● We have done all the theory that is needed.

● The next three chapters of the text turn to policy debates.

Documents

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