Chapter 16 - Monetary Policy
The Market for Money
The demand for money:
Transactions demand - the total money balances that households and businesses demand to hold to carry out the normal transactions of daily life. It is directly related to nominal GDP.
Asset demand - the total money balances that households and businesses demand to hold as as financial assets (to store value or purchasing power for future use). It is inversely related to the interest rate. Why? Because the interest rate is the opportunity cost of holding money as a financial asset.
Total demand - the horizontal sum of the transactions and asset demand at any interest rate.
The supply of money: The money supply is a function of the monetary policies of the central bank (the Fed). Because the money supply is not causally related to the interest rate, the money supply schedule is drawn as a vertical line.
** Pay particular attention to Key Graph, Figure 14.1
Monetary Policy refers to the governments use of its control of the money supply, and indirectly interest rates, to help keep the economy as close as possible to the full employment, non-inflationary level of output and income. If implemented properly, the money supply should be increased during periods of unemployment as a means of increasing total spending (aggregate demand). This is known as an easy money policy or expansionary monetary policy. Conversely, during inflationary periods, the money supply is decreased in an effort to decrease total spending (aggregate demand). This is referred to as a tight money policy or restrictive monetary policy. The Federal Reserve Board (Fed) carries out monetary policy through the use of three monetary tools or controls. It is through these tools that the Fed alters excess reserves in the banking system in order to either increase or decrease the banking system's ability to make loans and create new checkable deposits (electronic money).
Tools of monetary Policy:
1. Reserve Ratio - the most powerful tool at the Fed's disposal, but one that it seldom uses. The reason is that it has such a drastic impact bank reserves and therefore on bank profits. A small change in the reserve ratio changes excess reserves for every depository institution in the country and changes the multiplier. The last time the Fed changed the reserve requirement was 1992 when it lowered the ratio from 12% to 10%.
2. Discount Rate - the least effective tool. The discount rate is the interest rate that the Fed charges banks to borrow reserves. Since only a small percentage of reserves are borrowed from the Fed, this interest rate does not have a significant effect on bank reserves. It has become a passive tool of monetary policy. The Fed now sets the discount rate at 1% above the Federal funds rate. This is the only interest rate that the Fed directly controls.
3. Open-market operations - the most important tool in the Fed's arsenal. It refers to the Fed's buying and selling of U.S. government securities (bonds). When the Fed buys bonds, it increases excess reserves in the banking system. When the Fed sells bonds, it decreases excess reserves in the banking system.
Easy Money and Tight Money - I highly recommend pages 268-269 in the text.
How is a change in the money supply ultimately transmitted through the economy to affect output/income and the price level?
The accepted view is often referred to as the Keynesian Cause-effect chain. (See, Key graph, Figure 14.5). Assume the problem is recession. The Fed buys bonds which increases excess reserves in the banking system. This causes the interest rate to fall which causes an increase in investment spending. Through the spending multiplier, this causes Aggregate Demand to increase (shift to the right), causing an increase in Real GDP. But, what if the problem is demand pull inflation? The Fed undertakes a tight money policy by selling bonds. This decreases the money supply, causing interest rates to rise. Higher interest rates cause investment spending to fall. Through the multiplier, Aggregate Demand decreases (shifts to the left), causing the price level to fall. Table 14.3 provides a great study aid!!
Effectiveness of monetary policy:
Strengths: The greatest strength of monetary policy is its speed and flexibility.
Shortcomings:
Lags - As with fiscal policy, monetary policy does not effect the economy as quickly as we portray it in the classroom. With monetary policy, there is the same recognition lag. And once the Fed decides on the appropriate policy, there is a time lag before the action effects the economy. The big difference is there there is very little administrative lag. The FOMC meets every six weeks to review data on the economy and decide policy. there are o hearings and no politics.
Cyclical Asymmetry - This refers to the fact that monetary policy is not equally effective on both sides of the business cycle. While highly effective in controlling inflation, it is much less reliable in pushing the economy out of recession.
Targeting Interest Rates: There are three different interest rates that we are concerned with. We have already discussed the Discount rate. The Federal funds rate is the interest rate that banks charge each other to borrow reserves overnight. It is often referred to as simply the funds rate or the "overnight rate." This is the interest rate that the Fed targets. Because this rate is determined by the demand and supply of reserves, the Fed adjusts the rate by using open-market operations to either increase or decrease thje supply of reserves in the banking system. The prime rate is the interest rate that banks charge their large commercial customers. It is important because so many interest rates are linked directly to the prime rate.
Note the Taylor Rule on page 270:
1. If real GDP rises by 1% above potential GDP the Fed should raise the funds rate by 1/2 percentage point.
2. If inflation rises by 1% above its target 2%, the Fed should raise the Funds rate by 1/2 percentage point.
3. When GDP is equal to potential GDP and inflation is equal to its target rate of 2%, the Funds rate should remain at 4%, which would imply a real interest rate of 2%.