Monetary Policy

1
Monetary Policy
2

• A caveman points to two of his hairy relatives
  carrying clubs over their shoulders and says
• OKyou hunt, you gather, and Ill fine tune the
  economy.

3
Objectives

• Define monetary policy.

4
Objectives

• Define monetary policy.
• Summarize the structure and duties of the Fed.

5
Objectives

• Define monetary policy.
• Summarize the structure and duties of the Central
  Bank
• List the three tools of monetary policy and
  explain how they work.

6
Objectives

• Define the Federal fund rate and discuss how the
  Fed uses it as an intermediate target.

7
Objectives

• Define the CB fund rate and discuss how the CB
  uses it as an intermediate target.
• Explain how monetary policy works in the
  Keynesian model.

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Objectives

• Explain how monetary policy works in the
  Classical model.

9
Objectives

• Explain how monetary policy works in the
  Classical model.
• List five problems often encountered in
  conducting monetary policy.

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Introduction

• Economic policy aims at
• Economic Growth (GDP)
• Keeping inflation low
• Keeping unemployment low
• Two major sets of influence
• Fiscal policy
• Monetary policy

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Introduction

• Monetary policy influences the economy through
  changes in the money supply and availability of
  credit.

12
Introduction

• Monetary policy is one of the two main
  traditional macroeconomic tools to control the
  aggregate economy.

13
Introduction

• Monetary policy is one of the two main
  traditional macroeconomic tools to control the
  aggregate economy.
• Government (US President and Congress) control
  fiscal policy.

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Introduction

• Monetary policy is one of the two main
  traditional macroeconomic tools to control the
  aggregate economy.
• The Federal Reserve (The Fed) controls monetary
  policy.

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Introduction

• What is the effect of monetary policy on the
  macro policy model?

16
Introduction

• What is the effect of monetary policy on the
  macro policy model?
• Expansionary monetary policy shifts the AED curve
  to the right.

17
Introduction

• What is the effect of monetary policy on the
  macro policy model?
• Expansionary monetary policy shifts the AED curve
  to the right.
• Contractionary monetary policy shifts the AED
  curve to the left.

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Monetary Policy and the Macro Policy Model
C real income does not change the effect is
on the price level and inflation
A real income will rise with expansionary
monetary policy and decline with contractionary
monetary policy
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Introduction

• What is the effect of monetary policy on the
  macro policy model?
• In Range A, where the AS path is flat, real
  income will rise with expansionary monetary
  policy and decline with contractionary monetary
  policy.

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Introduction

• What is the effect of monetary policy on the
  macro policy model?
• In Range A, where the AS path is flat, real
  income will rise with expansionary monetary
  policy and decline with contractionary monetary
  policy.
• The price level is unaffected.

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Introduction

• What is the effect of monetary policy on the
  macro policy model?
• In Range C, where the AS path is vertical, real
  income does not change the effect is on the
  price level and inflation.

22
Introduction

• What is the effect of monetary policy on the
  macro policy model?
• In Range B, the effects are divided between real
  income and the price level.

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Introduction

• Thus, the AS path is central to the effect one
  believes monetary policy will have on the economy.

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Duties and Structure of the Fed

• A Central Bank Is a Bankers Bank

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Duties and Structure of the CB

• A Central Bank Is a Bankers Bank
• It conducts monetary policy and acts as financial
  adviser to the government.

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Duties and Structure of the CB

• A Central Bank Is a Bankers Bank
• If banks need to borrow money, they go to the
  central bank.

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Duties and Structure of the CB

• A Central Bank Is a Bankers Bank
• If there is a run on a bank, the central bank
  lends money to the imperiled bank until the
  danger has passed.

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Duties and Structure of the CB

• A Central Bank Is a Bankers Bank
• Its IOUs are cash, so simply issuing an IOU it
  can create money.

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Duties and Structure of the CB

• Historical Influences in the Federal Reserve
  Banks Structure

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Duties and Structure of the CB

• Historical Influences in the Federal Reserve
  Banks Structure
• In Great Britain, the Bank of England is part of
  the government.

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In the EU European Central Bank

• ECB
• Supranational institution
• Independent from governments
• National CBs independence
• Institutional (independent from the gov.)
• Operational (to keep inflation low)
• Financial (automatic financing)
• Personal (monpol decision makers )

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European Central Bank

• Legal basis for the single monetary policy is the
  Treaty establishing the European Community and
  the Statute of the European System of Central
  Banks and of the European Central Bank.
• The Statute established both
• the ECB and
• the European System of Central Banks (ESCB) as
  from 1 June 1998.
• The ECB was established as the core of the
  Eurosystem and the ESCB. The ECB and the national
  central banks together perform the tasks they
  have been entrusted with. The ECB has legal
  personality under public international law.

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Euro institutions

• European System of Central Banks
• The ESCB comprises the ECB and the national
  central banks (NCBs) of all EU Member States
  (Article 107.1 of the Treaty) whether they have
  adopted the euro or not.
• Eurosystem
• The Eurosystem comprises the ECB and the NCBs of
  those countries that have adopted the euro. The
  Eurosystem and the ESCB will co-exist as long as
  there are EU Member States outside the euro area.
  
• Euro area
• The euro area consists of the EU countries that
  have adopted the euro.

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Duties and Structure of the Fed

• Historical Influences in the Federal Reserve
  Banks Structure
• In the U.S., the Fed is not part of the
  government.

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Duties and Structure of the Fed

• Structure of the Fed

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Duties and Structure of the Fed

• Structure of the Fed
• The Fed is a semiautonomous organization composed
  of 12 regional banks.

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Duties and Structure of the Fed

• Structure of the Fed
• It is run by a Board of Governors appointed by
  the President with the advice and consent of the
  Senate.

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Duties and Structure of the Fed

• Structure of the Fed
• The Fed, although an agency of the federal
  government, has much more independence than most
  agencies.

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Duties and Structure of the Fed

• Structure of the Fed
• The considerable profits the Fed earns are turned
  over to the U.S. Treasury, not to the owners,
  the member banks.

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Duties and Structure of the Fed

• Structure of the Fed
• Once appointed for a term of 14 years, governors
  cannot be removed from office, which means they
  can pretty well do what they think is right.

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Duties and Structure of the Fed

• Structure of the Fed
• The seven Fed governors are paid less than they
  could receive in the private sector.

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Duties and Structure of the Fed

• Structure of the Fed
• Generally, the governors do not serve out their
  full terms but are recruited by private
  businesses for substantially higher salaries.

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Duties and Structure of the Fed

• Structure of the Fed
• The President appoints one of the seven members
  to chairman of the Board of Governors for a
  four-year term, generally conceded to be the
  second most powerful official in government.

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Duties and Structure of the Fed

• Structure of the Fed
• Geographically, the Feds districts reflects its
  political history, with nine of the twelve banks
  situated in the East and Midwest.

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Duties and Structure of the Fed

• Structure of the Fed

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Duties and Structure of the Fed

• Duties of the Fed
• Conducting monetary policy (influencing the
  supply of money and credit in the economy).

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Duties and Structure of the Fed

• Duties of the Fed
• Conducting monetary policy (influencing the
  supply of money and credit in the economy).
• This the most important job the Fed has to do.

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Duties and Structure of the Fed

• Duties of the Fed
• Supervising and regulating financial institutions.

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Duties and Structure of the Fed

• Duties of the Fed
• Serving as a lender of last resort to financial
  institutions.

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Duties and Structure of the Fed

• Duties of the Fed
• Providing banking services to the U.S. government.

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Duties and Structure of the Fed

• Duties of the Fed
• Issuing coin and currency.

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Duties and Structure of the Fed

• Duties of the Fed
• Providing financial services such as check
  clearing to commercial banks, savings and loan
  associations, savings banks, and credit unions.

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The Federal Reserve System
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The Federal Reserve System
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The Importance of Monetary Policy

• Monetary policy is the Feds most important job,
  and the most-used policy in macroeconomics.

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The Importance of Monetary Policy

• Monetary policy is the Feds most important job,
  and the most-used policy in macroeconomics.
• The Fed conducts monetary policy and controls it.

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The Importance of Monetary Policy

• Federal Open Market Committee (FOMC)

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The Importance of Monetary Policy

• Federal Open Market Committee (FOMC)
• Actual decisions about monetary policy are made
  by the Federal Open Market Committee.

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The Importance of Monetary Policy

• Federal Open Market Committee (FOMC)
• It is the Feds chief policymaking body.

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The Importance of Monetary Policy

• Federal Open Market Committee (FOMC)
• The membership is made up of the seven members of
  the Board of Governors, together with the
  president of the New York Fed and a rotating
  group of four of the presidents of the other
  regional banks.

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The Importance of Monetary Policy

• Federal Open Market Committee (FOMC)
• The actions of this group are closely
  watchedindeed some observers have made a career
  out of guessing with the Fed is likely to do in
  the future.

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The Importance of Monetary Policy

• The Conduct of Monetary Policy

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The Importance of Monetary Policy

• The Conduct of Monetary Policy
• Bank reserves are IOUs of the Fedeither vault
  cash or deposits are the Fed.

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The Importance of Monetary Policy

• The Conduct of Monetary Policy
• Bank reserves are IOUs of the Fedeither vault
  cash or deposits are the Fed.
• These are called the monetary base.

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The Importance of Monetary Policy

• The Conduct of Monetary Policy
• By controlling the monetary base, the Fed can
  influence the amount of money in the economy and
  the activities of commercial banks.

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The Importance of Monetary Policy

• The Conduct of Monetary Policy
• Other things being equal, as reserves decline,
  the interest rate will rise.

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The Importance of Monetary Policy

• The Conduct of Monetary Policy
• Other things being equal, as reserves decline,
  the interest rate will rise.
• As reserves increase, interest rates will fall.

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The Importance of Monetary Policy

• The Conduct of Monetary Policy
• Thus, monetary policy is concerned with the cost
  of money interest rates.

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Tools of Monetary Policy

• Changing the Reserve Requirement

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Tools of Monetary Policy

• Changing the Reserve Requirement
• By law, the Fed controls the minimum percentage
  of deposits banks keep in reserve by controlling
  the reserve requirement of all U.S. banks.

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Tools of Monetary Policy

• Changing the Reserve Requirement
• The reserve requirement is the percentage the
  Federal Reserve System sets as the minimum amount
  of reserves a bank must have.

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Tools of Monetary Policy

• Required Reserves and Excess Reserves

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Tools of Monetary Policy

• Required Reserves and Excess Reserves
• For most banks, the Feds reserve requirement
  determines what they hold as reserves.

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Tools of Monetary Policy

• Required Reserves and Excess Reserves
• Banks hold as little in reserves as possible
  since they earn no interest on them.

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Tools of Monetary Policy

• Required Reserves and Excess Reserves
• In the late 1990s, required reserves for demand
  deposits were about 10 percent, and zero for all
  other accounts, making the reserve requirement
  for all liabilities a little under 2 percent.

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Tools of Monetary Policy

• Required Reserves and Excess Reserves
• In some situations, as in the Spring of 1992,
  banks have excess reserves available, but do not
  lend them out.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• By changing the reserve requirement, the Fed can
  increase or decrease the money supply.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• If the Fed increases the reserve requirement, it
  contracts the money supply.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• Since they have less money to lend out, the
  decreased money multiplier (the multiple
  contraction of deposits occurring in response to
  a change in reserves) further contracts the money
  supply.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• If the Fed decreases the money supply, it expands
  the money supply.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• The money multiplier further expands the money
  supply.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• The approximate real-world money multiplier in
  the economy is the following

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply
• The approximate real-world money multiplier in
  the economy is the following
• 1/(r c)
• r the percentage of deposits banks hold in
  reserve
• c the ratio of money people hold in cash to the
  money they hold as deposits

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• Assume banks keep 8 in reserve and the ratio of
  individuals cash holdings to their deposits is
  20.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• The approximate real-world money multiplier is

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• The approximate real-world money multiplier is
• 1/(.08 .20) 1/.28 3.57

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• The approximate real-world money multiplier is
• 1/(.08 .20) 1/.28 3.57
• So 1,000,000 in vault cash will support a total
  3,570,000 money supply.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• In reality, the cash-to-deposit ratio (c) is
  about 0.4 and the average reserve requirement
  for demand deposits (r) is about 0.1.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• The realistic approximate money multiplier for
  demand deposits (M1) is

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• The realistic approximate money multiplier for
  demand deposits (M1) is
• 1/(0.1 0.4) 1/.5 2

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• The realistic approximate money multiplier for
  demand deposits (M1) is
• 1/(0.1 0.4) 1/.5 2
• A 1,000,000 increase of reserves will support a
  2,000,000 increase in demand deposits.

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Tools of Monetary Policy

• The Reserve Requirement and the Money Supply An
  Example
• For other deposits, the reserve requirement is
  much lower, so the money multiplier is larger for
  those.

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Tools of Monetary Policy

• What to do if there is a shortage of reserves.

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Tools of Monetary Policy

• What to do if there is a shortage of reserves.
• Go to the Federal funds market where the bank can
  borrow reserves from another bank that has excess
  reserves.

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Tools of Monetary Policy

• What to do if there is a shortage of reserves.
• If the Federal funds market dries up, the bank
  may stop making new loans and keep as reserves
  the proceeds of loans that are paid off.

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Tools of Monetary Policy

• What to do if there is a shortage of reserves.
• Sell Treasury bonds in order to get reserves.

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Tools of Monetary Policy

• What to do if there is a shortage of reserves.
• Sell Treasury bonds in order to get reserves.
• The bonds themselves cannot be used as reserves
  (they are sometimes called secondary reserves)
  but the cash that comes from their sales does.

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Tools of Monetary Policy

• Changing the Discount Rate

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Tools of Monetary Policy

• Changing the Discount Rate
• This tool concerns an alternative to those listed
  aboveborrow reserves directly from the Fed, the
  bankers bank.

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Tools of Monetary Policy

• Changing the Discount Rate
• The discount rate is the rate of interest the Fed
  charges for those loans it makes to banks.

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Tools of Monetary Policy

• Changing the Discount Rate
• An increase in the rate of interest makes it more
  expensive for banks to borrow from the Fed.

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Tools of Monetary Policy

• Changing the Discount Rate
• A decrease in the rate of interest makes it less
  expensive for banks to borrow from the Fed.

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Tools of Monetary Policy

• Changing the Discount Rate
• Therefore, by changing the discount rate, the Fed
  can expand or contract the money supply.

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Tools of Monetary Policy

• Changing the Discount Rate
• In practice, the discount rate is generally lower
  than other rates banks would have to pay to
  borrow reserves.

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Tools of Monetary Policy

• Changing the Discount Rate
• So why not just go to the Fed and pay the
  discount rate?

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Tools of Monetary Policy

• Changing the Discount Rate
• So why not just go to the Fed and pay the
  discount rate?
• The Fed discourages banks from using this option.

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Tools of Monetary Policy

• Changing the Discount Rate
• So why not just go to the Fed and pay the
  discount rate?
• Therefore, most banks do this as a last resort.

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Tools of Monetary Policy

• Changing the Discount Rate
• So why not just go to the Fed and pay the
  discount rate?
• Fed auditors may show up if this option is
  overused.

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Tools of Monetary Policy

• Changing the Discount Rate
• The Fed uses announced changes in the discount
  rate as a signal that the Fed wants the money
  supply to either expand or contract.

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Tools of Monetary Policy

• Open Market Operations

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Tools of Monetary Policy

• Open Market Operations
• Changes in the discount rate and reserve
  requirements are not used in day-to-day
  operations of the Fed.

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Tools of Monetary Policy

• Open Market Operations
• These tools are used for major changes.

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Tools of Monetary Policy

• Open Market Operations
• Open market operations is the Feds buying and
  selling of government securities.

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Tools of Monetary Policy

• Open Market Operations
• To expand money supply, the Fed buys bonds.

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Tools of Monetary Policy

• Open Market Operations
• To expand money supply, the Fed buys bonds.
• To contract money supply, the Fed sells bonds.

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Tools of Monetary Policy

• Open Market Operations
• Open market operations are the Feds most-used
  tool in controlling money supply.

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Tools of Monetary Policy

• Open Market Operations
• Periodically, the FOMC decides what its open
  market operations will be and whether it want to
  expand or contract the money supply.

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Tools of Monetary Policy

• An Open Market Purchase

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Tools of Monetary Policy

• An Open Market Purchase
• When the Fed buys bonds, it deposits the money in
  federal government accounts at a bank.

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Tools of Monetary Policy

• An Open Market Purchase
• When the Fed pays the government for its bonds,
  bank cash reserves rise, encouraging the banks to
  lend out the excess.

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Tools of Monetary Policy

• An Open Market Purchase
• The money supply rises.

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Tools of Monetary Policy

• An Open Market Purchase
• An open market purchase is an example of
  expansionary monetary policy.

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Tools of Monetary Policy

• An Open Market Purchase
• Expansionary monetary policy is usually defined
  to be a monetary policy that tends to reduce
  interest rates and raise income.

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Tools of Monetary Policy

• An Open Market Sale

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Tools of Monetary Policy

• An Open Market Sale
• Here, the Fed sells bonds.

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Tools of Monetary Policy

• An Open Market Sale
• In return for the bond, the Fed receives a check
  drawn against a bank.

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Tools of Monetary Policy

• An Open Market Sale
• The banks reserve assets are reduced and money
  supply falls.

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Tools of Monetary Policy

• An Open Market Sale
• An open market sale is an example of
  contractionary monetary policy.

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Tools of Monetary Policy

• An Open Market Sale
• Contractionary monetary policy is usually defined
  to be a monetary policy that tends to raise
  interest rates and lower income.

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market purchase

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market purchase
• When the Fed buys bonds in an open market
  purchase, it raises the demand for bonds.

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market purchase
• Bond prices rise and interest rates fall.

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market purchase
• This happens in an expansionary monetary policy.

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market sale

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market sale
• When the Fed sells bonds in an open market sale,
  the supply of bonds moves to the right, thereby
  lowering the demand for bonds.

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market sale
• Bond prices fall and interest rates rise.

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Tools of Monetary Policy

• What happens to bond prices and interest rates
  during this process?
• An open market sale
• This happens in a contractionary monetary policy.

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Open Market Operations
S
Price of a bond
A
D
0
Quantity of bonds
(a)
An open market purchase
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Open Market Operations
S
B
Price of a bond
A
D
D
0
Quantity of bonds
(a)
An open market purchase
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Open Market Operations
S
Price of a bond
A
D
0
Quantity of bonds
(b)
An open market sale
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Open Market Operations
S
S
Price of a bond
A
B
D
0
Quantity of bonds
(b)
An open market sale
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Tools of Monetary Policy

• How the Fed Funds Market Works

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Tools of Monetary Policy

• How the Fed Funds Market Works
• Banks with surplus reserves can lend money to
  banks with a reserve shortage.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• It is lent overnight as Fed fundsloans of their
  reserves banks make to each other.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• Banks with surplus reserves will call a Federal
  funds dealer to learn the Federal funds ratethe
  interest rate banks charge each other for Fed
  funds.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• This is all done electronically.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• The Federal funds marketthe market in which
  banks lend and borrow reservesis highly
  efficient.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• When banks have shortages of reserves (tight
  money) the interest rates are high.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• When banks have a surplus of reserves (loose
  money) interest rates are low.

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Tools of Monetary Policy

• How the Fed Funds Market Works
• Generally, large city banks are borrowers of Fed
  funds, while small country banks are lenders of
  Fed funds.

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Tools of Monetary Policy

• Offensive and Defensive Actions in the Fed Funds
  Market

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Tools of Monetary Policy

• Offensive and Defensive Actions in the Fed Funds
  Market
• The Federal funds rate is an important
  intermediate target.

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Tools of Monetary Policy

• Offensive and Defensive Actions in the Fed Funds
  Market
• When it is impossible for businesses or
  individuals to get to the bank to make loan
  payments the Fed will step in and buy or sell
  bonds to offset such changes.

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Tools of Monetary Policy

• Offensive and Defensive Actions in the Fed Funds
  Market
• When it is impossible for businesses or
  individuals to get to the bank to make loan
  payments the Fed will step in and buy or sell
  bonds to offset such changes.
• These actions are called defensive actions.

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Tools of Monetary Policy

• Offensive and Defensive Actions in the Fed Funds
  Market
• Defensive actions are meant to maintain the
  current monetary policy.

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Tools of Monetary Policy

• Offensive and Defensive Actions in the Fed Funds
  Market
• Offensive actions are those meant to make
  monetary policy have expansionary or
  contractionary effects on the economy.

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Tools of Monetary Policy

• The Fed Funds Rate As an Intermediate Target

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Tools of Monetary Policy

• The Fed Funds Rate As an Intermediate Target
• Monetary policy affects interest rates such as
  the Federal funds rate.

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Tools of Monetary Policy

• The Fed Funds Rate As an Intermediate Target
• The Fed looks at the Federal funds rate to
  determine whether monetary policy is tight or
  loose.

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Tools of Monetary Policy

• The Fed Funds Rate As an Intermediate Target
• If the Federal funds rate goes above the Feds
  target range, it buys bonds, which increases
  reserves and lowers the Federal funds rate.

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Tools of Monetary Policy

• The Fed Funds Rate As an Intermediate Target
• If the Federal funds rate goes below the Feds
  target range, it sells bonds, which decreases
  reserves and raises the Federal funds rate.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy
• A rise in the domestic interest rate tends to
  increase the demand for a nations currency, and
  push up that nations exchange rate.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy
• A rise in the domestic interest rate tends to
  increase the demand for a nations currency, and
  push up that nations exchange rate.
• That currency will cost more in terms of the
  currencies of other nations.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy
• A fall in a nations interest rate works in the
  opposite direction.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy An Example

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy An Example
• A nation has decided to run an expansionary
  monetary policy, pushing its interest rate down.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy An Example
• The fall in the interest rate leads investors to
  invest elsewhere, lowering the value of that
  nations currency and causing an outflow of
  financial resources.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy An Example
• The outflow tends to push interest rates back up.

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Tools of Monetary Policy

• International Considerations in the Conduct of
  Monetary Policy An Example
• If the nation has international agreements to
  keep its exchange rate at a certain level, this
  outflow must be offset in some manner.

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Tools of Monetary Policy

• Contrasting Views of the Channels of Monetary
  Policy

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Tools of Monetary Policy

• Contrasting Views of the Channels of Monetary
  Policy
• Both Keynesians and Classicals agree that
  monetary policy is important.

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Tools of Monetary Policy

• Contrasting Views of the Channels of Monetary
  Policy
• They differ in how they see monetary policy
  affecting the economy.

180
Monetary Policy in the Keynesian Model

• In Keynesian terms, monetary policy is seen
  working primarily through its effect on interest
  rates.

181
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)

182
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• The interest rates go up.

183
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• The interest rates go up.
• As interest rates go up, the quantity of
  investment goes down.

184
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• The interest rates go up.
• As interest rates go up, the quantity of
  investment goes down.
• As investment goes down, aggregate demand goes
  down.

185
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• Through repercussion effects, aggregate
  equilibrium demand and income go down by a
  multiple of decrease in investment.

186
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• The AED curve shifts to the left by a multiple of
  the shift in investment.

187
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• The AED curve shifts to the left by a multiple of
  the shift in investment.
• Income and output decrease.

188
Monetary Policy in the Keynesian Model

• The Fed Decreases Money Supply (Uses
  Contractionary Monetary Policy)
• The AED curve shifts to the left by a multiple of
  the shift in investment.
• Income and output decrease.
• M i I Y

189
Monetary Policy in the Keynesian Model

• Expansionary monetary policy works in the
  opposite direction.

190
Monetary Policy in the Keynesian Model

• Expansionary monetary policy works in the
  opposite direction.
• M i I Y

191
Contractionary Monetary Policy
192
Contractionary Monetary Policy
193
Expansionary Monetary Policy
194
Monetary Policy in the Keynesian Model

• Keynesian Monetary Policy in the Circular Flow

195
Monetary Policy in the Keynesian Model

• Keynesian Monetary Policy in the Circular Flow
• If monetary and fiscal policy are needed, it is
  because the financial sector is in some ways
  clogged and is not correctly translating savings
  into investment.

196
Monetary Policy in the Keynesian Model

• Keynesian Monetary Policy in the Circular Flow
• Monetary policy works to unclog the financial
  sector.

197
Monetary Policy in the Keynesian Model

• Keynesian Monetary Policy in the Circular Flow
• Fiscal policy provides an alternative route for
  savings around the financial sector.

198
Monetary Policy in the Keynesian Model

• Keynesian Monetary Policy in the Circular Flow
• A government budget deficit absorbs excess
  savings and translates it back into the spending
  stream.

199
Monetary Policy in the Keynesian Model

• Keynesian Monetary Policy in the Circular Flow
• A government budget surplus supplements the
  shortage of savings and reduces the flow back
  into the spending stream.

200
Keynesian Monetary Policy in the Circular Flow
201
Monetary Policy in the Keynesian Model

• The Keynesian Emphasis on the Interest Rate

202
Monetary Policy in the Keynesian Model

• The Keynesian Emphasis on the Interest Rate
• Keynesians interpret a rising interest rate as a
  tightening monetary policy.

203
Monetary Policy in the Keynesian Model

• The Keynesian Emphasis on the Interest Rate
• Keynesians interpret a falling interest rate as a
  loosening of monetary policy.

204
Monetary Policy in the Keynesian Model

• The Keynesian Emphasis on the Interest Rate
• The early Keynesians advocated keeping the
  interest rate low.

205
Monetary Policy in the Keynesian Model

• The Keynesian Emphasis on the Interest Rate
• Keynesians today advocate keeping the interest
  rate low enough to foster growth, but high enough
  to keep inflation in check.

206
Monetary Policy in the Keynesian Model

• The Keynesian Emphasis on the Interest Rate
• Keynesians today advocate keeping the interest
  rate low enough to foster growth, but high enough
  to keep inflation in check.
• A difficult task indeed.

207
Monetary Policy in the Classical Model

• The Quantity Theory of Money
• The quantity theory of money asserts that the
  price level varies in response to changes in the
  quantity of money.

208
Monetary Policy in the Classical Model

• The Quantity Theory of Money
• The Classical quantity theory of money centers
  around the equation of exchange.

209
Monetary Policy in the Classical Model

• The Quantity Theory of Money
• According to the equation of exchange, the
  quantity of money times velocity of money equals
  price level times the quantity of real goods
  sold.

210
Monetary Policy in the Classical Model

• The Equation of Exchange

211
Monetary Policy in the Classical Model

• The Equation of Exchange
• MV PQ

• M money supply
• V velocity of money (is constant and determined
  by institutional forces)
• P price level
• Q real output (is relatively constant and
  determined by real, not monetary forces)

• PQ the economys nominal output (nominal
  GDPthe quantity of goods valued at whatever
  price level exists at the time

212
Monetary Policy in the Classical Model

• The Classicals make certain assumptions about the
  variables in the equation of exchange.

213
Monetary Policy in the Classical Model

• Velocity is constant.

214
Monetary Policy in the Classical Model

• Velocity is constant.
• Its rate is determined by the economys
  institutional structure.

215
Monetary Policy in the Classical Model

• Velocity is constant.
• If velocity is constant, the quantity theory can
  be used to predict how much nominal GDP will grow
  if we know how much the money supply grows.

216
Monetary Policy in the Classical Model

• Q is independent of the money supply.

217
Monetary Policy in the Classical Model

• Q is independent of the money supply.
• That is, Classicals believe Q is autonomous,
  meaning real output is determined by forces
  outside the quantity theory.

218
Monetary Policy in the Classical Model

• Q is independent of the money supply.
• If Q grows, it is because of incentives in the
  real economy.

219
Monetary Policy in the Classical Model

• Q is independent of the money supply.

220
Monetary Policy in the Classical Model

• The Veil of Money Assumption

221
Monetary Policy in the Classical Model

• The Veil of Money Assumption
• Classical policy analysis is on the real
  economythe supply side of the economy, not the
  demand side.

222
Monetary Policy in the Classical Model

• The Veil of Money Assumption
• This assumption is called the veil of money
  assumption, which holds that real output is not
  influenced by changes in the money supply.

223
Monetary Policy in the Classical Model

• The Veil of Money Assumption
• The veil of money assumption allows Classical
  economists to separate two puzzleshow the real
  economy works, and how the financial sector works.

224
Monetary Policy in the Classical Model

• The Veil of Money Assumption
• With both V and Q unaffected by changes in M, the
  only thing that can change is P.

225
Monetary Policy in the Classical Model

• The Veil of Money Assumption
• With both V and Q unaffected by changes in M, the
  only thing that can change is P.
• Classicals say that M and P would change by
  equivalent percentages.

226
Monetary Policy in the Classical Model

• The Direction of Causation
• Changes in money supply cause changes in the
  price level.

227
Monetary Policy in the Classical Model

• The Direction of Causation
• Changes in money supply cause changes in the
  price level.
• The arrow of causation goes from left to right

228
Monetary Policy in the Classical Model

• The Direction of Causation
• Changes in money supply cause changes in the
  price level.
• The arrow of causation goes from left to right
• MV PQ

229
Monetary Policy in the Classical Model

• Summary of the Classicals View

230
Monetary Policy in the Classical Model

• Summary of the Classicals View
• Expansionary monetary policy increases M, which
  in the long run simply increases the price level,
  P.

231
Monetary Policy in the Classical Model

• Summary of the Classicals View
• Contractionary monetary policy will do the
  opposite.

232
Monetary Policy in the Classical Model

• Summary of the Classicals View
• In the long run, monetary policy has no effect on
  real economic variables such as income or
  employment.

233
Monetary Policy in the Classical Model

• The Classical Emphasis on Money Supply

234
Monetary Policy in the Classical Model

• The Classical Emphasis on Money Supply
• A large increase in money supply indicates
  expansionary monetary policy.

235
Monetary Policy in the Classical Model

• The Classical Emphasis on Money Supply
• A large decrease in money supply indicates
  contractionary monetary policy.

236
Monetary Policy in the Classical Model

• Steady-As-You-Go Policy

237
Monetary Policy in the Classical Model

• Steady-As-You-Go Policy
• Classicals favor a monetary policy that increases
  the money supply just enough each year to allow
  for the normal real growth of the economy.

238
Monetary Policy in the Classical Model

• Steady-As-You-Go Policy
• They oppose the Keynesian policy of an activist
  monetary policy.

239
Monetary Policy in the Classical Model

• Steady-As-You-Go Policy
• They feel that in the short run no one knows
  exactly what the outcome will be for an activist
  monetary policy.

240
Monetary Policy in the Classical Model

• Steady-As-You-Go Policy
• They feel the markets are doing a pretty good job
  of coordinating savings and investment.

241
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates

242
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates
• Classical point out the difference between real
  and nominal interest rates.

243
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates
• Nominal interest rates are those you actually see
  and pay.

244
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates
• Real interest rates are those adjusted for
  expected inflation.

245
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates
• The real interest rate cannot be observed since
  it depends on expected inflation, which cannot be
  directly observed.

246
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates
• Nominal interest rate Real interest rate
  Expected inflation rate

247
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates and Monetary
  Policy

248
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates and Monetary
  Policy
• If expansionary monetary policy leads to
  expectations of increased inflation, nominal
  interest rates will go up.

249
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates and Monetary
  Policy
• The distinction between nominal and real interest
  rates strengthens the Classical case that the
  best monetary policy is an unchanging policy.

250
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates and Monetary
  Policy
• In the short run, the monetary policys effects
  are too uncertain.

251
Monetary Policy in the Classical Model

• Real and Nominal Interest Rates and Monetary
  Policy
• In the short run, the monetary policys effects
  are too uncertain.
• In the long run, they simply lead to changes in
  the price level.

252
Monetary Policy in the Classical Model

• Monetary Policy in the Fed Model of the 1990s

253
Monetary Policy in the Classical Model

• Monetary Policy in the Fed Model of the 1990s
• The Fed is eclectic sometimes it uses the
  Keynesian model and sometimes the Classical model.

254
Monetary Policy in the Classical Model

• Monetary Policy in the Fed Model of the 1990s
• Thus, they use both interest rates and money
  supply measures in their planning.

255
Problems in the Conduct of Monetary Policy

• Knowing What Policy to Use

256
Problems in the Conduct of Monetary Policy

• Knowing What Policy to Use
• The potential level of income must be known.

257
Problems in the Conduct of Monetary Policy

• Knowing What Policy to Use
• The potential level of income must be known.
• Otherwise you dont know whether to use
  expansionary or contractionary monetary policy.

258
Problems in the Conduct of Monetary Policy

• Understanding the Policy Youre Using

259
Problems in the Conduct of Monetary Policy

• Understanding the Policy Youre Using
• In order to use monetary policy effectively, you
  must know whether the monetary policy you are
  using is expansionary or contractionary.

260
Problems in the Conduct of Monetary Policy

• Understanding the Policy Youre Using
• The money multiplier is influenced by both the
  amount of cash people hold as well as the lending
  process at the bank.

261
Problems in the Conduct of Monetary Policy

• Understanding the Policy Youre Using
• The money multiplier is influenced by both the
  amount of cash people hold as well as the lending
  process at the bank.
• Neither of these are stable numbers.

262
Problems in the Conduct of Monetary Policy

• Understanding the Policy Youre Using
• Then there are interest rates.

263
Problems in the Conduct of Monetary Policy

• Understanding the Policy Youre Using
• Then there are interest rates.
• If interest rates rise, is it because of expected
  inflation or is it that the real interest rate is
  going up?

264
Problems in the Conduct of Monetary Policy

• Lags in Monetary Policy

265
Problems in the Conduct of Monetary Policy

• Lags in Monetary Policy
• Monetary policy takes time to work.

266
Problems in the Conduct of Monetary Policy

• Lags in Monetary Policy
• Just because the Fed drops interest rates, that
  does not necessarily mean that people or
  businesses will go out and borrow money.

267
Problems in the Conduct of Monetary Policy

• Lags in Monetary Policy
• In the face of a contractionary monetary policy,
  banks have been creative in circumventing cuts in
  the money supply.

268
Problems in the Conduct of Monetary Policy

• Political Pressure

269
Problems in the Conduct of Monetary Policy

• Political Pressure
• The Fed is not totally insulated from political
  pressure.

270
Problems in the Conduct of Monetary Policy

• Political Pressure
• Presidents place great pressure on the Fed to
  loosen the purse strings, especially during an
  election year.

271
Problems in the Conduct of Monetary Policy

• Conflicting International Goals

272
Problems in the Conduct of Monetary Policy

• Conflicting International Goals
• Monetary policy is conducted in an international
  arena.

273
Problems in the Conduct of Monetary Policy

• Conflicting International Goals
• It must be coordinated with other nations.