MONETARY POLICY

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MONETARY POLICY
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MonetaryIndependence
Potential GDP
INFLATION
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RATE

• Rationale
• gain then pain scenario
• Kelly M. showed Tom C.
• time inconsistency
• political business cycle
• government borrowing from central bank
• How is independence achieved?
• Long terms of governors (14 years!)
• chairs term does not coincide with POTUS
• district Fed presidents not appointed by POTUS

LR
SR
REAL GDP
Real GDP rises above
potential GDP in
the short run.
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Arthur Burns, Fed chair under Richard Nixon, was
criticized for letting money grow too quickly,
raising inflation, despite what he said here in
congressional testimony
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AVERAGE INFLATION
(PERCENT, 1955-1988)
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Spain
8
Italy
United Kingdom
7
New Zealand
Denmark
6
5
Canada
United States
Japan
Belgium
4
Netherlands
Switzerland
3
Germany
2
1.0
3.0
3.5
2.5
2.0
4.0
1.5
MORE INDEPENDENT
LESS INDEPENDENT
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Two old tools of monetary policy

• Discount rate interest rate Fed charges on loans
  to commercial banks
• Borrowing is part of lender of last resort role
  of the Fed, aim is to discourage bank runs
• Bank runs occur when many depositors want cash at
  the same time--scene from Its a Wonderful Life ?
• Discount rate is now a side show
• Fed holds discount rate below federal funds rate
• Changes in reserve ratio used rarely
• last changed in 1991 to raise bank profits
• Now the federal funds rate is the main focus

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How the Fed changes the federal funds rate

• Example, what does it do to cut the rate from 5.0
  to 4.75 as it did last week?
• A short-cut explanation is that it buys bonds
  which raises bond prices and lowers the interest
  rate
• For a fuller explanation we look at money demand,
  money supply and the interest rate that gives
  equilibrium between them

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Money Demand

• Money demand is a negative relationship between
  the interest rate and the quantity of money
  people are willing to hold
• To derive money demand consider the choice
  between two things
• money or a financial asset that pays interest
• interest rate on the other asset is opportunity
  cost of holding money
• Thus, when interest rate rises people want to
  hold less money

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Graph showing money demand
INTEREST
RATE
Money demand
MONEY
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Money Supply (Review)

• M Currency plus deposits
• Fed controls M by controlling monetary base (MB
  currency plus reserves)
• example, M 4 times MB, where 4 is the money
  multiplier
• (1k)/(rk) (1.2)/(.1.2) (1.2)/(.3) 4
• Buy bonds to raise reserves, MB, and M
• Sell bonds to cut reserves, MB, and M

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INTEREST
RATE
Money supply
Interest rate is
determined by the
intersection of the
money supply line and
the money demand curve.

Money demand
MONEY
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Illustration of a cut in the federalfunds rate
by increasing supply of money
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INTEREST
RATE
Money supply
Interest rate falls.
Money demand
MONEY
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Illustration of an increase in the federal funds
rate through a decrease in the money supplyi
Illustration of an increase in the federal funds
rate by decreasing the supply of money
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INTEREST
RATE
Money supply
Interest rate rises.
Money demand
MONEY
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Alternative monetary policies

• Recall the monetary policy rule we used??
• Alternatives
• Constant money growth rule (Milton Friedman)
• not used now
• hard to define and measure money
• Interest rate responds to real GDP and inflation
• closer to reality

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Questions for Alan Greenspan

• Dr. Greenspan, weve heard a lot about the Fed
• How does the Fed conduct monetary policy?
• Does it set interest rates?
• What about the money supply?
• Is there any systematic framework?
  ?

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Key buzz words in Greenspans statement

• we have been setting the funds rate directly
• money demand has become too difficult to predict
• inflation is fundamentally a monetary
  phenomenon--determined by the growth rate of
  money
• there are lags in the effect of money
• we have a firm commitment to control inflation

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ENDOF LECTURE