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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 Publishing. All rights reserved.
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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
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.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
America’s Central Bank: The Federal Reserve SystemAmerica’s Central Bank: The Federal Reserve System
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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.
America’s Central Bank: The Federal Reserve SystemAmerica’s Central Bank: The Federal Reserve System
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Implementing Monetary PolicyImplementing Monetary Policy
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
FIGURE 1: The Market for Bank Reserves
FIGURE 1: The Market for Bank Reserves
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Implementing Monetary PolicyImplementing Monetary Policy
● 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:
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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.
Implementing Monetary PolicyImplementing Monetary Policy
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
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
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Implementing Monetary PolicyImplementing Monetary Policy
● 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
● Opposite when Fed sell bonds
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Implementing Monetary PolicyImplementing Monetary Policy
● Open-Market Operations, Bond Prices and Interest Rates
● When the Fed buys bonds: demand for bonds price of bonds
price of bonds = interest rate
● Opposite when Fed sell bonds
● Open-Market Operations, Bond Prices and Interest Rates
● When the Fed buys bonds: demand for bonds price of bonds
price of bonds = interest rate
● Opposite when Fed sell bonds
FIGURE 3: Open-Market Purchases and T-Bill Prices
FIGURE 3: Open-Market Purchases and T-Bill Prices
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
Quantity of Treasury Bills
P0
P1
S 0
S0
S1
S1
D
D
A
B
Pri
ce
of
a T
reas
ury
Bill
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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
How Monetary Policy WorksHow Monetary Policy Works
FIGURE 5: Effect of Interest Rates on Total Expenditure
FIGURE 5: Effect of Interest Rates on Total Expenditure
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
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)
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
How Monetary Policy WorksHow Monetary Policy Works
● 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
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
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
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
$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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● 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
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
$500 billion
103
6,400
S
S
D0
D0
6,000
100
Real GDP
Pri
ce
Le
ve
l
E
D1
D1
B
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Money and the Price Level in the Keynesian ModelMoney and the Price Level in the Keynesian Model
● 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
Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.
Federal Reserve Policy
1
M and r
2
I
3
C + I + G + (X - IM)
4
Y and P
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Money and the Price Level in the Keynesian ModelMoney and the Price Level in the Keynesian Model
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Money and the Price Level in the Keynesian ModelMoney and the Price Level in the Keynesian Model
● 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
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
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.