MonetaryIndependence

• 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!)– chair’s term does not coincide with POTUS– district Fed presidents not appointed by POTUS

30_01 Potential GDP

Old ADI

SR

New ADI

PA( LR)

PA(SR)

REAL GDP

INFLATION RATE

LR

Real GDP rises above potential GDP in the short run.

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

30_02AVERAGE INFLATION (PERCENT, 1955-1988)

1.0 3.0 3.52.52.0 4.01.5

9

8

7

6

5

4

3

2

New Zealand

Spain

Italy United Kingdom

Belgium

Denmark

United States

Switzerland

Germany

Netherlands

Japan

Canada

MORE INDEPENDENTLESS INDEPENDENT

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 It’s 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

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

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

Graph showing money demand 30_0

3

MONEY

Money demand

INTEREST RATE

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

• (1+k)/(r+k) = (1+.2)/(.1+.2) = (1.2)/(.3) = 4

• Buy bonds to raise reserves, MB, and M

• Sell bonds to cut reserves, MB, and M

30_04

Money supply

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

MONEY

Money demand

INTEREST RATE

Illustration of a cut in the federalfunds rate by increasing supply of money

30_05

Money supply

MONEY

Money demand

INTERESTRATE

Interest rate falls.

By increasing the supplyof money, the Fed lowersthe interest rate.

Illustration of an increase in the federal funds rate through a decrease in the money supplyi

Illustration of anincrease in thefederal funds rate by decreasing the supply of money

30_05

By decreasing the supplyof money, the Fed raisesthe interest rate.

Money supply

MONEY

Money demand

INTERESTRATE

Interest rate rises.

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

Questions for Alan Greenspan

• Dr. Greenspan, we’ve 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?

Key buzz words in Greenspan’s 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

ENDOF

LECTURE