16
Monetary Policy
Previously . . .
• A main U.S. government goal is economic
stability: preventing the highs of the business
cycle from getting too high and the lows from
getting too low.
• GDP requires investment; investment requires
borrowing.
• Banks create money whenever they extend
loans. Each time a bank receives a new deposit,
it is able to create money through new loans.
• The most important responsibility of the Fed is
monetary policy.
Big Questions
1. What are the tools of monetary policy?
2. What is the effect of monetary policy in
the short run?
3. Why doesn’t monetary policy always
work?
Monetary Policy Tools
• Fed goal: stable economic growth
• How? Monetary policy
– Adjusting the money supply to influence the
macroeconomy
• Primary tool:
– Open market operations
• Secondary tools:
– Quantitative easing
– Reserve requirements
– Discount rates
Open Market Operations
• Open market operations
– Purchases or sales by a central bank
– Fed typically buys and sells government bonds.
• Bonds
– Paper IOUs that join two parties in a contract that
specifies the conditions for repayment of the loan.
– Once created, they can be bought and sold in a
secondary market.
– Fed buys bonds from banks to increase the money
supply.
– Fed sells bonds to banks decrease the money supply.
Open Market Operations
• Why government bonds (as opposed to
commodities or real estate)?
– Gets the funds directly into the market for loanable
funds
– Can buy and sell large volumes daily ($500 billion)
without difficulty
• Why does the Fed buy from or sell to banks?
– Banks hold large amounts of them (reserves).
– The Fed can directly impact how much reserves the
banks have by buying bonds (more reserves for
banks) or selling them (banks give up reserves to
buy).
Open Market Operations
Quantitative Easing
• End of 2008, worst quarter in U.S. in 50 years
– Real GDP down 8.9%, unemployment up
– Fed decided additional measures needed.
• Quantitative easing
– Targeted use of open market operations where the
central bank buys securities specifically targeted in
certain markets
– Targeted the housing market
– Unprecedented; it amounted to the Fed
printing trillions of new dollars and putting
them in targeted sectors.
Quantitative Easing
2007–2014
Source: GDP data is from the U.S. Bureau of Economic Analysis. QE data is from the Federal Reserve. Data
quoted in 2009 dollars.
Quantitative Easing
Discussion
• Quantitative easing explained
– Two people discuss quantitative easing
and the Federal Reserve in this snarky
xtranormal video.
Two Traditional Tools
• Two traditional tools (not used recently, but
historically important)
– Reserve requirements
– Discount rate
• Reserve requirements
– The Fed sets the ratio of deposits banks must hold on
reserve, rr = reserve requirement ratio.
– The simple money multiplier mm depends on rr, and
mathematically, mm = 1/rr
– Implication: the Fed can change the money multiplier
by changing the reserve requirement.
Reserve Requirements and
the Simple Money Multiplier
Excess Reserves, 1990–2014
Two Traditional Tools
• Discount loans
– Loans from the Fed to private banks
– The method by which the Fed is the “lender of last
resort”
– Not prominent in the
macroeconomy but
reassuring during turbulent
times
• Discount rate
– The interest rate
on discount loans
Discount Rate
• Discount rate is the original tool of monetary
policy used by the Fed
• Historically
– Fed would increase the discount rate to discourage
borrowing by banks and decrease money supply (or
vice versa).
– Used actively until Great Depression era
• Today
– No longer considered useful
Impacts on Money Supply
• Expansionary monetary policy
– Entails a central bank acting to increase the
money supply in an effort to stimulate the
economy
• Contractionary monetary policy
– Entails a central bank acting to decrease the
money supply in an effort to slow down the
economy
Impacts on Money Supply
Expansionary Monetary
Policy: Example
Previous topics that will be used in this example:
1. The Fed uses open market operations to implement
monetary policy (it purchases or sells government
bonds).
2. These bonds are one important part of the loanable
funds market (Ch.14).
3. The price in the loanable funds market is the interest
rate. Changes in interest rates impact quantity
demanded and quantity supplied (Ch. 14).
4. Investment is one component of GDP, and higher
investment leads to increases in GDP (Ch. 11).
5. In the short run, increases in aggregate demand
increase output and lower the unemployment rate
(Ch.12).
Example
• A small business owner is deciding whether to
open a second location, when the central bank
decides to expand the money supply.
– Central bank buys securities, increasing reserves.
– Interest rates fall.
– Business owner decides the time is right to take out a
loan.
• End result of this?
– Investment and AD increase.
– Real GDP increases and unemployment falls.
Expansionary Monetary
Policy
• Expansionary monetary policy
– Central bank acts to increase the money
supply.
– Done through open market purchases: central
bank buys bonds, depositing money in the
accounts of the banks that sell them
– Increased supply of funds lowers the interest
rate.
– Firms take out more loans.
Expansionary Monetary Policy in the Short Run
Expansionary Policy ShortRun Result
• Summary
– In the short run, expansionary monetary policy
increases real GDP and reduces unemployment.
– Overall price level rises as flexible prices increase.
– Real employment and real output expand as a result
of simply increasing the money supply.
Real versus Nominal Effects
• If the Fed can increase real employment and
output by increasing the money supply, why
don’t we just keep creating money?
– Not all prices adjust in the short run. Some prices
adjust quickly, others do not.
– Eventually (in the long run when all prices adjust), the
real value of money will be at a lower level. The real
impacts of the monetary policy disappear.
• Important implication
– In the long run, monetary policy does not affect real
GDP or unemployment. The only long-run effect will
be on the price level, a nominal variable.
The Real Value of Money as
Prices Adjust
Unexpected Inflation Hurts
Some People
• If inflation is higher than expected, suppliers who
signed a fixed price contract are hurt by
tomorrow’s unexpected inflation.
• Examples:
– Workers who signed contracts with fixed raises in
wages. If inflation is greater than the raise amounts,
they have less spending power.
– Banks that lent money at fixed interest rates. If a
bank lent money at 3% interest and inflation is 5%,
then real return is -2%.
Economics in Wall Street:
Money Never Sleeps
• Wall Street: Money
Never Sleeps, 2010
– (Language warning)
– Concepts:
•
•
•
•
Financial markets
Moral hazard
Monetary policy
Banking
Contractionary Monetary
Policy
• Contractionary monetary policy
– Occurs when a central bank takes action to
reduce the money supply
– Often done during times of rapid expansion in
order to curb potential inflation
– Performed through open market operations
when the central bank sells bonds
– This takes money out of the loanable funds
market and raises the interest rate
Contractionary Monetary Policy in the Short Run
Contractionary Policy ShortRun Result
• Summary
– In the short run, contractionary monetary
policy decreases real GDP and increases
unemployment.
– Overall price level falls as flexible prices
decrease.
– Real employment and real output shrink as a
result of simply decreasing the money supply.
Why Doesn’t Monetary Policy
Always Work?
• Monetary policy has limitations that can
decrease its effectiveness.
• These include:
– Long run adjustments
– Adjustments in
expectations
– Uncooperative people
Long-Run Effects of Monetary
Policy
• Using our previous example:
– In the short run, monetary policy allowed a new
business to open or expand.
– In the long run, resource prices (including wages)
rise, and other prices rise as well.
• Possible outcomes?
– If demand for the product increases, the business will
stay open and compete.
– But if the store can’t afford the rising input prices
(costs for the firm), it likely will close.
• Effects wear off in the long run!
Short Run versus Long Run
• Long run
– So central banks can’t do much in the long run to
affect real economy
– It makes sense when we realize that we can increase
the money supply by just printing more paper (which
increases prices but not output).
– Long-term growth comes from changes in:
resources, technology, or institutions.
• Monetary neutrality
– The idea that the money supply does not affect real
(long-run) economic variables
Adjustments in Expectations
• People may expect inflation if they expect
monetary policy changes.
• The Fed will often announce its plans. This gives
people time to adjust and prepare.
• If this happens, input prices may not be sticky.
• Examples:
– Workers have an incentive to expect some inflation
and negotiate wage contracts accordingly.
– Other contracts have COLA clauses.
– Impact: firms will have less incentive to
borrow/invest, even at lower interest rates.
Why Doesn’t Monetary Policy
Always Work?
• “Uncooperative people”
– Individuals and banks may not do what the Fed
want them to do
• Great Recession example
– Fed increases money supply, so interest rates
decrease.\
– Many people still fearful, unwilling to borrow
– Banks under tighter restrictions, less able or
willing to lend
Conclusion
• Monetary policy can be expansionary or
contractionary. This occurs by taking
action that increases or decreases the
money supply, respectively.
• In the short run, monetary policy affects
the real variables of GDP and
unemployment.
• In the long run, monetary policy affects
only the price level.
Summary
• The Fed has three tools to adjust the
money supply: open market operations,
the discount rate, and the reserve ratio.
• Of these tools, the only one used with
regularity is open market operations.
• An extreme version of open market
operations is quantitative easing (QE),
which involves buying securities in
specifically targeted markets.
Summary
• Expansionary monetary policy can stimulate
the economy in the short run, increasing real
GDP and reducing the unemployment rate,
• The trade-off is the risk of higher inflation.
• Contractionary monetary policy can slow the
economy in the short run, which may help to
reduce inflation.
• The trade-off is lower GDP and higher
unemployment.
Summary
• Monetary policy fails to produce real (longrun) effects because:
1. It only works when some prices adjust slower
than others; and in the long run, all prices will
be able to adjust.
2. If inflation is fully anticipated, prices adjust
sooner.
3. The behavior of people and banks may not
be what the Fed desires.
Practice What You Know
How does the Fed engage in expansionary
monetary policy?
A.
B.
C.
D.
It buys bonds from financial institutions.
It sells bonds to financial institutions.
It lowers the prices of goods.
It raises the interest rate.
Practice What You Know
Which of these is the Fed’s most-commonly
used tool to contract the money supply?
A.
B.
C.
D.
Quantitative easing
Open market operations
Changing the discount rate
Changing the reserve requirements ratio
Practice What You Know
Why was the use of Quantitative Easing
during the Great Recession potentially
troublesome?
A. It could be deflationary.
B. It could be inflationary.
C. It could cause the housing market to
recover.
D. The Fed did not have the authority to use
this tool.
Practice What You Know
Suppose the Fed engages in contractionary
monetary policy to reduce the money supply.
What is the result in the loanable funds
market?
A. There is a shift in the demand for loanable
funds.
B. The amount of loanable funds increases.
C. Bank competition increases.
D. The interest rate rises.
Practice What You Know
Monetary policy is
A. more effective in the long run.
B. more effective in the short run.
C. equally effective in the long and short run.