Chapter 13
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
Outline
• Fed as a central bank
• Monetary policy
– Tools
– Mechanism
Money and Income: Difference
• Money
– At one point in time (stock)
– E.g.: money stock (M1)
• Income
– Over a period of time (flow)
– E.g.: nominal GDP per year
4
The Federal Reserve System
The Federal Reserve System
• The Federal Reserve System, “The Fed”
– U.S. central bank
• Bank for banks
– Origins
• 1873-1907: four severe banking panics
– Established in 1914 by the Congress to
regulate commercial banks
Discussion: Why do we need a central
bank?
6
Dow-Jones Industrial Average
Bank Run on Wall Street, 1907
The Federal Reserve System
• Organization of the Fed
– Board of Governors
– FOMC
– 12 Regional Banks
– Member Banks
The Federal Reserve System
• Board of Governors (7 members)
– Main governing body of the Fed
– Appointed by U.S. President
• Chairman (4-year term)
– Advice & consent of Senate
– 14-year term
– Oversees System operations, makes
regulatory decisions, and sets reserve
requirements
10
The Federal Reserve System
• The Fed has 12 regional banks
– Each independently incorporated with a
9-member board of directors
– Set discount rate, subject to approval by
Board of Governors
– Monitor economy and financial
institutions in their districts and provide
financial services to the U.S.
government and depository institutions
The Federal Reserve System
• Federal Open Market Committee (FOMC)
– 12 members
• 7 governors of the Fed
• President of the Fed – New York
• 4 (of 11) district banks presidents on a
rotating basis
– Meet eight times a year in DC
– Determine short-term interest rates (FFR)
– Size of U.S. money supply
12
FOMC Meeting
The Federal Reserve System
• 3400 member banks
– Private banks
– Hold stock in their local Federal Reserve
Bank
– Elect six of the nine members of
Reserve Banks’ boards of directors
The Federal Reserve System
• Central bank independence
– Make decisions without political
interference (without prior approval from
Congress or the President)
– Institutional arrangement guarantees the
independence
– Unique structure provides internal checks
and balances, not dominated by one part
of the system
– Help control inflation
Discussion: Why do we need CBI?
15
Central bank independence
Tools of Monetary Policy
• Open market operations
• Discount rate
• Reserve requirements
Implementing Monetary Policy
• Open-market operations (OMOs)
– Fed’s purchase / sale
• Short-term government securities (T-bills)
• Transactions: Open market
• The Fed uses OMOs to affect market
interest rates
– Purchase: Treasury bills
– Pays: newly created bank reserves
– Put pressure on market interest rate
• The most frequently used tool
18
Implementing Monetary Policy
• Market for bank reserves
– Supply curve
• Determined by Federal Reserve policy
• Upward-sloping
– Demand curve
• Banks – required to hold reserves
• Reflects
– Demand for transaction deposits – banks
• Depends on real GDP & price level
• Downward-sloping (Why?)
19
Figure 1
The market for bank reserves
S
D
Interest Rate
For given
Fed policy
E
For given
Y and P
D
S
Quantity of Bank Reserves
20
Implementing Monetary Policy
• Market for bank reserves
– Federal funds rate (FFR)
• Interest rate
• Borrow/lend reserves among banks
• The Fed – lower federal funds rate
– Purchase T-bills
• Additional reserves to market
– Supply curve – shift outward
• Lower interest rates
• More bank reserves
21
Figure 2
The effects of an open-market purchase
S0
S1
Interest Rate
D
E
A
D
S0
S1
Quantity of Bank Reserves
22
Implementing Monetary Policy
• Federal Reserve
– Wants lower interest rates
– Purchases U.S. government securities
• In the open market
• Pays - creating new bank reserves
• Required reserve – no change
• Actual reserves – increased
• Excess reserves
– Multiple expansion process
– Increase money supply by 1/m times
23
Table 1
Effects of an open-market purchase of securities on
the balance sheets of banks and the Fed
Federal Reserve System
Banks
Assets
Reserves +$100 million
U.S. government
securities -$100 million
Addendum: Changes
in Reserves
Actual Reserves
+$100 million
Required Reserves
No Change
Excess Reserves
+$100 million
Liabilities
Assets
Liabilities
Bank Reserves
U.S. government
+$100 million
securities +$100 million
Bank gets Reserves
Fed gets securities
24
Implementing Monetary Policy
• OMOs might not be perfect accurate
– People - hold cash
– Banks - hold excess reserves
• However, Fed can always achieve the
FFR it wants
– FFR is observable in the open market
every minute
– Fed can always adjust the volume of Tbills it needs to buy/sell
• OMOs is very flexible, fine tune policy
25
Implementing Monetary Policy
• Federal Reserve
– Wants to increase interest rates
– Sells U.S. government securities
• In the open market
• Banks pay: reserves (deposits at the Fed)
– Multiple contraction process
– Decrease money supply by 1/m times
Implementing Monetary Policy
Another way to look at OMO (via bond
market)
• Expansionary monetary policy
– Fed buys T-bills
– T-bill prices – increase
• Demand – unchanged
• Supply (available to private investors)
– Inward shift
– Interest rates – fall
• Interest rate = fixed dividend / bond price
• Bond price ↑ → interest rate ↓
27
Figure 3
Open-market purchases and treasury bill prices
Price of a Treasury Bill
S1
S0
D
P1
B
A
P0
D
S1
S0
Quantity of Treasury Bills
28
Implementing Monetary Policy
Summary of OMO:
• Open-market purchase-T-bills
– Raises the money supply
– Drives up T-bill prices
– Pushes interest rates down
• Open-market sale - T- bills
– Reduces the money supply
– Lowers T-bill prices
– Raises interest rates
29
Effective FFR
Nearly Zero FFR
• Discussion: In the current recession,
Fed already set FFR close to zero.
Does this mean the effect of OMOs is
limited? What should Fed do if OMOs
do not work?
Other Methods of Monetary Control
• The Fed – lender of last resort
– Lending to member banks
• Discount rate
– Interest rate charged by Fed for overnight
loans that member banks borrow via
“Discount Window”
– generally set at a rate close to 1% above
the target FFR
• Discount rate – decrease
– Banks – borrow more
– Increase excess reserves
32
Table 2
Balance sheet changes for borrowing from the Fed
Federal Reserve System
Banks
Assets
Liabilities
Reserves
Loan from
+$5 million Fed +$5 million
Addendum:
Changes in
Reserves
Actual Reserves
+$5 million
Required
Reserves
No Change
Excess Reserves
+$5 million
Assets
Liabilities
Loan to
Bank +$5 million
Bank Reserves
+$5 million
Bank borrows $5 million
And the proceeds are credited
to its reserve account
33
Other Methods of Monetary Control
• Minimum required reserve ratio (m)
– Decrease
• Increase excess reserves
– Money expansion
• Lower interest rates
– Increase
• Decrease excess reserves
– Money contraction
• Higher interest rates
– 10% since 1992
34
How Monetary Policy Works
• Expansionary monetary policy
– Open-market purchase
– Lower interest rates
• Contractionary monetary policy
– Open-market sale
– Raise interest rates
35
Figure 4
The effects of monetary policy on interest rates
S0
S2
S1
S0
D
D
Interest Rate
Interest Rate
E
A
S0
D
S1
Bank Reserves
(a)
Expansionary Monetary Policy
B
E
S2
S0
D
Bank Reserves
(b)
Contractionary Monetary Policy
36
How Monetary Policy Works
• Sensitive to monetary policy
– Investment (depends on r)
– Net exports (via exchange rate, Chp. 18)
• AD = C +I +G +(X-IM) is thus affected
• Reminder: fiscal policy affects AD
through G (directly) and C an I (indirectly
via tax)
• Discussion: fiscal policy vs. monetary
policy, pros and cons
37
Figure 5
The effect of interest rates on total expenditure
45°
C+I+G+(X-IM)
(lower interest rate)
Real Expenditure
C+I+G+(X-IM)
C+I+G+(X-IM)
(higher interest rate)
Real GDP
38
How Monetary Policy Works
• Expansionary monetary policy
– Lower interest rates (r)
– Encourage investment (I)
– Higher total spending
– Higher expenditure schedule
– Multiplier effect on aggregate demand
39
How Monetary Policy Works
• Contractionary monetary policy
– Higher interest rates (r)
– Lower investment spending (I)
– Lower total spending [C+I+G+(X-IM)]
– Lower expenditure schedule
– Lower aggregate demand through
multiplier
Mechanism of Mon. Policy (P constant)
Federal Reserve  1
2
3
 M and r   I 


Policy


3
4
 C  I  G  ( X  IM )  GDP
Figure 6
The effect of expansionary monetary policy on total
expenditure
45°
C+I1+G+(X-IM)
Real Expenditure
E1
C+I0+G+(X-IM)
E0
0
5,500
6,000
6,500
Real GDP
7,000
42
How Monetary Policy Works
• Effect of monetary policy
– On aggregate demand
– Depends on
• Sensitivity of interest rates
– To open-market operations
• Responsiveness of investment spending
– To interest rate
• Size of basic expenditure multiplier
43
Money & Price Level in Keynesian Model
• Expansionary monetary policy
– Increases aggregate quantity demanded
• At any given price level
– Causes some inflation
• Depends on slope of aggregate supply curve
44
Money & Price Level in Keynesian Model
Federal Reserve  1
2
3
 M and r   I 


Policy


3
4
 C  I  G  ( X  IM )  Y and P
Figure 7
Inflationary effects of expansionary monetary policy
D0
D1
S
Price Level
$500 billion
B
103
E
100
S
D0
0
6,000
D1
6,400
Real GDP
46
Money & Price Level in Keynesian Model
• Aggregate demand – slopes downward
– Higher price level (caused by
expansionary monetary policy)
• Reduce purchasing power
• Depress exports, Stimulate imports
• Increase quantity of bank deposits
demanded
– Demand curve (bank reserves) – shift outward
– Increase federal funds rate
– Higher interest rate
– Discourage investment
– Lower aggregate quantity demanded
47
Figure 8
The effect of a higher price level on the market for
bank reserves
S
D1
Interest Rate
D0
E1
Effect of a
higher P
E0
S
D0
D1
Bank Reserves
48
Summary
• Fed: Origin and structure
• Central bank independence
• Tools of monetary policy
– OMO
– Discount rate
– Reserve requirement
• Mechanism of the monetary policy
– Interest rate → Investment → AD → Y and P