Chapter 16
Domestic and
International
Dimensions of
Monetary Policy
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Today the total reserves that depository institutions
hold with the Fed exceed $1 trillion, as compared to less
than $45 billion in 2008.
What determines the quantity of reserves that
depository institutions choose to hold with the
Fed? Why are they opting to hold so many more
reserves now than a few years ago?
This chapter will help you understand the answers to
these questions.
Learning Objectives
• Identify the key factors that influence the quantity of money
that people desire to hold
• Describe how Federal Reserve monetary policy actions
influence market interest rates
• Evaluate how expansionary and contractionary monetary
policy actions affect equilibrium real GDP and the price level
in the short run
• Understand the equation of exchange and its importance in
the quantity theory of money and prices
Learning Objectives (cont'd)
• Discuss the interest-rate-based transmission mechanism of
monetary policy
• Explain why the Federal Reserve cannot stabilize both the
money supply and interest rates simultaneously
• Describe how the Federal Reserve achieves a target value of
the federal funds rate
• Explain key issues the Federal Reserve confronts in selecting
its target for the federal funds rate
Chapter Outline
•
•
•
•
The Demand for Money
How the Fed Influences Interest Rates
Effects of an Increase in the Money Supply
Open Economy Transmission of Monetary
Policy
• Monetary Policy and Inflation
• Monetary Policy in Action: The Transmission
Mechanism
Chapter Outline (cont'd)
• The Way Fed Policy is Currently Implemented
• Selecting the Federal Funds Rate Target
Did You Know That …
• In late 2000s, Zimbabwe’s daily inflation rate some times
exceeded 100 percent, meaning that the nation’s price level
more than doubled within 24-hour periods?
• Meanwhile, daily rates of money supply growth in Zimbabwe
also exceeded 100 percent.
• Why are higher rates of inflation associated with higher rates
of money growth?
• One objective of this chapter is to answer this question.
The Demand for Money
• To see how Fed monetary policy actions have an impact on
the economy by influencing market interest rates, we must
understand how much money people desire to hold—the
demand for money.
• All flows of nonbarter transactions involve a stock of money.
• To use money, one must hold money.
The Demand For Money
• People have certain motivation that causes
them to want to hold money balances:
– Transactions demand
– Precautionary demand
– Asset demand
The Demand for Money (cont'd)
• Money Balances
– Synonymous with money, money stock, and
money holdings
The Demand for Money (cont'd)
• Transactions Demand
– Holding money as a medium of exchange to make
payments
– The level varies directly with nominal GDP
The Demand for Money (cont'd)
• Precautionary Demand
– Holding money to meet unplanned expenditures
and emergencies
The Demand for Money (cont'd)
• Asset Demand
– Holding money as a store of value instead of other
assets such as certificates of deposit, corporate
bonds, and stocks
The Demand for Money (cont'd)
• The demand for money curve
– Assume the amount of money demanded for
transactions purposes is proportionate to income
– Precautionary and asset demand are determined
by the opportunity cost of holding money (the
interest rate)
Figure 16-1 The Demand for Money
Curve
How the Fed Influences Interest Rates
• The Fed seeks to alter consumption,
investment, and total aggregate expenditures
by altering the rate of growth of the money
supply
How the Fed Influences Interest Rates
(cont'd)
• The Fed has four tools at its disposal as
monetary policy actions:
– Open market operations
– Changes in the reserve ratio
– Changes in the interest rate paid on reserves
– Discount rate changes
How the Fed Influences Interest Rates
(cont'd)
• Open market operations
– Fed purchases and sells government bonds issued
by the U.S. Treasury
– An open market operation causes a change in the
price of bonds
Figure 16-2 Determining the Price of
Bonds, Panel (a)
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• The price of bond falls
Figure 16-2 Determining the Price of
Bonds, Panel (b)
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• The price of bond rises
How the Fed Influences Interest Rates (cont'd)
• Example
– You pay $1,000 for a bond that pays $50 per year
in interest
Bond Yield = $50 = 5%
$1,000
How the Fed Influences Interest Rates
(cont'd)
• Example
– Now suppose you pay $500 for the same bond
(with $50 in interest)
Bond Yield = $50 = 10%
$500
How the Fed Influences Interest Rates
(cont'd)
• The market price of existing bonds (and all
fixed-income assets) is inversely related to the
rate of interest prevailing in the economy
• Implications:
– A Fed open market sale that reduces the
equilibrium price of bonds brings about an
increase in the interest rate
– A Fed open market purchase that boosts the
equilibrium price of bonds generates a decrease in
the interest rate
Effects of an Increase in The Money
Supply
• What if hundreds of millions of dollars in justprinted bills is dropped from a helicopter?
• People pick up the money and put it in their
pockets, but how do they dispose of the new
money?
Effects of an Increase in The Money
Supply (cont'd)
• Direct effect
– Aggregate demand rises because with an increase
in the money supply, at any given price level
people now want to purchase more output of real
goods and services
Effects of an Increase in The Money
Supply (cont'd)
• Indirect effect
– Not everybody will necessarily spend the
newfound money on goods and services
– Some of the money gets deposited, so banks have
higher reserves (and they lend the excess out)
Effects of an Increase in The Money
Supply (cont'd)
• Indirect effect
– Banks lower rates to induce borrowing
• Businesses engage in investment
• Individuals consume durable goods (like housing and
autos)
– Increased loans generate an increase in aggregate
demand
• More people are involved in more spending (even
those who didn’t get money from the helicopter!)
Effects of an Increase in The Money
Supply (cont'd)
• Assume the economy is operating at less than
full employment
– Expansionary monetary policy can close the
recessionary gap
– Direct and indirect effects cause the aggregate
demand curve to shift outward
Figure 16-3 Expansionary Monetary Policy with
Underutilized Resources
• The recessionary gap is
due to insufficient AD
• To increase AD,
use expansionary
monetary policy
• AD increases and
real GDP increases
to full employment
Effects of an Increase in The Money
Supply (cont'd)
• Assume there is an inflationary gap
– Contractionary monetary policy can eliminate this
inflationary gap
– Direct and indirect effects cause the aggregate
demand curve to shift inward
Figure 16-4 Contractionary Monetary Policy with
Overutilized Resources
• The inflationary gap is shown
• To decrease AD, use
contractionary monetary policy
• AD decreases and real
GDP decreases
Open Economy Transmission of
Monetary Policy
• So far we have discussed monetary policy in a
closed economy
• When we move to an open economy,
monetary policy becomes more complex
Open Economy Transmission of
Monetary Policy (cont'd)
• The net export effect of contractionary
monetary policy
• Boosts the market interest rate
• Higher rates attract foreign investment
• International price of dollar rises
• Appreciation of dollar reduces net exports
• Negative net export effect
Open Economy Transmission of
Monetary Policy (cont'd)
• Contractionary monetary policy causes interest rates to rise
• Such a rise will induce international inflows of funds, thereby
raising the international value of the dollar and making U.S.
goods less attractive abroad
• The net export effect of contractionary monetary policy will
be in the same direction as the monetary policy effect,
thereby amplifying the effect of such policy
Open Economy Transmission of
Monetary Policy (cont'd)
• The net export effect of expansionary
monetary policy
• Lower interest rates
• Financial capital flows out of the United States
• Demand for dollars will decrease
• International price of dollar goes down
• Foreign goods look more expensive in United States
• Net exports increase (imports fall)
Open Economy Transmission of
Monetary Policy (cont'd)
• Globalization of international money markets
– The Fed’s ability to control the rate of growth of
the money supply may be hampered as U.S.
money markets become less isolated
– If the Fed reduces the growth of the money
supply, individuals and firms in the United States
can obtain dollars from other sources and more
regularly conduct transactions using other
nations’ currencies.
Monetary Policy and Inflation
• Most media discussions of inflation focus on
the short run when the price index can
fluctuate due to such events as
– Oil price shocks, labor union strikes
• In the long run, empirical studies show that
excessive growth in the money supply results
in inflation
Monetary Policy and Inflation (cont'd)
• Simple supply and demand analysis can be
used to explain why the price level rises when
the money supply increases
• If the supply of money expands relative to the
demand for money:
– People have more money balances than they
desire, so their spending on goods and services
increases (i.e., the price level has risen)
Monetary Policy and Inflation (cont'd)
• The Equation of Exchange
– The formula indicating that the number of monetary
units (Ms) times the number of times each unit is
spent on final goods and services (V) is identical to
the price level (P) times real GDP (Y)
– It shows the relationship between changes in the
quantity of money in circulation and the price level
Monetary Policy and Inflation (cont'd)
MsV  PY
MS = money balances held by nonbanking public
V = income velocity of money
P = price level or price index
Y = real GDP per year
Monetary Policy and Inflation (cont'd)
• Income Velocity of Money
– The number of times per year the dollar is spent
on final goods and services
– Equal to the nominal GDP divided by the money
supply
Monetary Policy and Inflation (cont'd)
• The equation of exchange as an identity ()
– Total funds spent on final output MsV equals total
funds received PY
– The value of goods purchased is equal to the value
of goods sold
– MsV  PY  nominal GDP
Monetary Policy and Inflation (cont'd)
• Quantity Theory of Money and Prices
– The hypothesis that changes in the money supply
lead to equiproportional changes in the price level
– If we assume that V and Y are constant, than an
increase in the money supply by, say 20%, can
lead only to a 20% increase in the price level
Figure 16-5 The Relationship Between Money Supply Growth
Rates and Rates of Inflation
International Policy Example: North Korea Divides Its Money by
100
• Inflation has been so rampant in North Korea that even the
poorest individuals commonly have held thousands of won, the
nation’s currency, and banks have routinely transferred single
payments denominated in trillions of won.
• To simplify matters, the North Korean government recently
stripped two zeros from the currency.
Figure 16-6 The Interest-Rate-Based Money
Transmission Mechanism
Figure 16-7 Adding Monetary Policy to the Aggregate
Demand–Aggregate Supply Model
At lower rates, a larger
quantity of money will
be demanded
The decrease in the interest
rate stimulates investment
Monetary Policy in Action: The
Transmission Mechanism
• The Fed’s target choice: The interest rate or
the money supply?
– The Fed has sought to achieve an interest rate
target
– There is a fundamental tension between targeting
the interest rate and controlling the money supply
– The Fed can attempt to stabilize the interest rate
or the money supply, but not both
Figure 16-8 Choosing a Monetary Policy Target
If the Fed selects re, it
must accept Ms
If the Fed selects M’s,
it must allow the
interest rate to fall
Monetary Policy in Action: The Transmission
Mechanism (cont’d)
• Choosing a policy target
– Money supply
• When variations in private spending occur
– Interest rates
• When the demand for (or supply of) money is unstable
• Interest rate targets are preferred
The Way Fed Policy is Currently Implemented
• At present the Fed announces an interest rate
target
• If the Fed wants to raise “the” interest rate, it
engages in contractionary open market
operations
– Fed sells more Treasury securities than it buys,
thereby reducing the money supply
• This tends to boost “the” rate of interest
The Way Fed Policy is Currently Implemented (cont'd)
• Conversely, if the Fed wants to decrease “the”
rate of interest, it engages in expansionary
open market operations
– Fed buys more Treasury securities, increasing the
money supply
• This tends to lower “the” rate of interest
The Way Fed Policy is Currently Implemented (cont'd)
• In reality, “the” interest rates that are relevant
to Fed policymaking:
– Federal funds rate
– Discount rate
– Interest rate on reserves
The Way Fed Policy is Currently Implemented (cont'd)
• Federal Funds Rate
– The interest rate that depository institutions pay
to borrow reserves in the interbank federal funds
market
• Federal Funds Market
– A private market (made up mostly of banks) in
which banks can borrow reserves from other
banks that want to lend them
– Federal funds are usually lent for overnight use
The Way Fed Policy is Currently Implemented (cont'd)
• Discount Rate
– The interest rate that the Federal Reserve charges
for reserves that it lends to depository institutions
(through the “discount window”)
– It is sometimes referred to as the rediscount rate
or, in Canada and England, as the bank rate
The Way Fed Policy is Currently Implemented (cont'd)
• The interest rate on reserves
– In October 2008, Congress granted the Fed
authority to pay interest on both required
reserves and excess reserves of depository
institutions
– If the Fed raises the interest rate on reserves and
thereby reduces the differential between the
federal funds rate and the interest rate on
reserves, banks have less incentive to lend
reserves in the federal funds market
Figure 16-9 The Market for Bank Reserves and the Federal Funds
Rate, Panel (a)
Figure 16-9 The Market for Bank Reserves and the Federal Funds
Rate, Panel (b)
An open market
purchase increases
the supply of
reserves, and thus
lowers the
equilibrium federal
funds rate
The Way Fed Policy is Currently Implemented (cont'd)
• FOMC Directive
– A document that summarizes the Federal Open
Market Committee’s general policy strategy
– Establishes near-term objectives for the federal
funds rate and specifies target ranges for money
supply growth
The Way Fed Policy is Currently Implemented (cont'd)
• Trading Desk
– An office at the Federal Reserve Bank of New York
charged with implementing monetary policy
strategies developed by the FOMC
Selecting the Federal Funds Rate Target
• The Neutral Federal Funds Rate
– A value of the interest rate on interbank loans at
which the growth rate of real GDP tends neither
to rise nor to fall relative to the rate of growth of
potential, long-run, real GDP, given the expected
rate of inflation
Selecting the Federal Funds Rate Target (cont’d)
• The value of neutral federal funds rate varies
over time. The potential rate of growth of real
GDP is not constant
• When the rate of growth rises or falls, so does
the value of the neutral federal funds rate
• The FOMC must respond by changing the
target for the federal funds rate that it
includes in the FOMC Directive transmitted to
the Trading Desk
Selecting the Federal Funds Rate Target (cont’d)
• Taylor Rule
– A suggested guideline for monetary policy
– An equation determining the Fed’s interest rate
target based on
• Estimated long-run real interest rate
• Deviation of the actual inflation rate from the Fed’s
objective
• Gap between actual real GDP and a measure of
potential GDP
Figure 16-10 Actual Federal Funds Rates and Values
Predicted by a Taylor Rule
Why Not … just follow the Taylor rule?
• After 2008, during the Great Recession, following the Taylor
rule was not feasible for the Fed.
• Figure 16-10 shows that the Taylor rule specified a negative
value for the federal funds rate, which is not possible.
You Are There: How Zimbabwe Undercut Collectors’ Hopes of
Profits
• During Zimbabwe’s periods of hyperinflation—an inflation
rate so high that the Zimbabwe dollar often lost more than
half its value in a single day, its government printed onetrillion-dollar notes.
• As those notes were printed and distributed in very large
volumes, their market values might never exceed what money
collectors paid for them.
Issues & Applications: Explaining the Rise in the Quantity of Bank
Reserves
• Figure 16-11 shows that since the late summer of 2008, the
total reserves of depository institutions have increased by
nearly 25 times, to a level exceeding $1 trillion.
• Most of this increase came from the rise in voluntary holdings
of excess reserves because since October 2008, the Federal
Reserve has paid interest on all reserves held at Federal
Reserve district banks.
Figure 16-11 Reserves of Depository Institutions Since
June 2008
Summary Discussion of Learning
Objectives
• Key factors that influence the quantity of money that people
desire to hold
– When nominal GDP rises
• People generally make more transactions
• They require more money
• They desire to hold more money
– The interest rate is the opportunity cost for holding money as a
precaution against unexpected expenditures
– The quantity of money demanded declines as the market interest rate
increases
Summary Discussion of Learning Objectives (cont'd)
• How the Fed’s Open Market Operations
Influence Market Interest Rates
– The market price of existing bonds and the
prevailing interest rate are inversely related
• The market interest rate rises when the Fed sells bonds
• The market interest rate declines when the Fed
purchases bonds
Summary Discussion of Learning
Objectives
• How expansionary and contractionary
monetary policy affect equilibrium real GDP
and the price level in the short run
– Expansionary monetary policy
• Pushing up money supply, inducing a fall in interest
rates
• Total planned expenditures rise, AD shifts rightward
– Contractionary monetary policy
• Reduces the money supply increasing interest rates
• Total planned expenditures fall, AD shifts leftward
Summary Discussion of Learning
Objectives (cont'd)
• The equation of exchange and the quantity
theory of money and prices
– Equation of exchange
• MsV = PY
– Quantity theory of money and prices
• V is constant and Y is stable
• Increases in Ms lead to equiproportional increases in P
Summary Discussion of Learning
Objectives (cont'd)
• The interest-rate-based transmission
mechanism of monetary policy
– Operates through effects of monetary policy
actions on market interest rates
• Bring about changes in desired investment and thereby
affect equilibrium GDP via the multiplier effect
Summary Discussion of Learning
Objectives (cont'd)
• Why the Federal Reserve cannot stabilize the
money supply and the interest rate
simultaneously
– To target the money supply the Fed must permit
the interest rate to vary when the demand for
money changes
– To target a market interest rate the Fed must
adjust the money supply as necessary when the
demand for money changes
Summary Discussion of Learning Objectives (cont'd)
• How the Federal Reserve Achieves a Target Value
of the Federal Funds Rate
– The interest rate at which banks can borrow excess
reserves from other banks is at an equilibrium level
when the quantity of reserves demanded by banks
equals the quantity of reserves supplied by the Fed
– The Trading Desk conducts open market sales or
purchases to alter the supply of reserves as necessary
to keep the federal funds rate at the FOMC’s target
Summary Discussion of Learning Objectives (cont'd)
• Issues the Federal Reserve Confronts in
Selecting its Target for the Federal Funds Rate
– The FOMC target is the neutral federal funds rate
– The Taylor Rule specifies an equation for the
federal funds rate target based on
• an estimated long-run real interest rate
• the current deviation from the Fed’s inflation goal
• the gap between actual real GDP and a measure of
potential real GDP
Appendix E: Increasing the Money Supply
• According to the Keynesian approach,
increasing the money supply:
– Pushes interest rates down
– Increases the level of investment spending
– Causes real GDP to rise, which in turn causes real
consumption to rise
– Real GDP rises further (multiplier effect)
Figure E-1 An Increase in the Money Supply
Appendix E: Decreasing the Money Supply
• According to the Keynesian approach,
decreasing the money supply:
– Pushes interest rates up
– Decreases the level of investment spending
– Causes real GDP to fall, which in turn causes real
consumption to fall
– Real GDP falls further (multiplier effect)
Appendix E: Arguments Against Monetary Policy
• Many traditional Keynesians argue that monetary
policy is likely to be relatively ineffective as a
recession fighter because:
– During recessions, people try to build up as much as
they can in liquid assets to protect themselves from
risks of unemployment and other losses of income
– An increase in the money supply does not reduce
interest rate as individuals are willing to allow most of
it to accumulate in their bank accounts, preventing
interest rates from falling