Chapter 12 Monetary Policy

Chapter 12Monetary PolicyChapter OutlineGOALS, TOOLS AND A MODEL OF MONETARY POLICYCENTRAL BANK INDEPENDENCEMODERN MONETARY POLICYThe Federal ReserveNicknamed “The Fed”.Established in 1913 by Congress primarily as the authority for bank regulation.The power to “coin money” was granted to Congress by Article 1 Section 8 of the US Constitution but this power was delegated to the Federal Reserve.The power to regulate the amount that exists in the economy was granted to the Federal Reserve in an attempt to avoid the boom and bust periods of the late 1800s.This power allows the Federal Reserve to alter interest rates without political interference. There are 12 regional Federal Reserve BanksBoston, New York, Philadelphia, Richmond, Atlanta, Cleveland, St. Louis, Kansas City, Chicago, Dallas, Minneapolis, and San Francisco Goals of Monetary PolicyProvide sufficient money to the economy so that it may grow at a sustainable rate.Dampen the impact of the business cycle.Measures of the Amount of Money in the EconomyMonetary Aggregate: a measure of the quantity of money in the economyThe commonly used ones are M1 =cash+coin and checking accountsM2=M1+saving accounts+ small CDsM3=M2+large CDsThe Banking System When a bank takes a deposit into an account on which a check can be written, it must place a percentage of that deposit on reserve at a Federal Reserve bank. That percentage is called the reserve ratio.The Tools of Monetary PolicyOpen Market OperationsA relatively fine tool that can be used to make small adjustments. These adjustments can be daily and often occur without much fanfare.Targeted Interest RatesA relatively blunt tool that can be used to make large adjustments. In typical years, changes in targeted interest rates a few times per year. Reserve RatioA rather blunt tool that is only used when very large adjustments are in order.Tools of Monetary Policy:Open Market OperationsThe Fed buys US government debt in order to get cash into the economy.The Fed sells US government Debt in order to get cash out of the economy.More money in the economy puts downward pressure on interest rates.Tools of Monetary Policy:Targeted Interest RatesThe Fed directly controls the Discount Rate (the rate at which the Fed itself loans money to banks).The Fed seeks to influence the Federal Funds Rate (the rate at which banks borrow from one another to meet reserve requirements)Tools of Monetary Policy:The Reserve RatioThe Fed directly controls the percentage of deposits that banks must have at their regional Fed bank.Money CreationThe banking system can create more “money” than physically exists in the form of coin and cash.The banking system creates money by a series of loans. Person 1 makes a $1000 deposit at Bank 1Bank 1 loans Person 2 $900 who buys something from Person 3 Person 3 makes a $900 deposit in Bank 2.Bank 2 loans $810 to Person 4 who buys something from Person 5.. and so on.In the end there are deposits totaling $10,000 ($1,000+$900+$810+$729+....) that resulted from that initial $1000. Modeling Monetary PolicyIf the Fed wants to expand the economy it canbuy bondsdecrease the Federal Funds or Discount Ratelower the reserve ratio.This increases the supply of loanable funds. This lowers interest rates which increases aggregate demand.If the Fed wants to contract the economy it can sell bondsincrease the Federal Funds or Discount Rateraise the reserve ratio.This decreases the supply of loanable funds. This raises interest rates which decreases aggregate demand.Expansionary Monetary PolicyRGDPInterest Rates Price LevelLoanable FundsSASAD1DrS’r’AD2Contractionary Monetary PolicyLoanable FundsInterest Rates Price LevelRGDPSASAD1DrAD2S’r’Central Bank IndependenceCountries with Central Banks (the general name for institutions like the US Federal Reserve) that are more independent of political control have higher rates of economic growth.This is because political influences tend to create inflationary tendencies which raises interest rates and lowers long-term investment.Fed History 1975-1983In the late 1970s, the Fed battled the slow growth caused by high oil prices by increasing loanable funds so as to lower interest rates. The result was high inflation and even higher interest rates.The Fed induced the 1982 recession with contractionary policy. Once inflation fell below 6% in 1983 it engaged in expansionary policy.Fed History 1984-1990The Fed battled high deficits (expansionary fiscal policy) by keeping real interest rates fairly high.The Fed chose not to react to the 1990 recession hoping to persuade Congress and the first President Bush to compromise on deficit reduction.Fed History 1990-2001The Fed steered a stabilization course through the 1990’s.A fear of inflation led to a rapid increase in interest rates in 2000.A fear of recession led to a rapid decrease in interest rates in 2001.The Fed tried to dampen the economic impact of the Sept 11, 2001 terrorist attacks with quick and deep rate cuts.The Fed’s Inflation FixationThe Fed is often criticized by economists but primarily by politicians for being more concerned about inflation than preventing recession or getting the most out of the US economy.