Contents Money and Income: The Important Difference America’s Central Bank: The Federal Reserve System Implementing Monetary Policy: Open Market Operations Other Methods of Monetary Control Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

JOHN KENNETH GALBRAITH 29 Monetary Policy and the National Economy 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

Contents (continued) Supply-Demand Analysis of the Money Market How Monetary Policy Works Money and the Price Level in the Keynesian Model From Models to Policy Debates Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Money and Income: The Important Difference Stock variables are measured at a moment in time. Flow variables are measured over time.

Money and Income: The Important Difference Money is a stock, income a flow. Stock of money influences the rate at which people earn income. Money affects GDP.

America’s Central Bank: The Federal Reserve System The Federal Reserve System, established in 1914, is the U.S. central bank. Comprised of twelve district banks Governed by a seven-member Board of Governors Decisions on the money supply made by the Federal Open Market Committee

America’s Central Bank: The Federal Reserve System Central Bank Independence Fed board members: Appointed to fourteen-year terms Independent of political pressures

America’s Central Bank: The Federal Reserve System Central Bank Independence In some other countries, the central banks are less independent. Countries without independent central banks often have less stable economies.

Implementing Monetary Policy The Fed can increase the money supply by buying government securities on the open market. It pays for these securities by creating new bank reserves. These additional reserves  multiple expansion of the money supply To reduce the money supply, the Fed sells securities.

TABLE 29-1 Effects of an Open-Market Purchase of Securities Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Implementing Monetary Policy Open-Market Operations, Bond Prices and Interest Rates When the Fed buys bonds:  demand for bonds   price of bonds  price of bonds =  interest rate Opposite when Fed sell bonds

FIGURE 29-1 Open-Market Sales and Bond Prices S 1 D P A Price of a Bond P B 1 Quantity of Bonds Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Other Methods of Monetary Control Lending to Banks The Fed lends to member banks, occasionally as a “lender of last resort.” Discount rate = interest rate Fed charges member banks when it makes loans to them

Other Methods of Monetary Control Lending to Banks  discount rate   Borrowing by member banks   Reserves   Money supply Opposite if Fed raises discount rate

TABLE 29-2 Balance Sheet Changes, Borrowing from Fed Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Other Methods of Monetary Control Changing Reserve Requirements  Required reserve ratio   Excess reserves   Loans   Money supply Opposite if Fed increases reserve requirement In practice, the Fed seldom changes the reserve requirements.

Supply-Demand Analysis of the Money Market  Interest rates   Profit opportunities for banks  Excess reserves  Volume of loans

Supply-Demand Analysis of the Money Market However, the Fed can shift the relationship between the money supply and interest rates by employing any of its principal weapons of monetary control. Open-market operations  reserve requirements  lending policy to banks

FIGURE 29-2 (a) The Supply Schedule for Money 7 M S 5 Interest Rate 3 1 800 820 830 850 Money Supply (a) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

FIGURE 29-2 (b, c) The Supply Schedule for Money 7 7 M S M 1 S M 2 S M S 5 5 Interest Rate 3 Interest Rate 3 1 1 800 850 800 850 Money Supply Expansionary Policy Change (b) Money Supply Contractionary Policy Change (c) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Supply-Demand Analysis of the Money Market The Money Supply Mechanism Money supply curve: slightly positive slope Indicates a weak sensitivity to changes in the interest rate

Supply-Demand Analysis of the Money Market The Demand for Money Money is demanded for transactions.  nominal GDP   Spending  Demand for money

Supply-Demand Analysis of the Money Market The Demand for Money Interest = opportunity cost of holding money  Interest rates   Money demand Demand curve for money curve Negatively sloped Shifts as nominal GDP changes

FIGURE 29-3 (a) The Demand Schedule for Money Interest Rate Quantity of Money Demanded (a) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

FIGURE 29-3 (b, c) The Demand Schedule for Money 1 D D M M D D 2 M Interest Rate Interest Rate Quantity of Money Demanded Higher Y or P (b) Quantity of Money Demanded Lower Y or P (c) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Supply-Demand Analysis of the Money Market Equilibrium in the Money Market The interest rate equilibrates the demand and supply of money. The Fed can lower (raise) interest rates by increasing (reducing) the money supply.

FIGURE 29-4 Equilibrium in the Money Market 8 D M M S 7 For given Fed policy 6 E 5 Interest Rate 4 3 For given Y and P 2 1 800 830 850 Money Stock Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

FIGURE 29-5 Effects of Monetary Policy on the Money Market D M M S D M M 2 S M S M 1 S B E Interest Rate Interest Rate E A Money Stock (a) Money Stock (b) Expansionary Monetary Policy Contractionary Monetary Policy Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

How Monetary Policy Works Of the four components of aggregate demand, investment and net exports are the most sensitive to monetary policy. Assume that net exports (X - IM) are fixed. Focus on monetary policy’s influence on investment (I)

How Monetary Policy Works Investment and Interest Rates  interest rates   investment spending  investment  multiplier effect Lowers GDP  interest rates  opposite

FIGURE 29-6 Effect of Interest Rates on Total Expenditure 45 ° C + I G ( X – M ) (lower interest rate) C + I G ( X – M ) Real Expenditure C + I G ( X – M ) (higher interest rate) Real GDP Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

How Monetary Policy Works Monetary Policy and Total Expenditure Fed actions   money supply  interest rates  interest rate   investment  investment   AD  AD   GDP

FIGURE 29-7 Expansionary Policy on Money Supply & Interest Rate M S 1 M M D 5 E Interest Rate 3 E 1 1 800 830 850 880 900 Money Stock Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

How Monetary Policy Affects GDP 1 2 3 4 Federal Reserve Policy M and r I C + I + G + (X - IM) GDP Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

FIGURE 29-8 Expansionary Policy on Total Expenditure 45 ° C + I 1 G ( X – M ) E 1 C + I G ( X – M ) $200 billion Real Expenditure E 5,500 6,000 6,500 7,000 Real GDP Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Money and the Price Level in the Keynesian Model Expansionary monetary policy causes some inflation under normal circumstances. How much inflation it causes depends on the state of the economy. Represented by the slope of the AS curve

FIGURE 29-9 The Inflationary Effects of Expansionary Policy D D 1 S $500 billion B 103 Price Level E 100 6,000 6,400 Real GDP Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Money and the Price Level in the Keynesian Model Fed policy  M & r AD Y & P Both output and prices are normally affected by monetary policy.

Effect of Monetary Policy on Output and Prices 1 2 3 4 Federal Reserve Policy M and r I C + I + G + (X - IM) Y and P Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Money and the Price Level in the Keynesian Model Application: Why the AD Curve Slopes Downward  price level   money demand  interest rates  investment

Money and the Price Level in the Keynesian Model Application: Why the AD Curve Slopes Downward  investment  negative multiplier effect on GDP Thus  price level   GDP

From Models to Policy Debates We have done all the theory that is needed. The next three chapters of the text turn to policy debates.