Chapter 10 Monetary Policy Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

10-2 Chapter Outline GOALS, TOOLS AND A MODEL OF MONETARY POLICY CENTRAL BANK INDEPENDENCE MODERN MONETARY POLICY

10-3 You Are Here

10-4 The Federal Reserve Nicknamed “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 Banks –Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, St. Louis, Kansas City, Chicago, Dallas, Minneapolis, and San Francisco

10-5 Goals of Monetary Policy Provide sufficient money to the economy so that it may grow at a sustainable rate. Dampen the impact of the business cycle. Control Inflation

10-6 Measures of the Amount of Money in the Economy Monetary Aggregate: a measure of the quantity of money in the economy The commonly used ones are –M1 =cash+coin and checking accounts –M2=M1+saving accounts+ small CDs

10-7 The 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.

10-8 Traditional and Ordinary Tools of Monetary Policy Open Market Operations –A relatively fine tool that can be used to make small adjustments. These adjustments can be daily and often occur without much fanfare. Targeted Interest Rates –A 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 Ratio –A rather blunt tool that is only used when very large adjustments are in order.

10-9 Tools of Monetary Policy: Open Market Operations The 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.

10-10 Tools of Monetary Policy: Targeted Interest Rates The Fed seeks to influence the Federal Funds Rate (the rate at which banks borrow from one another to meet reserve requirements) Fed Loans Directly to Banks –Banks with good credit pay the primary credit rate and can borrow unlimited amounts.

10-11 Tools of Monetary Policy: The Reserve Ratio The Fed directly controls the percentage of deposits that banks must have at their regional Fed bank.

10-12 Money Creation The 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 1 –Bank 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+$810+$ ) that resulted from that initial $1000.

10-13 Modeling Monetary Policy If the Fed wants to expand the economy it can –buy bonds –decrease the Federal Funds or Discount Rate –lower 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 bonds –increase the Federal Funds or Discount Rate –raise the reserve ratio. –This decreases the supply of loanable funds. This raises interest rates which decreases aggregate demand.

10-14 Expansionary Monetary Policy RGDP Interest RatesPrice Level Loanable Funds S AS AD 1 D rS’ r’ AD 2

10-15 Contractionary Monetary Policy Loanable Funds Interest ratePrice Level RGDP S AS AD 1 D r AD 2 S’ r’

10-16 Monetary Transmission The Monetary Transmission Mechanism is the means by which changes in the interest rate impact the overall economy through changes in business investment and consumer spending. The Fed can impact the interest rate with monetary policy. The Fed cannot count on interest rates changing business investment and consumer spending. When the Monetary Transmission Mechanism fails, you have a liquidity trap.

10-17 New Tools of Monetary Policy Purchases of Commercial Paper, short term debt of corporations. Purchases of longer term Federal Treasuries Purchases of mortgage backed securities.

10-18 Central Bank Independence Countries 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.

10-19 Fed History In 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.

10-20 Fed History The 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.

10-21 Fed History The Fed steered a stabilization course through the 1990’s. A fear of inflation led to a rapid increase in interest rates in A fear of recession led to a rapid decrease in interest rates in The Fed tried to dampen the economic impact of the Sept 11, 2001 terrorist attacks with quick and deep rate cuts. Rate cutes left the Federal Funds rate at 1% though 2003

10-22 Fed History Began raising interest rates in 2004 Raised interest rates 17 times until the Fed Funds rate was at 5.25% Maintained that rate for several months. In 2008, it began cutting interest rates in response to the economic slowdown. Brought the federal funds rate to zero (to 0.25) percent in late 2008.

10-23 Key Interest Rates

10-24 The Inflation/Deflation debate The 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. There was little the Fed could have done to stimulate the economy after the final cut to 1%. There was an active concern on 2003 that deflation was possible

10-25 Aggressive Fed Action on the Federal Funds Rate ( )

10-26 Inflation Targeting The European Central Bank currently targets inflation rather than a monetary aggregate or interest rate. Inflation targeting: involves publishing a desired range of a specified inflationary measure and then using the tools of monetary policy to bring that measure of inflation into that desired range. –The Fed’s target is the core PCE deflator. –Target range 1-2%

10-27 Yield Curves in Recent History