Monetary Policy Goals for the chapter: 1. Learn the three principal tools that the Fed uses to control the money supply plus know about the other tools well enough to recognize them in newspaper accounts. 2. Learn how monetary policy can and does work via the money market on until it shifts aggregate demand, AD. 3. Learn what the logical policy for Mr. Greenspan and the Fed is when: a. we need to cure unemployment; b. we need to control or actually reduce inflation.

The Tools of the Fed: How they control or try to control the money supply. 1. Open-Market Operations a. buy bonds: put money back into the hands of the public--thus it increases the money supply. b. sell bonds: replaces money in the hands of the public by giving them slips of paper (nonmoney) called bonds--thus it reduces the money supply. 2. Changes in Reserve Requirements. When the Fed raises the reserve requirement (the fraction of a bank’s demand deposits that it is required to hold in reserve (readily available in case there is a run on the bank), then it has less money to lend out--thus, this action reduces the money supply. More tools on next slide:

The Fed’s Tools continued: 3. Setting the Discount Rate When other banks borrow from the Fed, the interest rate they pay is called the Discount Rate. These other banks tend to borrow less money from the Fed when the Discount Rate is higher--thus, less mony is lent out and circulated into the money supply. 4. Other tools that have sometimes been used: “Moral suasion” (the Fed just tries to talk member banks into either expanding or contracting their loans, sort of like it was the “moral” and responsible thing to do; “Selective credit controls” means that the Fed manages the distribution of credit as opposed to the total volume of credit; and “Margin Credit” requirements on the stock market are also picked by the Fed.

Targeting the Federal Funds Rate The newspapers often say that the “Fed raised (or lowered) the federal funds rate today to.....” In fact, the Fed does not directly control the federal funds rate, instead it targets the federal funds rate. This means that the Fed uses open market operations (buys or sells bonds) until the federal funds rate ends up where the Fed wants it to be. The newspapers usually get the rest correct, they define the “federal funds rate” as the interest rate that banks charge each other on overnight loans (When banks need quick money like this it’s usually keep their reserves sufficient).

How Monetary Policy Tools Work to Affect AD The first step happens in the money market. Consider what an increased money supply looks like in the “money market.”

Notes: 1. Why does money demand slope downward, ie, why do people choose to hold more of their assets in money just because the interest rate is lower (as you move down the curve)? Because they have lower opportunity costs of holding money. 2. What happens to the interest rates (yields) in the bond and other lending markets when the money supply is increased? Answer: As shown on the graph (and in Fig 1 of Ruffin and Gregory), the larger money supply M’ intersects the money demand curve at a lower equilibrium rate of interest.

Put it all together: We assume the following to get the model going: 1. There is a natural level of output in the long run, which we will call y n. The idea is that when GDP is higher than this it is theorized to be unsustainably inflationary. 2. For the short run we have the usual AD and AS curves 3. Monetary and fiscal policy work according to the theories in these past two money chapters and the previous chapters on the Aggregate Expenditure Model as well as the AS and AD Model. Then try some questions “as if you were in charge.”: A. What monetary policy would you choose to cure a Keynesian (demand-led) recession?

B. What monetary policy to cure inflation? (Answer next).

Unfortunately, in practice the money supply growth has been very volatile. (See R&G Fig 6.

Why it is difficult in practice to use monetary policy effectively: 1. Lags (also applies to fiscal policy). a. recognition lag b. effectiveness lag 2. Limitations in the Fed’s ability to get the many banks to voluntarily do what the Fed wants them to do. “You can lead a horse to water but you can’t make him drink.”

Monetarism: It is a doctrine that monetary policy should follow a constant-monetary growth rule. A “constant-monetary-growth rule” fixes the percentage growth of the money supply to a constant rate per year. Milton Friedman is the inventor and most prominent proponent of this policy. Though experts describe there being clear drawbacks as well as advantages to this policy, nearly all agree that Friedman, in the process of his studies has become the world’s expert on the subject of money.

Rational Expectations: Definition: People have rational expectations, for example About future prices, when they make their guesses without Any biases. (A “bias” in estimating is when you error disproportionately Often either on the high side or the low side. Show on blackboard using the AS and AD context.