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 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

●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 ●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 Contents Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

●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 ●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 Contents (continued) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Stock variables are measured at a moment in time. ●Flow variables are measured over time. ●Stock variables are measured at a moment in time. ●Flow variables are measured over time. Money and Income: The Important Difference

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 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. ●Money is a stock, income a flow. ♦Stock of money influences the rate at which people earn income. ♦Money affects GDP.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 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 ●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

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. America’s Central Bank: The Federal Reserve System ●Central Bank Independence ♦Fed board members: ■Appointed to fourteen-year terms ■Independent of political pressures ●Central Bank Independence ♦Fed board members: ■Appointed to fourteen-year terms ■Independent of political pressures

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Central Bank Independence ♦In some other countries, the central banks are less independent. ♦Countries without independent central banks often have less stable economies. ●Central Bank Independence ♦In some other countries, the central banks are less independent. ♦Countries without independent central banks often have less stable economies. America’s Central Bank: The Federal Reserve System

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●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. ●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. Implementing Monetary Policy

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

Copyright© 2003 South-Western/Thomson Learning. 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 Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Quantity of Bonds P 1 P 0 S 0 S 0 S 1 S 1 D D B A Price of a Bond

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●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 ●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

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Lending to Banks ♦  discount rate  ■  Borrowing by member banks  ■  Reserves  ■  Money supply ♦Opposite if Fed raises discount rate ●Lending to Banks ♦  discount rate  ■  Borrowing by member banks  ■  Reserves  ■  Money supply ♦Opposite if Fed raises discount rate Other Methods of Monetary Control

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

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●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. ●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. Other Methods of Monetary Control

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Supply-Demand Analysis of the Money Market ●  Interest rates  ♦  Profit opportunities for banks ♦  Excess reserves ♦  Volume of loans ●  Interest rates  ♦  Profit opportunities for banks ♦  Excess reserves ♦  Volume of loans

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●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 ●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 Supply-Demand Analysis of the Money Market

FIGURE 29-2 (a) The Supply Schedule for Money Copyright © 2003 South-Western/Thomson Publishing. All rights reserved Money Supply (a) M S Interest Rate

FIGURE 29-2 (b, c) The Supply Schedule for Money Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. M 0 S Money Supply Contractionary Policy Change (c) Interest Rate Money Supply Expansionary Policy Change (b) Interest Rate M 2 S 2 M 1 S 1 M 0 S 0

Copyright© 2003 South-Western/Thomson Learning. 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 ●The Money Supply Mechanism ♦Money supply curve: slightly positive slope ♦Indicates a weak sensitivity to changes in the interest rate

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●The Demand for Money ♦Money is demanded for transactions. ♦  nominal GDP  ■  Spending ■  Demand for money ●The Demand for Money ♦Money is demanded for transactions. ♦  nominal GDP  ■  Spending ■  Demand for money Supply-Demand Analysis of the Money Market

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 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 ●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 Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. M D Interest Rate Quantity of Money Demanded (a)

FIGURE 29-3 (b, c) The Demand Schedule for Money Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. D 0 M 0 M 0 D 0 Interest Rate Quantity of Money Demanded LowerY orP (c) Quantity of Money Demanded HigherY orP (b) D 2 M 2 M 1 D 1

Copyright© 2003 South-Western/Thomson Learning. 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. ●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 Copyright © 2003 South-Western/Thomson Publishing. All rights reserved D M Money Stock M S Interest Rate For given Y andP For given Fed policy E

FIGURE 29-5 Effects of Monetary Policy on the Money Market Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Contractionary Monetary PolicyExpansionary Monetary Policy Money Stock (b) Interest Rate M 0 S 0 Money Stock (a) Interest Rate M 0 S 0 D M D M M 1 S 1 M 2 S 2 E A E B

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●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) ●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

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●Investment and Interest Rates ♦  interest rates   investment spending ♦  investment  multiplier effect ■Lowers GDP ♦  interest rates  opposite ●Investment and Interest Rates ♦  interest rates   investment spending ♦  investment  multiplier effect ■Lowers GDP ♦  interest rates  opposite How Monetary Policy Works

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

Copyright© 2003 South-Western/Thomson Learning. 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 ●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 Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. M D S 0 M Money Stock Interest Rate E 0 S 1 M 1 E 1

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

FIGURE 29-8 Expansionary Policy on Total Expenditure Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. $200 billion 7,0006,5006,  5,500 C+ I 0 + G+ (X– IM) Real Expenditure Real GDP E 0 C+ I 1 + G+ (X– IM) E 1

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ●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 ●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 Money and the Price Level in the Keynesian Model

FIGURE 29-9 The Inflationary Effects of Expansionary Policy Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. $500 billion 103 6,400 S S D 0 D 0 6, Real GDP Price Level E D 1 D 1 B

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

Copyright© 2003 South-Western/Thomson Learning. 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 ●Application: Why the AD Curve Slopes Downward ♦  price level  ■  money demand ■  interest rates ■  investment

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 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 ●Application: Why the AD Curve Slopes Downward ♦  investment  negative multiplier effect on GDP ♦Thus  price level   GDP

Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 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. ●We have done all the theory that is needed. ●The next three chapters of the text turn to policy debates.