Chapter 17 Domestic and International Dimensions of Monetary Policy

Copyright © 2008 Pearson Addison Wesley. All rights reserved Introduction Why does the Federal Reserve use a federal funds rate target as its primary tool of monetary policy, and what are the implications of its choice? When you have completed this chapter you will be able to answer this question.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives Identify the key factors that influence the quantity of money that people desire to hold Describe how the Federal Reserve’s tools of monetary policy influence market interest rates Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives (cont'd) Understand the equation of exchange and its importance in the quantity theory of money and prices Discuss the interest-rate-based transmission mechanism of monetary policy Explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline What’s So Special About Money? The Tools of Monetary Policy Effects of an Increase in the Money Supply Effects of an Increase in the Money Supply Open Economy Transmission of Monetary Policy Open Economy Transmission of Monetary Policy

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline (cont'd) Monetary Policy and Inflation Monetary Policy in Action: The Transmission Mechanism Monetary Policy in Action: The Transmission Mechanism Fed Target Choice: Interest Rates or Money Supply? Fed Target Choice: Interest Rates or Money Supply? The Way the Fed Policy is Currently Implemented The Way the Fed Policy is Currently Implemented

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That… Bond prices change noticeably during televised congressional hearings featuring testimony by Ben Bernanke, chair of the Fed’s Board of Governors? Fed policymaking, which involves varying the supply of money or the rate at which it grows, has something to do with market interest rates on bonds?

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? Money is the product of a “social contract” in which we all agree to 1. Express all prices in terms of a common unit of account, which in the United States we call the dollar 2. Use a specific medium of exchange for market transactions

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) Something that changes the amount of money in circulation will have some affect on many transactions and thus on elements of GDP.  Something that affects the amount of money in existence is going to affect all markets.

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) Holding money  To use money, one must hold money.  If people desire to hold money, there is a demand for money.

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) The demand for money, what people wish to hold  People have certain motivation that causes them to want to hold money balances.  There is a demand for money by the public, motivated by several factors.  Transactions demand  Precautionary demand  Asset demand

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) Money Balances  Synonymous with money, money stock, and money holdings

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) Transactions Demand  Holding money as a medium of exchange to make payments  The level varies directly with nominal GDP.

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) Precautionary Demand  Holding money to meet unplanned expenditures and emergencies

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) Asset Demand  Holding money as a store of value instead of other assets such as certificates of deposit, corporate bonds, and stocks

Copyright © 2008 Pearson Addison Wesley. All rights reserved What’s So Special About Money? (cont'd) The demand for money curve  Assume the amount of money demanded for transactions purposes is proportionate to income  Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate).

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-1 The Demand for Money Curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Demand for Money Curve Quantity of Money Interest Rate MdMd When the interest rate rises the opportunity cost of holding money increases and the quantity of money demanded falls The location of M d is determined by the level of income Q1Q1 B r2r2 A r1r1 Q2Q2

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy The Fed seeks to alter consumption, investment, and aggregate demand as a whole by altering the rate of growth of the money supply.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy (cont'd) The Fed has three tools at its disposal as part of its policymaking action.  Open market operations  Discount rate changes  Reserve requirement changes

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy (cont'd) Open market operations  Fed purchases and sells government bonds issued by the U.S. Treasury  At first, there is some equilibrium level of interest rate (and bond prices).  An open market operation must cause a change in the price of bonds.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall Figure 17-2 Determining the Price of Bonds, Panel (a)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise Figure 17-2 Determining the Price of Bonds, Panel (b)

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy (cont'd) Relationship between the price of existing bonds and the rate of interest  There is an inverse relationship between the price of existing bonds and the rate of interest. Question  So what happens to the yield on a bond when the price of a bond increases (decreases)?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Bond yield = $50 $1,000 = 5% The Tools of Monetary Policy (cont'd) Example  You pay $1,000 for a bond that pays $50/year in interest.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Bond yield = $50 $500 = 10% The Tools of Monetary Policy (cont'd) Example  Now suppose you pay $500 for the same bond.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy (cont'd) The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy (cont'd) Changes in the difference between the discount rate and the federal funds rate  The discount rate is kept at 1 percentage point above the market-determined federal funds rate.  Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Tools of Monetary Policy (cont'd) Changes in the reserve requirements  An increase (decrease) in the required reserve ratio  Makes it more (less) expensive for banks to meet reserve requirements  Reduces (expands) bank lending

Copyright © 2008 Pearson Addison Wesley. All rights reserved Effects of an Increase in The Money Supply What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter? People pick up the money and put it in their pockets, but how do they dispose of the new money?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Direct effect  Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Indirect effect  Not everybody will necessarily spend the newfound money on goods and services.  Some of the money gets deposited, so banks have higher reserves (and they lend the excess out).

Copyright © 2008 Pearson Addison Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Indirect effect  Banks lower rates to induce borrowing.  Businesses engage in investment.  Individuals consume durable goods (like housing and autos).  Increased loans generate an increase in aggregate demand.  More people are involved in more spending (even those who didn’t get money from the helicopter!).

Copyright © 2008 Pearson Addison Wesley. All rights reserved Graphing the Effects of an Expansionary Monetary Policy Assume the economy is operating at less than full employment  Expansionary monetary policy can close the recessionary gap.  Direct and indirect effects cause the aggregate demand curve to shift outward.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-3 Expansionary Monetary Policy with Underutilized Resources The recessionary gap is due to insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

Copyright © 2008 Pearson Addison Wesley. All rights reserved Graphing the Effects of Contractionary Monetary Policy Assume there is an inflationary gap  Contractionary monetary policy can eliminate this inflationary gap.  Direct and indirect effects cause the aggregate demand curve to shift inward.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The inflationary gap is shown To decrease AD, use contractionary monetary policy AD decreases and real GDP decreases Figure 17-4 Contractionary Monetary Policy with Overutilized Resources

Copyright © 2008 Pearson Addison Wesley. All rights reserved International Policy Example: The People’s Bank of China Learns About the Real Interest Rate In 2003 and 2005 the People’s Bank of China engaged in monetary policy actions that pushed up market interest rates for the first time in nine years. The objective of the interest rate increase was to try to reduce the growth of aggregate demand and thereby prevent higher inflation levels from occurring. The problem was that higher inflation expectations already existed, and so the expected inflation rate rose faster than nominal interest rates.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Open Economy Transmission of Monetary Policy So far we have discussed monetary policy in a closed economy. When we move to an open economy, monetary policy becomes more complex.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Open Economy Transmission of Monetary Policy (cont'd) The net export effect  Impact of contractionary monetary policy  Boosts the market interest rate  Higher rates attract foreign investment  International price of dollar rises  Appreciation of dollar reduces net exports  Negative net export effect

Copyright © 2008 Pearson Addison Wesley. All rights reserved Open Economy Transmission of Monetary Policy (cont'd) The net export effect  Impact of expansionary monetary  Lower interest rates  Financial capital flows out of the United States  Demand for dollars will decrease  International price of dollar goes down  Foreign goods look more expensive in United States  Net exports increase (imports fall)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Open Economy Transmission of Monetary Policy (cont'd) Globalization of international money markets  How will global money markets impact the Fed's ability to control the rate of growth in the money supply?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation Most theories of inflation relate to the short run and the price index in the short run can fluctuate due to  Oil price shocks, labor union strikes In the long run, there is a more stable relationship between growth in the money supply and inflation.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation (cont'd) Simple supply and demand analysis can be used to explain  Why the price level rises when the money supply is increased If the supply of money expands relative to the demand for money  It takes more units of money to purchase given quantities of goods and services (i.e., the price level has risen)

Copyright © 2008 Pearson Addison Wesley. All rights reserved M s V = PY Monetary Policy and Inflation (cont'd) The Equation of Exchange  The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation (cont'd) The equation of exchange and the quantity theory: M S V = PY  M S = actual money balances held by nonbanking public  V = income velocity of money; the number of times, on average per year, each monetary unit is spent on final goods and services

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation (cont'd) Income Velocity of Money  The number of times per year the dollar is spent on final goods and services; equal to the nominal GDP divided by the money supply.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation (cont'd) The equation of exchange and the quantity theory: M S V = PY  P = price level or price index  Y = real GDP per year

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation (cont'd) The equation of exchange as an identity  Total funds spent on final output MsV equals total funds received PY  The value of goods purchased is equal to the value of goods sold  MsV = PY = nominal GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy and Inflation (cont'd) Quantity Theory of Money and Prices  The hypothesis that changes in the money supply lead to equiproportional changes in the price level

Copyright © 2008 Pearson Addison Wesley. All rights reserved M s V = PY Monetary Policy and Inflation (cont'd) The quantity theory of money and prices  Assume:V is constant Y is stable

Copyright © 2008 Pearson Addison Wesley. All rights reserved M s V = PY Monetary Policy and Inflation (cont'd) The quantity theory of money and prices  Increases in M s must be matched by equal increases in the price level

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-5 The Relationship Between Money Supply Growth Rates and Rates of Inflation

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Policy in Action: The Transmission Mechanism Recall we talked about the direct and indirect effects of monetary policy.  Direct effect: implies increase in money supply causes people to have excess money balances.  Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-6 The Interest-Rate-Based Money Transmission Mechanism

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a) At lower rates, a larger quantity of money will be demanded

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (b) The decrease in the interest rate stimulates investment

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c) The increase in investment shifts the AD curve to the right

Copyright © 2008 Pearson Addison Wesley. All rights reserved Fed Target Choice: Interest Rates or Money Supply? It is not possible to stabilize the money supply and interest rates simultaneously. The Fed has often sought to achieve an interest rate target. There is a fundamental tension between targeting interest rates and controlling the money supply.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-8 Choosing a Monetary Policy Target If the Fed selects r e, it must accept M s If the Fed selects M’ s, it must allow the interest rate to fall

Copyright © 2008 Pearson Addison Wesley. All rights reserved Fed Target Choice: Interest Rates or Money Supply? (cont'd) The Fed, in the short run, can select an interest rate or a money supply target but not both.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Fed Target Choice: Interest Rates or Money Supply? (cont'd) Choosing a policy target  Money supply  When variations in private spending occur  Interest rates  When the demand for (or supply of) money is unstable  Interest rate targets are preferred

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Way Fed Policy is Currently Implemented At present the Fed announces an interest rate target. The rate referred to is the federal funds rate of interest. Or, the rate at which banks can borrow excess reserves from each other.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Way Fed Policy is Currently Implemented (cont'd) If the Fed wants to raise “the” interest rate, it engages in contractionary open market operations.  Fed sells more Treasury securities than it buys, thereby reducing the money supply.  This tends to boost “the” rate of interest.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Way Fed Policy is Currently Implemented (cont'd) Conversely, if the Fed wants to decrease “the” rate of interest, it engages in expansionary open market operations.  Fed buys more Treasury securities, increasing the money supply.  This tends to lower “the” rate of interest.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Way Fed Policy is Currently Implemented (cont'd) FOMC Directive  A document that summarizes the Federal Open Market Committee’s general policy strategy  Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Way Fed Policy is Currently Implemented (cont'd) Trading Desk  An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Way Fed Policy is Currently Implemented (cont'd) Taylor Rule  A suggested guideline for monetary policy  An equation determining the Fed’s interest rate target based on  Estimated long-run real interest rate  Deviation of the actual inflation rate from the Fed’s objective  Gap between actual real GDP and a measure of potential GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 17-9 Actual Federal Funds Rates and Values Predicted by a Taylor Rule

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: How the Fed Pursues Monetary Policymaking The Fed conducts open market operations to keep the federal funds rate at a target level called the neutral federal funds rate. At this neutral interest level the growth rate of real GDP tends not to speed up or slow down in relation to its potential, where all the economy’s resources are being fully utilized.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives Key factors that influence the quantity of money that people desire to hold  To make transactions  To hold for precautionary reasons  To hold as an asset (store of value)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) How the Federal Reserve’s monetary policy tools influence market interest rates  Open market purchases, reducing the discount rate, or reducing the required reserve ratio increases the money supply and lowers the interest rate.  Open market sales, raising the discount rate, or increasing the required reserve ratio decreases the money supply and raises the interest rate.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run  Expansionary monetary policy  Pushing up money supply, inducing a fall in interest rates  Total planned expenditures rise, AD shifts rightward  Contractionary monetary policy  Reduces the money supply increasing interest rates  Total planned expenditures fall, AD shifts leftward

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The equation of exchange and the quantity theory of money and prices  Equation of exchange  MV = PY  Quantity theory of money and prices  V is constant and Y is stable  Increases in M lead to equiproportional increases in P

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The interest-rate-based transmission mechanism of monetary policy  Operates through effects of monetary policy actions on market interest rates  Bring about changes in desired investment and thereby affect equilibrium GDP via the multiplier effect

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously  To target the money supply the Fed must permit the interest rate to vary when the demand for money changes.  To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes.

End of Chapter 17 Domestic and International Dimensions of Monetary Policy