McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 12 Monetary Policy

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline GOALS, TOOLS AND A MODEL OF MONETARY POLICY CENTRAL BANK INDEPENDENCE MODERN MONETARY POLICY

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 –M3=M2+large CDs

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Tools of Monetary Policy: Targeted Interest Rates The Fed directly controls the Discount Rate (the rate at which the Fed itself loans money to banks). The Fed seeks to influence the Federal Funds Rate (the rate at which banks borrow from one another to meet reserve requirements)

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Tools of Monetary Policy: The Reserve Ratio The Fed directly controls the percentage of deposits that banks must have at their regional Fed bank.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Expansionary Monetary Policy RGDP Interest RatesPrice Level Loanable Funds S AS AD 1 D r S’ r’ AD 2

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Contractionary Monetary Policy Loanable Funds Interest RatesPrice Level RGDP S AS AD 1 D r AD 2 S’ r’

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Fed’s Inflation Fixation 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.