1. Monetary Policy and the Central Bank
Chapter 23
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2. Learning Objectives
Describe the structure and responsibilities of the Central Banking System
Analyze how changes in the federal funds rate and real interest rate affect planned aggregate expenditure and short-run equilibrium output
Show how the demand for money and the supply of money interact to determine the equilibrium nominal interest rate
Discuss how the central bank uses its ability to control the money supply to influence nominal and real interest rates

3. Fed Watch
Analysts attempt to forecast Fed (the U.S. central bank) decisions about monetary policy
Greenspan briefcase indicator
Central bank decisions have significant effects on financial markets and the macro economy
Monetary policy is a major stabilization tool
Quickly decided and implemented
More flexible and responsive than fiscal policy

4. Central Banks of Selected Economies
Country/Economy
Central Bank
Australia
Reserve Bank of Australia
Canada
Bank of Canada
China
People’s Bank of China
Hong Kong
Hong Kong Monetary Authority
Indonesia
Bank Indonesia
Japan
Bank of Japan
Malaysia
Bank Negara Malaysia
Singapore
Monetary Authority of Singapore
South Korea
Bank of Korea
United Kingdom
Bank of England
United States
Federal Reserve System (Fed)

5. The Central Banking System and the Federal Reserve
Responsibilities of the central bank:
Conduct monetary policy
Oversee and regulate financial markets
Central to solving financial crises
The Federal Reserve System began operations in 1914
Does not attempt to maximize profit
Promotes public goals such as economic growth, low inflation, and smoothly functioning financial markets

6. The Federal Reserve Organization
12 Federal Reserve Bank districts
Assess economic conditions in their region
Provide services to commercial banks in their region
Leadership is provided by the Board of Governors
Seven governors are appointed by the President to 14-year terms
President selects one of the seven as chairman for a four-year term
The Federal Open Market Committee (FOMC) reviews economic conditions and sets monetary policy
12 members who meet eight times a year

7. Stabilizing Financial Markets
Motivation for creating the central bank was to stabilize the financial markets and the economy
Banking panics occurred when customers believe one or more banks might be bankrupt
Depositors rush to withdraw funds
Banks have inadequate reserves to meet demand
Banks close
The central bank prevents bank panics by
Supervising and regulating banks
Loaning banks funds if needed
Fed did not prevent the bank panics of 1930 – 1933

8. Bank Panics, 1930 - 1933 One-third of the banks closed
Increased the severity of the Great Depression
Difficult for small businesses and consumers to get credit
Money supply decreased
With no federal deposit insurance, people held cash
Feared banks would close and they would lose their deposits
Holding cash reduced banks’ reserves
Lower reserves decreased the money supply by a multiple of the change in reserves

9. Currency Held by Public ($B) Reserve – Deposit Ratio
Bank Panics,
Banks increased their reserve – deposit ratio
Further decreased the money supply
Date
Currency Held by Public ($B)
Reserve – Deposit Ratio
Bank Reserves ($B)
Money Supply ($B)
12 / 1929
3.85
0.075
3.15
45.9
12 / 1930
3.79
0.082
3.31
44.1
12 / 1931
4.59
0.092
3.11
37.3
12 / 1932
4.82
0.109
3.18
34.0
12 / 1933
4.85
0.133
3.45
30.8

10. Deposit Insurance U.S. Congress created deposit insurance in 1934
Deposits of less than $100,000 will be repaid even if the bank is bankrupt
Decreases incentive to withdraw funds on rumors
No significant bank panics since 1934
With less risk, depositors pay less attention to whether banks are making prudent investments
In the 1980s, many savings and loan associations went bankrupt
Cost the taxpayers hundreds of billions of dollars

11. The Central Bank and the Economy
Eliminate output gaps by changing the money supply
Changes in money supply cause changes in nominal interest rate
Interest rates affect planned aggregate expenditure, PAE

12. Can the Central Bank Control The Real Interest Rate?
The central bank controls the money supply to control the nominal interest rate, i
Investment and saving decisions are based on the real interest rate, r
The central bank has some control over r
r = i - 
where  is the rate of inflation
The central bank has good control over i
Inflation changes relatively slowly
Changes in nominal rates become changes in real rates

13. Role of the Federal Funds Rate
The federal funds rate is the rate commercial banks in the United States charge each other on short-term (usually overnight) loans
Banks borrow from each other if they have insufficient funds
Market determined rate
Targeted by the Fed
To decrease the federal funds rate the Fed conducts open market purchases
Reserves increase
Interest rates tend to move together

14. The Federal Funds Rate, 1970-2013

15. Planned Spending and Real Interest Rate
Planned aggregate expenditure has components that are affected by r
Saving decisions of households
More saving at higher real interest rates
Higher saving means less consumption
Investment by firms
Higher interest rates mean less investment
Investments are made if the cost of borrowing is less than the return on the investment
Both consumption and planned investment decrease when the interest rate increases

16. Interest in the Keynesian Model – An Example
Components of aggregate spending are
C = (Y – T) – 400 r
IP = 250 – 600 r
G = 300
NX = 20
T = 250
If r increases from 0.04 to 0.05 (that is, from 4% to 5%)
Consumption decreases by 400 (0.01) = 4
Planned investment decreases by 600 (0.01) = 6
A one percentage point increase in r reduces planned spending by 10 – before the multiplier is considered

17. Planned Aggregate Expenditure
PAE = C + IP + G + NX
PAE = (Y – 250) – 400 r – 600 r
PAE = 1,010 – 1,000 r Y
In this example, planned aggregate expenditure depends on both the real interest rate and the level of output
Equilibrium output can only be found once we know the value of r

18. Planned Aggregate Expenditure
PAE = 1,010 – 1,000 r Y
Suppose the real interest rate is 5%, or 0.05
Planned aggregate expenditure becomes
PAE = 1,010 – 1,000 (0.05) Y
PAE = Y
Short-run equilibrium output is PAE = Y
Y = Y
0.2 Y = 960
Y = $4,800
The graphical solution is the same as before

19. Monetary Policy Recessionary Gap r  C, IP  PAE 
Y  via the multiplier
Expansionary Gap
r 
C, IP
PAE 
Y  via the multiplier

20. Monetary Policy for a Recessionary Gap
PAE = 1,010 – 1,000 r Y
The real interest rate, r, is 5%
Short-run equilibrium output is $4,800
Potential output is $5,000
Recessionary gap is $200
Multiplier is 5
Monetary policy can be used to increase PAE
The first change in spending required is 200 / 5 = 40
1,000 (change in r) = 40
Change in r = 40 / 1,000 = 0.04
The central bank should decrease the real interest rate to 1%

21. The Central Bank Fights a Recession
Y = PAE
Expenditure line (r = 1%) F
5,000 Y* E
Expenditure line (r = 5%)
4,800
Planned aggregate expenditure (PAE)
A reduction in r shifts the expenditure line upward and closes the recessionary gap
Output (Y)

22. The Fed’s Response to 9/11 Economy began slowing in late 2000
Terrorist attack led to contraction in travel, financial, and other industries
The federal funds rate is the interest rate banks charge each other for overnight loans
This interest rate is the one the Fed targets when changing the money supply
In late 2000, the fed funds rate was 6.5%
January, 2001, the Fed cut the rate to 6.0%
More rate cuts followed
July, 2001, the rate was less than 4%

23. The Fed Response to 9/11 After the 9/11 attacks
Fed immediately worked to restore normal operation of the financial markets and institutions
The Fed temporarily lowered the rate to 1.25% in the week following the attack
In the aftermath, the Fed grew concerned that consumers would decrease spending
Interest rate was 2.0% in November, 2001
4.5 percentage points lower than a year before
Combination of tax cuts and aggressive monetary policy helped keep the 2001 recession shallow and short

24. The Central Bank Fights Inflation
Expansionary gap can lead to inflation
Planned spending is greater than normal output levels at the established prices
Short-run unplanned decreases in inventories
If gap persists, prices will increase
The central bank attempts to close expansionary gaps
Raise interest rates
Decrease consumption and planned investment
Decrease planned aggregate expenditure
Decrease equilibrium output

25. Monetary Policy for an Expansionary Gap
PAE = 1,010 – 1,000 r Y
The real interest rate, r, is 5%
Short-run equilibrium output is $4,800
Potential output is $4,600
Expansionary gap is $200
Multiplier is 5
Monetary policy can be used to decrease PAE
The first change in spending required is 200 / 5 = 40
1,000 (change in r) = 40
Change in r = 40 / 1,000 = 0.04
The central bank should decrease the real interest rate to 9%

26. The Central Bank Fights Inflation
Y = PAE E
Expenditure line (r = 5%)
4,800
4,600 Y*
Expenditure line (r = 9%) G
Planned aggregate expenditure (PAE)
An increase in r shifts the expenditure line down and closes the expansionary gap
Output (Y)

27. Interest Rates Increased in 2004 and 2005
With slow recovery beginning in November, 2001 in the United States, the Fed continued to decrease interest rates until it reached 1.0% in June 2003
Real GDP growth was nearly 6% in the 2nd half, 2003
Growth was 4.4% in 2004
Unemployment was 5.6% in June 2004
Inflation increased in 2004, mainly due to oil prices
Fed began tightening in June, 2004
Fed funds rate increased from 1.0% to 1.25%
Continued gradually raising the fed funds rate
August, 2005, the rate was 3.5%

28. Inflation and the Stock Market
Bad news about inflation causes stock prices to decrease
Investors anticipate the central bank will increase interest rates
Slows down economic activity, lowering firms' sales and perhaps profits
Lower profits mean lower dividends which mean lower stock prices
Higher interest rates make non-stock financial instruments more attractive
Reduces the demand for stocks and the stock prices

29. Fed and the U.S. Stock Market
Fed gets credit for sustained economic growth and rising asset prices in the 1990s
S&P 500 increased 233% between January 1995, and March 2000
Stocks buoyed consumption; supported growth
Possible stock speculation led to sharp decreases
If the Fed had acted sooner, the run-up would have been curtailed and the crash moderated
Greenspan's response is
Separating speculation from growth is difficult
The Fed could not have timed the stock market

30. Monetary Policy and the Stock Market
The central bank has limited ability to manage the stock market
The central bank does not know the "right" prices
Information available to the central bank is publicly available
Monetary policy is not well suited to addressing an asset bubble (a speculative increase in asset prices over their underlying market value)
The central bank can raise interest rates and slow the economy
Could result in a recession and rising unemployment
The debate over the Fed's role in asset prices got new attention after the mortgage meltdown in the United States in

31. The Central Bank and Interest Rates
In the United States, controlling the money supply is the primary task of the FOMC
Money supply and demand determine the interest rate
The central bank manipulates supply to achieve its desired interest rate
Portfolio allocation decisions allocate a person's wealth among alternative forms
Diversification is owning a variety of different assets to manage risk
The demand for money is the amount of wealth held in the form of money

32. Demand for Money
Demand for money is sometimes called an individual's liquidity preference
The Cost – Benefit Principle indicates people will balance the marginal cost of holding money versus the marginal benefit
Money's benefit is the ability to make transactions
Quantity of money demanded increases with income
Technologies such as online banking and ATMs have reduced the demand for money
M1 in the United States has decreased from 28% of GDP in 1960 to 12% in 2004

33. Demand for Money
The marginal cost of holding money is the interest foregone
Most forms of money pay little or no interest
Assume the nominal interest rate on money is 0
Alternative assets such as stocks or bonds have a positive nominal interest rate
The higher the nominal interest rate, the smaller the quantity of money demanded
Business demand for money is similar to individuals'
Businesses hold more than half of the money stock

34. Demand for Money Demand for money depends on:
Nominal interest rate (i)
The higher the interest rate, the lower the quantity of money demanded
Real income or output (Y)
The higher the level of income, the greater the quantity of money demanded
The price level (P)
The higher the price level, the greater the quantity of money demanded

35. Nominal interest rate (i)
The Money Demand Curve
Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate
The money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal interest rate
An increase in the nominal interest rate increases the opportunity cost of holding money
Negative slope
Money (M)
Nominal interest rate (i) MD

36. Nominal interest rate (i)
The Money Demand Curve
Changes in factors other than the nominal interest rate cause a shift in the money demand curve
An increase in demand for money can result from
An increase in output
Higher price levels
Technological advances
Financial advances
Foreign demand for dollars
MD'
Nominal interest rate (i) MD
Money (M)

37. Demand for Dollars in Argentina
The average Argentine holds more dollars than the average U.S. citizen
In the 1970s and 1980s, Argentina had high rates of inflation
Real returns on assets in pesos declined
Argentines switched to dollars as a store of value
In 1990, the U.S. dollar and Argentine peso traded 1:1
Both were accepted for transactions
By 2001, inflation in Argentina caused the system to break down
Peso was worth less than the dollar

38. International Demand for U.S. Dollars
Political instability in some countries also increases the demand for dollars
Avoids confiscation and taxes
Largest U.S. bill is $100, popular with drug dealers
The Euro is available in €500 bills, worth more than $500
More compact way of storing a given amount of wealth
If drug dealers switch to holding their cash in Euros, the demand for the U.S. dollar will decrease

39. Supply of Money
The central bank primarily controls the supply of money with open-market operations
An open-market purchase of bonds by the central bank increases the money supply
An open-market sale of bonds by the central bank decreases the money supply
Supply of money is vertical
Equilibrium is at E
Money (M) MD E MS M i
Nominal interest rate (i)

40. Equilibrium in the Money Market
Bond prices are inversely related to the interest rate
Suppose the interest rate is at i1, below equilibrium
Quantity of money demanded is M1, more than the money available
To get more money, people sell bonds
Bond prices go down, interest rates rise
Quantity of money demanded decreases from M1 to M MS
Nominal interest rate (i) E i i1 MD M1 M
Money (M)

41. The Central Bank Controls the Nominal Interest Rate
Central bank policy is stated in terms of interest rates
The tool they use is the supply of money
Initial equilibrium at E
The central bank increases the money supply to MS'
New equilibrium at F
Interest rated decrease to i' to convince the market to hold the new, larger amount of money MS M'
MS'
Nominal interest rate (i) E i i' F MD M
Money (M)

42. The Central Bank (CB) Controls the Nominal Interest Rate
CB sells bonds to the public
Supply of bonds increases
Price of bonds decrease
Interest rate increases
To Decrease the Money Supply
To Increase the Money Supply
CB buys bonds from the public
Demand for bonds increases
Price of bonds increase
Interest rate decreases

43. The Central Bank Targets the Interest Rate
The central bank cannot set the interest rate and the money supply independently
Central bank policy is announced in terms of interest rates because
Public is not familiar with the size of the money supply
Interest rate changes affect planned spending and the level of economic activity
Interest rates are easier to monitor than the money supply

44. Federal Funds Rate
The federal funds rate is the interest rate that banks in the United States charge each other for very short-term loans
Closely watched in financial markets
The Fed targets this interest rate because it is closely tied to the level of bank reserves
Changes in the federal funds rate indicate the Fed's plans for monetary policy
Other interest rates could be used to indicate the Fed's intentions

45. Additional Controls over the Money Supply
Open market operations are the main tool of money supply
The central bank offers lending facility to banks, called discount window lending
If a bank needs reserves, it can borrow from the central bank at the discount rate
The discount rate is the rate the central bank charges banks to borrow reserves
Lending increases reserves and ultimately increases the money supply
Changes in the discount rate signal tightening or loosening of the money supply

46. Additional Controls over the Money Supply
The central bank can also change the reserve requirement for banks
The reserve requirement is the minimum percentage of bank deposits that must be held in reserves
The reserve requirement is rarely changed
The central bank could increase the money supply by decreasing the reserve requirement
Banks would have excess reserves to loan
The central bank could decrease the money supply by increasing the reserve requirement

47. Stabilizing the Economy: The Role of the Central Bank
Stock Market
Central Bank
Keynesian Model
Interest Rates: Real, Nominal, Fed Funds
Supply of Money
Monetary Policy
Money Market
Open Market Operations
Stabilization Policy
Discount Rate
Demand for Money
Reserve Requirement