1. Contents 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
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2. JOHN KENNETH GALBRAITH29
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

3. Contents (continued) 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
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4. Money and Income: The Important Difference
Stock variables are measured at a moment in time.
Flow variables are measured over time.

5. 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.

6. 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

7. America’s Central Bank: The Federal Reserve System
Central Bank Independence
Fed board members:
Appointed to fourteen-year terms
Independent of political pressures

8. America’s Central Bank: The Federal Reserve System
Central Bank Independence
In some other countries, the central banks are less independent.
Countries without independent central banks often have less stable economies.

9. Implementing Monetary Policy
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.

10. TABLE 29-1 Effects of an Open-Market Purchase of Securities
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11. 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

12. FIGURE 29-1 Open-Market Sales and Bond PricesS 1 D P A
Price of a Bond P B 1
Quantity of Bonds
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13. Other Methods of Monetary Control
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

14. Other Methods of Monetary Control
Lending to Banks
 discount rate 
 Borrowing by member banks 
 Reserves 
 Money supply
Opposite if Fed raises discount rate

15. TABLE 29-2 Balance Sheet Changes, Borrowing from Fed
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16. Other Methods of Monetary Control
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.

17. Supply-Demand Analysis of the Money Market
 Interest rates 
 Profit opportunities for banks
 Excess reserves
 Volume of loans

18. Supply-Demand Analysis of the Money Market
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

19. FIGURE 29-2 (a) The Supply Schedule for Money7 M S 5
Interest Rate 3 1
800
820
830
850
Money Supply
(a)
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20. FIGURE 29-2 (b, c) The Supply Schedule for Money7 7 M S M 1 S M 2 S M S 5 5
Interest Rate 3
Interest Rate 3 1 1
800
850
800
850
Money Supply
Expansionary Policy Change
(b)
Money Supply
Contractionary Policy Change
(c)
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21. 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

22. Supply-Demand Analysis of the Money Market
The Demand for Money
Money is demanded for transactions.
 nominal GDP 
 Spending
 Demand for money

23. 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

24. FIGURE 29-3 (a) The Demand Schedule for Money
Interest Rate
Quantity of
Money Demanded
(a)
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25. FIGURE 29-3 (b, c) The Demand Schedule for Money1 D D M M D D 2 M
Interest Rate
Interest Rate
Quantity of
Money Demanded
Higher Y or P
(b)
Quantity of
Money Demanded
Lower Y or P
(c)
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26. 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.

27. FIGURE 29-4 Equilibrium in the Money Market8 D M M S 7
For given Fed policy 6 E 5
Interest Rate 4 3
For given Y
and P 2 1
800
830
850
Money Stock
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28. FIGURE 29-5 Effects of Monetary Policy on the Money MarketD M M S D M M 2 S M S M 1 S B E
Interest Rate
Interest Rate E A
Money Stock
(a)
Money Stock
(b)
Expansionary Monetary Policy
Contractionary Monetary Policy
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29. How Monetary Policy Works
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)

30. How Monetary Policy Works
Investment and Interest Rates
 interest rates   investment spending
 investment  multiplier effect
Lowers GDP
 interest rates  opposite

31. FIGURE 29-6 Effect of Interest Rates on Total Expenditure45 C + I G ( X – M )
(lower interest rate) C + I G ( X – M )
Real Expenditure C + I G ( X – M )
(higher interest rate)
Real GDP
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32. How Monetary Policy Works
Monetary Policy and Total Expenditure
Fed actions 
 money supply
 interest rates
 interest rate   investment
 investment   AD
 AD   GDP

33. FIGURE 29-7 Expansionary Policy on Money Supply & Interest RateM S 1 M M D 5 E
Interest Rate 3 E 1 1
800
830
850
880
900
Money Stock
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34. How Monetary Policy Affects GDP1 2 3 4
Federal Reserve
Policy
M and r I
C + I + G + (X - IM)
GDP
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35. FIGURE 29-8 Expansionary Policy on Total Expenditure45 C + I 1 G ( X – M ) E 1 C + I G ( X – M )
$200 billion
Real Expenditure E
5,500
6,000
6,500
7,000
Real GDP
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36. Money and the Price Level in the Keynesian Model
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

37. FIGURE 29-9 The Inflationary Effects of Expansionary PolicyD D 1 S
$500 billion B
103
Price Level E
100
6,000
6,400
Real GDP
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38. 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.

39. Effect of Monetary Policy on Output and Prices1 2 3 4
Federal Reserve
Policy
M and r I
C + I + G + (X - IM)
Y and P
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40. Money and the Price Level in the Keynesian Model
Application: Why the AD Curve Slopes Downward
 price level 
 money demand
 interest rates
 investment

41. 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

42. 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.