1. Maclachlan, Macroeconomics Fall 2004 1 Principles & Policies I: Macroeconomics Chapter 12: Monetary Policy and the Debate about Macro Policy

2. Maclachlan, Macroeconomics Fall 2004 2 Chapter 12 Learning Objectives. You should be able to: Summarize the structure and duties of the Fed. List the three tools of monetary policy and explain how they work. Define the Federal funds rate and discuss how the Fed uses it as an operating target. State the Taylor rule and explain its relevance to monetary policy. Explain how monetary policy works in the AS/AD model. Discuss problems encountered in conducting monetary policy.

3. Maclachlan, Macroeconomics Fall 2004 3 Federal Reserve System Passed through Congress narrowly in December 1913 Regional banks to disperse power and allay fears of monopoly capitalism Lender of last resort (discount loans only) 12 - 7- 12

4. Maclachlan, Macroeconomics Fall 2004 4 Federal Reserve Districts

5. Maclachlan, Macroeconomics Fall 2004 5 Functions of the Fed Banks Member bankers’ bank (keeps deposits and makes loans when reserves are too low) Clear checks Issue new currency and withdraw old Oversee bank mergers Liaison with the business community and collect data Bank examinations Research for input into MP decisions

6. Maclachlan, Macroeconomics Fall 2004 6 Federal Reserve Bank of New York

7. Maclachlan, Macroeconomics Fall 2004 7 Board of Governors 7 members. 14 year non-renewable terms, one opens up every second January. Chairman has 4 year renewable term.

8. Maclachlan, Macroeconomics Fall 2004 8 Federal Open Market Committee 12 members 7 members of Board of Governors + 5 Federal Reserve Bank Presidents (always including the President of the FRBNY) Meets every 6-8 weeks in Washington to determine course of monetary policy

9. Maclachlan, Macroeconomics Fall 2004 9 FOMC Books Green (national forecast) Blue (projected monetary aggregates) Beige (regional banks assessment of economy)

10. Maclachlan, Macroeconomics Fall 2004 10 Fed Funds Rate Rate of interest that banks charge one another for short-term loans. Determined by supply of and demand for reserves Fed adjusts the supply of reserves through open market operations.

11. Maclachlan, Macroeconomics Fall 2004 11 Most Important Tool of Monetary Policy Open market operations: the purchase or sale of Treasury securities by the Fed Sell Treasury securities: contractionary. Buy Treasury securities: expansionary.

12. Maclachlan, Macroeconomics Fall 2004 12 Two Other Tools of Monetary Policy Changing reserve requirements. Changing the discount rate.

13. The Complex Nature of Monetary Policy Fed tools Open market operations Discount rate Reserve requirement Operating target Fed funds Intermediate targets Consumer confidence Stock prices Interest rate spreads Housing starts Ultimate targets Stable prices Sustainable growth Acceptable employment Moderate long-term interest rates McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

14. Maclachlan, Macroeconomics Fall 2004 14 The Taylor Rule The Fed funds rate conforms to this rule: Fed funds rate = 2% + Current inflation + 0.5 X (actual inflation less desired inflation) + 0.5 X (percent deviation of aggregate output from potential)

15. Maclachlan, Macroeconomics Fall 2004 15 Contractionary Monetary Policy The AD curve shifts to the left by a multiple of the shift in investment. Income and output decrease. M  i  I  Y 

16. Maclachlan, Macroeconomics Fall 2004 16 Expansionary Monetary Policy Expansionary monetary policy works in the opposite direction. M  i  I  Y 

17. Maclachlan, Macroeconomics Fall 2004 17 Real output Price level Contractionary Monetary Policy Y1Y1 P1P1 P0P0 Y0Y0 AD 0 Short-run aggregate supply AD 1

18. Maclachlan, Macroeconomics Fall 2004 18 Real output Price level Expansionary Monetary Policy Y1Y1 P0P0 P1P1 Y0Y0 AD 1 Short-run aggregate supply AD 0

19. Maclachlan, Macroeconomics Fall 2004 19 Problems in the Conduct of Monetary Policy –Knowing what policy to use. –Understanding the policy you're using. –Lags in monetary policy. –Liquidity traps –Political pressure. –Conflicting international goals.

20. Maclachlan, Macroeconomics Fall 2004 20 Problem 12-2 The money supply is at 4000 and Fed wants to increase it by 200. The multiplier is 3. No cash holdings. A decrease in the discount rate of 1% leads to an increase in borrowing of 20. -reserve requirement is.333 1. Decrease reserve requirement to.317 to get money supply to 4200 2. Decrease the discount rate by 3.33 to increase borrowing by 3.33x20 = 66.67, to increase money supply by 66.67x3 = 200 3. Fed buys 66.67 worth of Treasury securities to increase reserves by 66.67 and money supply by 66.67x3.

21. Maclachlan, Macroeconomics Fall 2004 21 12.7 a)Inflation is 2 percent, inflation target is 3 percent and output is 2 percent below potential. Fed Funds = 2 + 2 –.5 – 1 = 2.5 b) Inflation is 4 percent, inflation target is 2 percent and output is 3 percent above potential. Fed Funds = 2 +4 + 1 + 1.5 = 8.5 c) Inflation is 4 percent, the inflation target is 3 percent and output is 2 percent below potential. Fed Funds = 2+ 4 +.5 – 1 = 5.5