1. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 23 Modern Monetary Policy and the Challenges Facing Central Bankers

2. 23-2 Modern Monetary Policy: The Big Questions 1.What are the various channels of monetary policy transmission? 2.What are the factors that make modern monetary policy so difficult?

3. 23-3 Japan and the U.S. What made the Japanese and U.S. experiences of the last 20 years so different?

4. 23-4 Japan: Growth and Interest Rates

5. 23-5 U.S.: Growth and Interest Rates

6. 23-6 Modern Monetary Policy: Roadmap Monetary Policy Transmission Mechanism Challenges Facing Modern Monetary Policymakers

7. 23-7 The Monetary Policy Transmission Mechanism: Traditional Channels Interest Rates and Exchange Rates the traditional channels of monetary policy transmission aren’t very powerful

8. 23-8 The Monetary Policy Transmission Mechanism: Credit Channels Bank Lending and Balance Sheet Channels By altering the supply of funds to the banking system, policymakers can affect banks' ability and willingness to lend an open market purchase has a direct impact on the supply of loans, increasing their availability to those who depend on banks for financing as interest rates fall, the supply of loans increases

9. 23-9 The Monetary Policy Transmission Mechanism: Asset Price Channels Investment and Wealth a fall in the interest rate –pushes stock prices up –drives the mortgage rate down leading to higher demand for residential housing, driving up the prices of existing homes Higher asset prices mean increased wealth and higher consumption

10. 23-10 The Monetary Policy Transmission Mechanism

11. 23-11 If neighborhoods with high crime rates have more police, does that mean police cause crime? Finding correlations is straightforward Establishing causal relationships is difficult

12. 23-12 Why did Japan’s economy fail to respond to interest rates near zero? One possibility is that the stock market collapse lowered borrower net worth In addition, with borrowers unable to repay, banks had virtually no capital and could not make additional loans.

13. 23-13

14. 23-14 The Challenges Modern Monetary Policymakers Face: Estimating Potential During the late 1990s, people failed to recognize potential output was growing more rapidly than it had earlier. As a result, forecasts of GDP were consistently too low.

15. 23-15 Computing real returns means subtracting inflation from nominal returns In order to evaluation nominal interest rates, wage increase and the like, you need to know the level of inflation

16. 23-16 In the 1970s inflation rose in two big bursts

17. 23-17 One possible explanation is that Fed policymakers failed to realize that growth had slowed.

18. 23-18 The Challenges Modern Monetary Policymakers Face: Deflation Deflation & Zero Nominal Interest Rate Bound: –Nominal interest rates can't fall below zero –This places a restriction on what monetary policymakers can do –The most effective way to expand the monetary base when the overnight interest rate has fallen to zero is to shift to targeting longer-term rates.

19. 23-19 The Challenges Modern Monetary Policymakers Face: Booms and Busts Booms & Busts in Equity & Property Prices Bubbles that inflate and then burst are particularly damaging, because the wealth effects they create cause consumption to explode and then contract just as rapidly.

20. 23-20 The Nasdaq Bubble

21. 23-21 The Challenges Modern Monetary Policymakers Face Evolving Financial Structure changes in financial structure will change the impact of monetary policy.

22. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 23 End of Chapter