1. 13 Managing Aggregate Demand: Monetary Policy 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 Managing Aggregate Demand: Monetary Policy 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

2. ●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 ●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 Contents Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

3. ●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 ●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 Contents (continued) Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

4. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Stock variables are measured at a moment in time. ●Flow variables are measured over time. ●Stock variables are measured at a moment in time. ●Flow variables are measured over time. Money and Income: The Important Difference

5. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 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. ●Money is a stock, income a flow. ♦Stock of money influences the rate at which people earn income. ♦Money affects GDP.

6. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 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 ●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. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. America’s Central Bank: The Federal Reserve System ●Central Bank Independence ♦Fed board members: ■Appointed to fourteen-year terms ■Independent of political pressures ●Central Bank Independence ♦Fed board members: ■Appointed to fourteen-year terms ■Independent of political pressures

8. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Central Bank Independence ♦In some other countries, the central banks are less independent. ♦Countries without independent central banks often have less stable economies. ●Central Bank Independence ♦In some other countries, the central banks are less independent. ♦Countries without independent central banks often have less stable economies. America’s Central Bank: The Federal Reserve System

9. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Implementing Monetary Policy ●Market for Reserves ♦Supply of reserves controlled by the Fed ♦Demand for reserves depends on banks’ need for reserves ■Required reserves = m x D ■Dollar value of transactions = P x Y

10. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Implementing Monetary Policy ●Market for Reserves ♦Federal funds rate = interest rate banks charge each other for interbank loans ■Banks with excess reserves can loan out funds to other banks and charge the federal funds rate ■Banks with a shortage of reserves can borrow funds from other banks and pay the federal funds rate

11. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 1: The Market for Bank Reserves

12. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Implementing Monetary Policy ●Market for Reserves ♦Downward sloping demand: ■↑ federal funds rate →↑ cost of reserves→↓quantity of reserves demanded ♦Upward sloping supply: ■↑ federal funds rate →↑ interest earned from interbank loans →↑quantity of reserves supplied ♦Equilibrium: Quantity of reserves demanded = Quantity of reserves supplied:

13. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Mechanics of an Open-Market Operation ♦The Fed affect the interest rate by buying government securities on the open market. ■It pays for these securities by creating new bank reserves. ■These additional reserves  lower interest rate ♦To increase the interest rate, the Fed sells securities. ●Mechanics of an Open-Market Operation ♦The Fed affect the interest rate by buying government securities on the open market. ■It pays for these securities by creating new bank reserves. ■These additional reserves  lower interest rate ♦To increase the interest rate, the Fed sells securities. Implementing Monetary Policy

14. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 2: Effects of an Open- Market Purchase

15. TABLE 1: Effects of an Open- Market Purchase of Securities Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

16. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Implementing Monetary Policy ●Mechanics of an Open-Market Operation ●When the Fed buys bonds: ♦  supply of reserves  ♦  federal funds rate  ♦  quantity of reserves  ♦ deposit creation ●Opposite when Fed sell bonds

17. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 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

18. FIGURE 3: Open-Market Purchases and T-Bill Prices Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Quantity of Treasury Bills P 0 P 1 S 0 S 0 S 1 S 1 D D A B Price of a Treasury Bill

19. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●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 ●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 Other Methods of Monetary Control

20. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Lending to Banks ♦  discount rate  ■  Borrowing by member banks  ■  Reserves  ■  Money supply ♦Opposite if Fed raises discount rate ●Lending to Banks ♦  discount rate  ■  Borrowing by member banks  ■  Reserves  ■  Money supply ♦Opposite if Fed raises discount rate Other Methods of Monetary Control

21. TABLE 2: Balance Sheet Changes, Borrowing from Fed Copyright © 2006 South-Western/Thomson Publishing. All rights reserved.

22. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●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. ●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. Other Methods of Monetary Control

23. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●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) ●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) How Monetary Policy Works

24. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Investment and Interest Rates ♦  interest rates   investment spending ♦  investment  multiplier effect ■Lowers GDP ♦  interest rates  opposite ●Investment and Interest Rates ♦  interest rates   investment spending ♦  investment  multiplier effect ■Lowers GDP ♦  interest rates  opposite How Monetary Policy Works

25. FIGURE 5: Effect of Interest Rates on Total Expenditure Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. C+ I+ G+ (X– IM) 45  Real GDP Real Expenditure C+ I+ G+ (X– IM) (higher interest rate) C+ I+ G+ (X– IM) (lower interest rate)

26. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. How Monetary Policy Works ●Monetary Policy and Total Expenditure ♦Fed actions  ■  money supply ■  interest rates ♦  interest rate   investment ♦  investment   AD ♦  AD   GDP ●Monetary Policy and Total Expenditure ♦Fed actions  ■  money supply ■  interest rates ♦  interest rate   investment ♦  investment   AD ♦  AD   GDP

27. How Monetary Policy Affects GDP Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Federal Reserve Policy 1 M and r 2 I 3 C + I + G + (X - IM) 4 GDP

28. FIGURE 6: Expansionary Policy on Total Expenditure Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. $200 billion 7,0006,5006,000 45  5,500 C+ I 0 + G+ (X– IM) Real Expenditure Real GDP E 0 C+ I 1 + G+ (X– IM) E 1

29. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●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 ●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 Money and the Price Level in the Keynesian Model

30. FIGURE 7: The Inflationary Effects of Expansionary Policy Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. $500 billion 103 6,400 S S D 0 D 0 6,000 100 Real GDP Price Level E D 1 D 1 B

31. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 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. ●Fed policy  ♦M & r ♦AD ♦Y & P ●Both output and prices are normally affected by monetary policy.

32. Effect of Monetary Policy on Output and Prices Copyright © 2006 South-Western/Thomson Publishing. All rights reserved. Federal Reserve Policy 1 M and r 2 I 3 C + I + G + (X - IM) 4 Y and P

33. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Money and the Price Level in the Keynesian Model ●Application: Why the AD Curve Slopes Downward ♦  price level  ■  money demand ■  interest rates ■  investment ●Application: Why the AD Curve Slopes Downward ♦  price level  ■  money demand ■  interest rates ■  investment

34. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 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 ●Application: Why the AD Curve Slopes Downward ♦  investment  negative multiplier effect on GDP ♦Thus  price level   GDP

35. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 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. ●We have done all the theory that is needed. ●The next three chapters of the text turn to policy debates.