1. CHAPTER 15 Monetary Policy
ECONOMICS 5e
Michael Parkin
CHAPTER 15 Monetary Policy
Chapter 32 in Economics 1

2. Learning Objectives
Describe the structure of the Federal Reserve System (the Fed)
Describe the tools used by the Fed to conduct its monetary policy
Explain what an open market operation is and how it works 2

3. Learning Objectives (cont.)
Explain how an open market operation changes the money supply
Explain what determines the demand for money 3

4. Learning Objectives (cont.)
Explain how the Fed influences interest rates
Explain how interest rates influence the economy 4

5. Learning Objectives
Describe the structure of the Federal Reserve System (the Fed)
Describe the tools used by the Fed to conduct its monetary policy
Explain what an open market operation is and how it works 5

6. The Federal Reserve System
The Federal Reserve System serves as the central bank for the United States.
A central bank is a bank’s bank and a public authority that regulates a nation’s financial institutions and markets. 6

7. The Federal Reserve System
Monetary policy is conducted by the Fed.
Monetary policy is the adjustment of the quantity of money in circulation to achieve specific economic goals. 7

8. The Federal Reserve System
These goals include:
1) Keeping inflation in check.
2) Maintaining full employment.
3) Moderating the business cycle.
4) Contributing toward achieving long-term growth. 8

9. The Federal Reserve System
The Structure of the Federal Reserve System
The primary elements in the Federal Reserve System are:
1) The Board of Governors
2) The Regional Federal Reserve Banks
3) The Federal Open Market Committee 9

10. The Federal Reserve System
The Board of Governors
Seven members
Appointed by the President
Confirmed by the Senate
Serve 14-year term 10

11. The Federal Reserve System
The Board of Governors (cont.)
Terms are staggered so that one comes vacant every two years
President appoints a member as Chairman to serve a four-year term 11

12. The Federal Reserve System
The Federal Reserve Banks
12 District banks
Nine directors
Three are appointed by the Board of Governors
Six are elected by the commercial banks in the district
The directors appoint the district president which is approved by the Board of Governors 12

13. The Federal Reserve System
The Federal Reserve Banks
The New York Fed implements some of the Fed’s most important policy decisions. 13

14. The Federal Reserve System
Instructor Notes:
1) The nation is divided into 12 Federal Reserve districts, each having a Federal Reserve bank. (Some of the larger districts also have branch banks.)
2) The Board of Governors of the Federal Reserve System is located in Washington, D.C. 14

15. The Federal Reserve System
The Federal Open Market Committee (FOMC)
Serves as the main policy-making organ of the Federal Reserve System
Meets approximately every six weeks to review the economy 15

16. The Federal Reserve System
The Federal Open Market Committee (FOMC)
Made up of the following voting members:
The chairman and the other six members of the Board of Governors
The president of the Federal Reserve Bank of New York
The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis) 16

17. The Federal Reserve System
The Fed’s Power Center
The chairman of the Board of Governors has the largest influence on the Fed’s monetary policy actions.
Paul Volcker
Alan Greenspan 17

18. The Federal Reserve System
The Fed’s Power Center (cont.)
The chairman’s power and influence stem from:
First, the chairman controls the agenda and dominates the meetings of the FOMC.
Secondly, contact with a staff of economists and other experts provides the chairman with detailed briefings on monetary policy issues. 18

19. The Federal Reserve System
The Fed’s Power Center (cont.)
The chairman’s power and influence stem from:
Lastly, the chairman is the Fed’s spokesperson and the point of contact with the President and government and with foreign central banks and governments. 20

20. Learning Objectives
Describe the structure of the Federal Reserve System (the Fed)
Describe the tools used by the Fed to conduct its monetary policy
Explain what an open market operation is and how it works 21

21. The Federal Reserve System
The Fed’s Policy Tools
The Fed controls the money supply by adjusting the reserves of the banking system.
The Fed has three main tools it uses to achieve this objective. 22

22. The Federal Reserve System
The Fed’s Policy Tools
The three main policy tools are:
1) Required reserve ratios
2) Discount rate
3) Open market operations 23

23. The Federal Reserve System
Required Reserve Ratios
The Fed determines a required reserve ratio for each type of deposit.
In 1997, banks were required to keep 3 percent of checking deposits up to $49 million and 10 percent of deposits in excess of $49 million.
Other deposits had no reserve requirement. 24

24. The Federal Reserve System
Discount Rate
The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks. 25

25. The Federal Reserve System
Open Market Operations
Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market. 26

26. The Structure of the Fed
Instructor Notes:
1) The Board of Governors sets required reserve ratios and, on the proposal of the 12 Federal Reserve banks, sets the discount rate.
2) The Board of Governors and presidents of the regional Federal Reserve banks sit on the FOMC to determine open market operations 27

27. The Federal Reserve System
The Fed’s Balance Sheet
The Fed’s three main assets are:
1) Gold and foreign exchange
2) U.S. government securities
3) Loans to banks 28

28. The Federal Reserve System
The Fed’s Balance Sheet
The Fed’s two main liabilities are:
1) Federal Reserve notes in circulation
Nonconvertible notes or “fiat money”
Federal reserve notes are backed by the Fed’s holdings of U.S. government securities
2) Bank’s deposits 29

29. The Federal Reserve System
The Fed’s Balance Sheet
The Fed’s liabilities along with the coins in circulation make up the monetary base.
Note: Coins are issued by the Treasury and not liabilities of the Fed.
The monetary base serves as the base for the nation’s money supply. 30

30. The Fed’s Balance Sheet, December 1996
Assets Liabilities
(billions of dollars) (billions of dollars)
Gold and foreign exchange 21 Federal Reserve notes 427
U.S. government securities 460 Bank’s deposits 25
Loans to banks 0 Other liabilities (net) 29
Total assets 481 Total liabilities (net) 481 31

31. Learning Objectives
Describe the structure of the Federal Reserve System (the Fed)
Describe the tools used by the Fed to conduct its monetary policy
Explain what an open market operation is and how it works 32

32. Controlling the Money Supply
How Required Reserve Ratios Work
When the Fed increases the required reserve ratio:
Banks must hold more reserves.
To increase reserves, banks must decrease lending.
The decrease in lending decreases the quantity of money. 33

33. Controlling the Money Supply
How Required Reserve Ratios Work
When the Fed decreases the required reserve ratio:
Banks may hold less reserves.
As a result of the decrease in reserves, banks increase lending.
The increase in lending increases the quantity of money. 34

34. Controlling the Money Supply
How the Discount Rate Works
When the Fed increases the discount rate:
Banks must pay a higher price for any reserves that they borrow from the Fed.
Banks try to get by with smaller reserves.
But given the required reserve ratio, banks must decrease their lending.
This decreases the quantity of money. 35

35. Controlling the Money Supply
How the Discount Rate Works
When the Fed decreases the discount rate:
Banks pay a lower price for any reserves that they borrow from the Fed.
Banks are willing to borrow more reserves and increase their lending.
This increases the quantity of money. 36

36. Controlling the Money Supply
How an Open Market Operation Works
When the Fed buys securities in an open market operation:
The monetary base increases.
Banks increase their lending.
The quantity of money increases. 37

37. Controlling the Money Supply
How an Open Market Operation Works
When the Fed sells securities in an open market operation:
The monetary base decreases.
Banks decrease their lending.
The quantity of money decreases.
Open market operations are used more often than the other two options. 38

38. Controlling the Money Supply
The Fed Buys Securities
The Fed can buy securities from either:
A commercial bank
The public 39

39. Learning Objectives (cont.)
Explain how an open market operation changes the money supply
Explain what determines the demand for money 40

40. Controlling the Money Supply
Two things occur when the Fed buys $100 million of securities from a Manhattan Commercial Bank:
1) The bank has $100 million less securities, and the Fed has $100 million more securities. 41

41. Controlling the Money Supply
Two things occur when the Fed buys $100 million of securities from a Manhattan Commercial Bank:
2) The Fed pays for the securities by crediting the bank’s deposit account at the Fed with $100 million. 42

42. The Fed Buys Securities in the Open Market
(a) The Fed buys securities from a commercial bank

43. Reserves +$100
The Federal Reserve Bank of New York
(a) The Fed buys securities from a commercial bank
Assets
Liabilities
Securities +$100
Reserves of
Manhattan
Commercial
Bank
The Fed buys
securities from
a commercial
bank ...
The Manhattan Commercial Bank
Securities -$100
… and pays for the securities by increasing
the reserves of the commercial bank.
+$100

44. Controlling the Money Supply
Three things occur when the Fed buys $100 million of securities from the Goldman Sachs:
1) Goldman Sachs has $100 million less securities, and the Fed has $100 million more securities. 44

45. Controlling the Money Supply
Three things occur when the Fed buys $100 million of securities from the Goldman Sachs:
2) The Fed pays for the securities with a check for $100 million drawn on itself, which Goldman Sachs deposits in its account at the Manhattan Commercial Bank. 45

46. Controlling the Money Supply
Three things occur when the Fed buys $100 million of securities from the Goldman Sachs:
3) The Manhattan Commercial Bank collects payment of this check from the Fed, and $100 million is deposited in Manhattan’s deposit account at the Fed. 46

47. (b) The Fed buys securities from the public
The Fed Buys Securities in the Open Market
(b) The Fed buys securities from the public

48. (b) The Fed buys securities from the public
The Federal Reserve Bank of New York
Assets
Liabilities
Securities +$100
Reserves of
Manhattan
Commercial
Bank
The Fed buys securities
Goldman Sachs, a member
of the general public ...
+$100
Goldman Sachs
Assets
Liabilities
Securities -$100
… and pays for the securities by
writing a check that is deposited
to Goldman Sachs’s account and
that increases the reserves of the
commercial banks.
Deposits at
Manhattan
Commercial Bank
+$100
The Manhattan Commercial Bank
Assets
Liabilities
Reserves +$100
Goldman Sach’s Deposit
+$100

49. Controlling the Money Supply
When the Fed sells securities, the events are the reverse of what was just presented. 48

50. Controlling the Money Supply
The effects of an open market operation are far reaching:
Banks are able to make more loans, which increases the quantity of money (multiplier effect).
It changes interest rates.
It changes aggregate expenditure and real GDP. 49

51. Controlling the Money Supply
Monetary Base and Bank Reserves
The money multiplier is the amount by which a change in the monetary base is multiplied to determine the resulting change in the quantity of money.
It differs from the deposit multiplier. 50

52. Controlling the Money Supply
Monetary Base and Bank Reserves
A currency drain is an increase in currency held outside the banks.
This reduces the amount of additional money that can be created. 51

53. Controlling the Money Supply
The Multiplier Effect of an Open Market Operation
If the Fed purchases securities from banks a series of events occur. 52

54. Controlling the Money Supply
The purchase of securities from a bank leads to:
1) An increase in the bank’s reserves (no change in the quantity of money).
2) Banks lend excess reserves.
3) New deposits are used to make payments. 53

55. Controlling the Money Supply
The purchase of securities from a bank leads to:
4) The money supply increases.
5) Some of the new money is held as currency — a currency drain.
6) Some of the new money remains on deposit in banks. 54

56. Controlling the Money Supply
The purchase of securities from a bank leads to:
7) Banks’ required reserves increase.
8) Excess reserves decrease, but remain positive. 55

57. A Round in the Multiplier Process Following an Open Market Operation
Instructor Notes:
1) An open market purchase increases bank reserves and creates excess reserves.
2) Banks lend the excess reserves, and new loans are used to make payments.
3) Households and firms receiving payments keep some of the receipts in the form of currency--a currency drain--and place the rest on deposit in banks.
4) The increase in bank deposits increases banks’ reserves but also increases banks’ required reserves.
5) Required reserves increase by less than actual reserves, so the banks still have some excess reserves, though less than before.
6) The process repeats until excess reserves have been eliminated. 56

58. The Multiplier Effect of an Open Market Operation
The Sequence
The Running Tally
Reserves
Deposits
Currency
Money
Open Market Operation
$100,000
$66,667
$33,333
Loan
$100,000
Instructor Notes:
With additional deposits, required reserves increase by $6,667 (10 percent required reserve ratio) and the banks lend $60,000.
Currency
$33,333
Deposit
$66,667
$100,000
Reserve
$6,667
Loan
$60,000 61

59. The Multiplier Effect of an Open Market Operation
The Sequence
The Running Tally
Reserves
Deposits
Currency
Money
Currency
$20,000
Deposit
$40,000
$6,667
$106,667
$53,333
$160,000
$10,667
$130,667
$65,333
$196,000
Reserve
$4,000
Loan
$36,000
Instructor Notes:
An additional $100,000 of reserves creates $250,000 of money.
Currency
$12,000
Deposit
$24,000
$16,667
$166,667
$83,333
$250,000
and so
on... 65

60. Learning Objectives (cont.)
Explain how an open market operation changes the money supply
Explain what determines the demand for money 66

61. The Demand for Money The Influences on Money Holding
The quantity of money people hold depends on:
1) The price level
2) The interest rate
3) Real GDP
4) Financial innovation 67

62. The Demand for Money The Price Level
Nominal money is the quantity of money measured in dollars.
The quantity of nominal money demanded is proportional to the price level.
Real money is the quantity of money measured in constant dollars.
The quantity of real money demanded is independent of the price level. 68

63. The Demand for Money The Interest Rate
The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money. 69

64. The Demand for Money Real GDP
Money holdings depend upon planned spending.
The quantity of money demanded in the economy as a whole depends on Real GDP. 70

65. The Demand for Money Financial Innovation
Changing technologies affect the quantity of money held. These include:
Daily interest checking deposits
Automatic transfers between checking and savings deposits
Automatic teller machines
Credit cards 71

66. The Demand for Money The Demand for Money Curve
The demand for money is the relationship between the quantity of real money demanded and the interest rate. 72

67. The Demand for Money
Effect of an
increase in
the interest
rate MD 6 5
Interest rate (percent per year)
Effect of an
increase in
the interest
rate
Instructor Notes:
1) The interest rate is the opportunity cost of holding money.
2) A change in the interest rate brings a movement along the demand curve. 4
2.9
3.0
3.1
Real money (trillions of 1992 dollars) 75

68. The Demand for Money Shifts in the Demand Curve for Real Money
Changes in real GDP or financial innovation changes the demand for money and shifts the demand curve for real money. 76

69. Changes in the Demand for Money
MD2 6
Effect of increase
in real GDP
MD1 5
Effect of decrease in
real GDP or financial
innovation
Interest rate (percent per year)
Instructor Notes:
1) An increase in real GDP increases the demand for money and shifts the demand curve rightward from MD0 to MD2.
2) Financial innovation generally decreases the demand for money. 4
MD0
2.9
3.0
3.1
Real money (trillions of 1992 dollars) 79

70. The Demand for Money in the United States
Instructor Notes:
1) The dots show the quantity of real money and the interest rate in each year between 1970 and 1996.
2) In 1970, the demand for M1 was MD70.
3) The demand for M1 decreased during the early 1970s because f financial innovation, and the demand curve shifted leftward to MD76.
4) But the demand for M1 has increased because of real GDP growth, and by 1994, the demand curve had shifted rightward to MD94.
5) Further financial innovation decreased the demand for M1 in 1995 and 1996 and shifted the demand curve leftward again to MD96. 80

71. The Demand for Money in the United States
Instructor Notes:
1) In 1970, the demand for M2 curve was MD70.
2) The growth of real GDP increased the demand for M2, and by 1989, the demand curve had shifted rightward to MD89.
3) During the 1990s, new substitutes for M2 decreased the demand for M2 and the demand curve shifted leftward to MD96. 81

72. Learning Objectives (cont.)
Explain How the Fed influences interest rates
Explain how interest rates influence the economy 82

73. Interest Rate Determination
A percentage yield on a financial security is the interest rate.
The higher the price of a financial security, other things remaining the same, the lower is the interest rate.
We will focus on the market for money, since the Fed can influence the supply of money. 83

74. Interest Rate Determination
Money Market Equilibrium
The interest rate is determined by the supply of and demand for money.
At any given moment in time, the quantity of real money supplied is a fixed amount. 84

75. Money Market EquilibriumMS MD 6
Excess supply of
money. People buy
bonds and interest
rate falls
Interest rate (percent per year) 5
Excess demand for
money. People sell
bonds and interest
rate rises
Instructor Notes:
1) Money market equilibrium occurs when the interest rate has adjusted to make the quantity of money demanded equal to the quantity supplied.
2) Here, equilibrium occurs at an interest rate of 5 percent.
3) At interest rates above 5 percent, the quantity of money demanded is less than the quantity supplied, so people buy bonds, and the interest rate falls.
4) At interest rates below 5 percent, the quantity of real money demanded exceeds the quantity supplied, so people sell bonds and the interest rate rises.
5) Only at 5 percent is the quantity of real money in existence willingly held. 4
2.9
3.0
3.1
Real money (trillions of 1992 dollars) 88

76. Learning Objectives (cont.)
Explain How the Fed influences interest rates
Explain how interest rates influence the economy 89

77. Interest Rate Determination
Changing the Interest Rate
Suppose the Fed begins to fear inflation.
It decides to raise interest rates to discourage borrowing and the purchase of goods and services. 90

78. Interest Rate Determination
Changing the Interest Rate
To do so, the Fed sells securities in the open market.
Bank reserves decline.
Less new loans are made.
The money supply decreases. 91

79. Interest Rate Changes MS1 MS0 MS2 MS0 MS0 6 5 4 MD 2.8 2.9 3.0 3.1 3.2
An increase in
the money
supply lowers
the interest rate 5
Interest rate (percent per year) 4
Instructor Notes:
An open market purchase of securities shifts the money supply curve rightward to MS2and the interest rate falls to 4 percent.
A decrease in
the money
supply raises
the interest rate MD
2.8
2.9
3.0
3.1
3.2
Real money (trillions of 1992 dollars) 94

80. Monetary Policy
Does the Fed actually change the money supply and interest rates?
We will look at two different things:
Short-term interest rates since 1970 and see how the Fed influenced their fluctuations
The period since the stock market crash of 1987 95

81. Short-Term Interest Rates
Instructor Notes:
1) The Fed directly determines the discount rate (the rate at which the Fed lends reserves to banks) and closely monitors the federal funds rate (the rate at which banks lend reserves to each other).
2) All short-term interest rates move up and down together, so the Fed influences all short-term rates such as the 3-month Treasury bill rate (the rate at which the federal government borrows in the short term) and the 6-month commercial bill rate (the rate at which big corporations borrow in the short term). 96

82. Money and Interest Rates
Instructor Notes:
1) When the ratio of M2 to GDP (measured on the left scale) rises, either the supply of money increases or the demand for money decreases.
2) The result, before 1990, is a fall in the federal funds rate (measured on the right scale).
3) Similarly, when the ration of M2 to GDP falls, either the supply of money has decreased or the demand for money has increased and (again before 1990) the federal funds rate rises.
40 After 1990, the relationship between M2 and interest rates broke down because new substitutes for M2 decreased the demand for M2. 97

83. Monetary Policy Paul Volcker’s Fed
When Volcker became chairman, in 1979, the U.S. was experiencing double-digit inflation.
Volcker ended the inflation.
He did so by increasing interest rates sharply between 1979 and 1981. 98

84. Monetary Policy Paul Volcker’s Fed (cont.)
This was accomplished by open market operations and increases in the discount rate.
The interest rates increased not because Volcker decreased the money supply, but because he slowed the growth of the money supply. 99

85. Monetary Policy Paul Volcker’s Fed (cont.)
T-bill rates increased form 10 to 14 percent.
The prime increased from 9 to 14 percent.
Mortgage rates increased from 11 to 15 percent.
100

86. Monetary Policy Paul Volcker’s Fed (cont.)
The economy went into recession.
Real GDP fell and the inflation rate slowed.
101

87. Monetary Policy Alan Greenspan’s Fed
Greenspan became chairman in 1987.
During the two preceding years, the money supply had grown rapidly, and interest rates had fallen.
The stock market was recording record closings regularly.
102

88. Monetary Policy Alan Greenspan’s Fed (cont.)
Then, without warning, the stock market crashed.
The Fed immediately emphasized their flexibility and sensitivity in the attempt to avoid any fear of a banking crisis.
It soon became clear that the economy was not heading for a recession.
103

89. Monetary Policy Alan Greenspan’s Fed (cont.)
Again, the economy began to grow.
The Fed cut the growth of the money supply in the attempt to avoid an increase in the inflation rate.
By 1989 the economy began to slow, and fears of a recession became prominent.
104

90. Monetary Policy Alan Greenspan’s Fed (cont.)
The money supply growth rate was increased and interest rates were lowered.
In 1990, the recession had become a reality.
The Fed took actions that cut interest rates by 3 percentage points.
105

91. Monetary Policy Alan Greenspan’s Fed (cont.)
By mid-1991, the economy had begun to recover and real GDP expanded.
The economy continued to grow, and by 1997 was threatening to set a record for the longest peacetime expansion.
106

92. Monetary Policy Profiting by Predicting the Fed
People try to anticipate what the Fed is about to do buy and sell bonds in the hope of incurring a profit.
People who anticipate that the Fed is about to increase the money supply buy bonds right away, pushing their prices upward and pushing interest rates downward before the Fed acts.
107

93. The Ripple Effects of Monetary Policy

94. The Fed buys securities in the open market The Fed sells securities
Bank reserves increase,
and the quantity of
money increases
Bank reserves decrease,
and the quantity of
money increases
Interest rates fall
Interest rates rise
The dollar falls on
the foreign
exchange market
The dollar rises on
the foreign
exchange market
Net
exports
increase
Consumption
and investment
increases
Net
exports
decrease
Consumption
and investment
decreases
Aggregate demand
increases
Aggregate demand
decreases
Real GDP and
inflation speed up
Real GDP and
inflation slow down
108

95. Interest Rates and Real GDP Growth
Instructor Notes:
1) When the Fed increases short-term interest rates, the short-term rate rises above the long-term rate and, later, real GDP growth slows down.
2) Similarly, when the Fed decreases short-term interest rates, the short-term rate falls below the long-term rate and, later, real GDP speeds up.
109

96. The End