1. Macroeconomics Econ 2301 Dr. Jacobson Coach Stuckey

2. Chapter 15 Monetary Policy 14-1 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

3. The Theory of Liquidity Preference Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money. Liquidity preference theory attempts to explain both nominal and real rates by holding constant the rate of inflation.

4. The Theory of Liquidity Preference Money Supply –The money supply is controlled by the Fed through: Open-market operations Changing the reserve requirements Changing the discount rate –Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. –The fixed money supply is represented by a vertical supply curve.

5. The Theory of Liquidity Preference Money Demand –Money demand is determined by several factors. –According to the theory of liquidity preference, one of the most important factors is the interest rate. –People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. –The opportunity cost of holding money is the interest that could be earned on interest-earning assets. –An increase in the interest rate raises the opportunity cost of holding money. –As a result, the quantity of money demanded is reduced.

6. The Theory of Liquidity Preference Equilibrium in the Money Market –According to the theory of liquidity preference: The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

7. The Theory of Liquidity Preference Equilibrium in the Money Market –Assume the following about the economy: The price level is stuck at some level. For any given price level, the interest rate adjusts to balance the supply and demand for money. The level of output responds to the aggregate demand for goods and services.

8. Figure 1 Equilibrium in the Money Market Quantity of Money Interest Rate 0 Money demand Quantity fixed by the Fed Money supply r2r2 M2M2 d M d r1r1 Equilibrium interest rate

9. The Downward Slope of the Aggregate-Demand Curve The price level is one determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls.

10. The Downward Slope of the Aggregate-Demand Curve The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

11. Figure 2 The Money Market and the Slope of the Aggregate- Demand Curve Quantity of Money Quantity fixed by the Fed 0 Interest Rate Money demand at price levelP2P2,MD 2 Money demand at price levelP,MD Money supply (a) The Money Market(b) The Aggregate-Demand Curve 3.... which increases the equilibrium interest rate... 2.... increases the demand for money... Quantity of Output 0 Price Level Aggregate demand P2P2 Y2Y2 Y P 4.... which in turn reduces the quantity of goods and services demanded. 1. An increase in the price level... r r2r2

12. Changes in the Money Supply The Fed can shift the aggregate demand curve when it changes monetary policy. An increase in the money supply shifts the money supply curve to the right. Without a change in the money demand curve, the interest rate falls. Falling interest rates increase the quantity of goods and services demanded.

13. Figure 3 A Monetary Injection MS 2 Money supply, MS Aggregate demand,AD Y Y P Money demand at price levelP AD 2 Quantity of Money 0 Interest Rate r r2r2 (a) The Money Market (b) The Aggregate-Demand Curve Quantity of Output 0 Price Level 3.... which increases the quantity of goods and services demanded at a given price level. 2.... the equilibrium interest rate falls... 1. When the Fed increases the money supply...

14. Changes in the Money Supply When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate- demand to the right. When the Fed decreases the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate- demand to the left.

15. The Role of Interest-Rate Targets in Fed Policy Monetary policy can be described either in terms of the money supply or in terms of the interest rate. Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply. A target for the federal funds rate affects the money market equilibrium, which influences aggregate demand.

16. Objectives 14-2 The organization of the Federal Reserve System Reserve requirements The deposit expansion multiplier The tools of monetary policy The Feds effectiveness in fighting inflation and recession The Banking Act of 1980 and 1999 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

17. The Federal Reserve Act of 1913 created the Federal Reserve System –To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes –First United States Bank [ 1791 - 1811] –Second United States Bank [ 1816 - 1836] The charters of both were allowed to lapse –The 1907 bank crises caused the public to demand the government do something to keep this from happening again The Federal Reserve System 14-3 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

18. The Federal Reserve System The Federal Reserve has five main jobs –Conduct monetary policy which is, by far, the most important job Monetary policy is the control of the rate of growth of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth –Serve as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions 14-4 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

19. The Federal Reserve System The Federal Reserve has five main jobs –Issue currency –Provide banking services to the U.S. government –Supervise and regulate our financial institutions 14-5 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

20. The Federal Reserve District Banks Each Federal Reserve District Bank is owned by the several hundred member banks in that district –A commercial bank becomes a member by buying stock in the Federal Reserve District Bank –So, the Fed is a quasi public-private enterprise, not controlled by the President or Congress Effective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C. 14-6 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

21. The Federal Reserve System Board of Governors –Seven members –Appointed by President –Confirmed by Senate Sets reserve requirements Supervises and regulates member banks Establishes and administers regulations Oversees Federal Reserve Banks 12 District Banks Propose discount rates Hold reserve balances for member institutions Lends reserves Furnish currency Collects & clears checks Handle U.S. government debt & cash balances Federal Open Market Committee (Board of Governors plus 5 Reserve Bank Presidents. This committee directs open market operations which is the primary instrument of monetary policy 14-7 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

22. 14-8 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve System

23. Independence of the Board of Governors Neither the President nor Congress has any control over the Board of Governors –The President gets to appoint Board members when a vacancy occurs Sometime this may be the Chairman –Once the Senate confirms the President’s appointment the person appointed is not answerable to the President nor the Senate –This independence allows them to follow unpopular policies if they feel it is in the best economic interest of the nation 14-9 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

24. Legal Reserve Requirements The most important job of the Federal Reserve is to control the money supply The focal point of the Federal Reserve’s control of our money supply is legal reserve requirements deposits –Every financial institution in the country is legally required to hold a certain percentage of its deposits on reserve, either in the form of deposits and/or cash at its Federal Reserve District Bank or its own vaults 14-10 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

25. Legal Reserve Requirements Technical Term Meanings –Required Reserves (RR) is the minimum amount of vault cash and deposits (RD) at the Federal Reserve District Bank that must be held (kept on the books) by the financial institution –Actual Reserves (RD) is what the bank is holding (on the books) –Excess Reserves = Actual Reserves - Required Reserves ER = RD - RR 14-11 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

26. 14-12 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

27. 14-13 If a bank had $100 million in checking deposits (DD), how much reserves would it be required to hold? Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. First $7.8 million of deposits: 0% reserve requirement Next 40.5 million: $40,500,000 X.03 = 1,215,000 Next 51.7 million: $51,700,000 X.10 = 5,170,000 Required Reserves = $6,385,000

28. What About Negative Excess Reserves? If actual reserves (RD) are less than Required Reserves (RR), the excess Reserves (ER) are negative –If a bank does find itself short, it will usually borrow reserves from another bank that does have excess reserves. These are called federal funds and the interest rate charge is called the federal funds rate –A bank may also borrow reserves (RD) from its Federal Reserve District Bank at its discount window 14-14 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

29. A bank’s primary reserves are its vault cash and its deposits at the the Federal District Bank –These reserves pay no interest, therefore the banks try to hold no more than the Federal Reserve requires Primary and Secondary Reserves 14-15 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

30. Every bank holds secondary reserves, mainly in the form of very short-term U.S. government securities –Treasury bills, notes, certificates, and bonds (that will mature in less than a year) are generally considered a bank’s secondary reserves –These can be quickly converted to cash without loss if a bank suddenly needs money Primary and Secondary Reserves 14-16 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

31. 14-17 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

32. Deposition Expansion (Continued) 14-18 How Deposit Expansion Works Bank AFED DD + 100RD + 100A> RD +100 Assume a 10% RR Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

33. Deposition Expansion 14-19 How Deposit Expansion Works Bank A FED DD + 100RD + 100 A> RD +100 Assume a 10% RR RR 10 ER + 90 Bank B DD + 90RD + 90 B> RD + 90 RR 9 ER + 81 Bank C DD + 81.0RD + 81 C> RD + 81.0 ER 8.1 ER + 72.9 Etc. RD + $1,000,000 When RDs at the Fed increase the money supply is increasing Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

34. Deposit Expansion Multiplier (DEM) 14-20 DEM = 1 Reserve Ratio Assume a RR of 10% DEM = 1.10 = 10 Assume a RR of 25% DEM = 1.25 = 4 When RR increases DEM decreases When RR decreases DEM increases Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

35. Three Modifications of the Deposit Expansion Multiplier Not every dollar of deposit expansion will actually be re-deposited again and lent out repeatedly –Some people may choose to hold or spend some money as currency It is also possible that some banks will carry excess reserves –This is not likely in times of high inflation 14-21 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

36. Three Modifications of the Deposit Expansion Multiplier There are leakages of dollars to foreign countries –This is caused mainly by our foreign trade imbalance The Deposit Expansion Multiplier is, in reality, quite a bit lower than if we based it solely on the reserve ratio –If the reserve ratio tells us it is 10, perhaps it’s only 6 14-22 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

37. Cash, Checks, and Electronic Money One of the jobs of the Federal Reserve is check clearing In 2004 Congress passed the Check Clearing Act of the 21 st Century –This was intended to hasten the adoption of electronic check processing When you use your debit card the amount is deducted within seconds after the card is swiped We still carry out about 80 percent of our transactions in cash –However cash covers less than one percent of monetary transactions –Electronic transfers account for five out of every six dollars that move in the economy 14-23 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

38. Cash, Checks, and Electronic Money One of the jobs of the Federal Reserve is check clearing 14-24 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

39. Increasingly, money is changing hands electronically –Today, $1.5 trillion a day is transferred electronically –About one-third of these transfers are carried out by the Federal Reserve’s electronic network –About two-thirds are done by the Clearing House Interbank Payment System (CHIPS) which is owned by 10 big New York Banks Does all this mean that we are well on our way to a checkless, cashless society? –Yes and no Cash, Checks, and Electronic Money 14-25 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

40. Does all this mean that we are well on our way to a checkless, cashless society? –Yes and no –We still carry out nearly 85 percent of our monetary transactions in cash –When the total dollars actually spent is considered, cash covers less than 1 percent of the total value –Electronic transfers account for five out of every six dollars that move in the economy Cash, Checks, and Electronic Money 14-26 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

41. The Tools of Monetary Policy The most important job of the Fed is to control the rate of growth of the money supply This effort focuses on the reserves held by financial institutions –The most important policy tool to do this is open-market operations 14-27 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

42. How Open-Market Operations Work Open-Market operations are the buying and selling of U.S. government securities –U.S. government securities are treasury bills, notes, certificates, and bonds –The Fed buys and sells securities that have already been marketed by the treasury The total value of all outstanding U.S. government securities is more than $4.0 trillion. This is our national debt –What open market operations consist of, then, is the buying and selling of chunks of the national debt 14-28 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

43. How the Fed Increases the Money Supply 14-29 The FED buys U. S. Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 The multiplier would be 10 10 X 90 million = 900 million X.60 = approximate increase in the money supply of 540 million over a period of time Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

44. How the Fed Increases the Money Supply 14-30 The FED buys U. S. Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities IR = Interest Paid Price of Bond Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

45. How the Fed Increases the Money Supply 14-31 The FED buys U. S. Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities IR = $80 $1000 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

46. How the Fed Increases the Money Supply 14-32 The FED buys U. S. Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of U.S. government securities IR = $80 $1000 = 8% Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

47. How the Fed Increases the Money Supply 14-33 The FED buys U. S. Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 Suppose this pushed the price of the bond up to $1200? IR = $80 $1000 = 8% IR = $80 $1200 = 6.67% Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

48. How the Fed Increases the Money Supply 14-34 The FED buys U. S. Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm DD + $100 Assume 10% RR RD + $100 RR - 10 ER + 90 When the Fed goes into the open market to buy securities, it bids up their price and lowers their interest rate IR = $80 $1000 = 8% IR = $80 $1200 = 6.67% Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

49. How the Fed Decreases the Money Supply 14-35 The FED sells U. S. Government Securities The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed) Securities Firm DD - $100 Assume 10% RR RD - $100 When the Fed goes into the open market to sell securities, bond, and notes prices fall and interest rates climb The money supply decreases by approximately $540 million over time Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

50. How the Fed Decreases the Money Supply 14-36 The FED sells U. S. Government Securities The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed) Securities Firm DD - $100 Assume 10% RR RD - $100 When the Fed goes into the open market to sell securities, bond prices fall and interest rates climb IR = $80 $1000 = 8% IR = $80 $1200 = 6.67% The money decreases by approximately $540 million over time Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

51. The Federal Open-Market Committee (FOMC) Open-market operations are conducted by the Federal Open-Market Committee (FOMC) –This committee consist of 12 people Eight permanent members – the board of Governors and the president of the New York Federal Reserve District Bank The other four are presidents of the other 11 Federal Reserve District Banks –They serve on a rotating basis 14-37 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

52. The Federal Open-Market Committee (FOMC) 14-38 The FOMC meets about once every six weeks to decide what policy to follow –To fight recessions, the FOMC buys securities This increases the rate of growth of the money supply –To fight inflation, the FOMC sells securities This decreases the rate of growth of the money supply Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

53. The discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at their Federal Reserve District Bank The federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other –This is higher than the discount rate Banks borrow to maintain their required reserves (RR) –Banks tend to borrow reserve deposits from each other because they may not like to call attention to the fact they are having to borrow reserve deposits 14-39 Borrowing Reserve Deposits Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

54. 14-40 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Increase in the Money SupplyDecrease in the Money Supply

55. 14-41 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 1954-2006

56. Changing Reserve Requirements The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14 percent for checkable deposits –Changing reserve requirements is the ultimate weapon and is rarely used 14-42 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

57. Changing Reserve Requirements To fight inflation, before the Board would take the drastic step of raising reserve requirements –The District Banks would raise the discount rate –The FOMC will be actively selling securities –Credit will be getting tighter –The chairman will be publicly warning that the banks are advancing too many loans 14-43 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

58. Changing Reserve Requirements If the money supply is still growing too rapidly – the Fed reaches for its biggest stick and raises reserve requirements –This weapon is so rarely used because it is simply too powerful –If the reserve requirement on demand deposits were raised by just one half of 1 percent, the nation’s banks and thrift institutions would have to come up with nearly $4 billion in reserves This would drastically reduce the nation’s money supply 14-44 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

59. Summary: The Tools of Monetary Policy To fight recession, the Fed will –Lower the discount rate –Buy securities on the open market –Lower reserve requirements This would be done only as a last resort 14-45 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

60. Summary: The Tools of Monetary Policy To fight inflation, the Fed will –Raise the discount rate –Sell securities on the open market –Raise reserve requirements This would be done only as a last resort 14-46 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

61. The Fed’s Effectiveness in Fighting Inflation (Assume all the tools have been used) Bond prices have plunged Interest rates have soared The growth of the money supply has been stopped dead in its tracks Banks find it impossible to increase their loan portfolios Buying by consumers and businesses is declining The inflation rate has no choice but to decline 14-47 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

62. The Fed’s Effectiveness in Fighting Recession (Assume all the tools have been used) Bond prices have increased Interest rates have gone down Banks will have excess reserves and want to make loans –But who wants to borrow the money? Creditworthy individuals and business have little incentive to borrow any money Businesses and individuals who really need to borrow money can’t because the first rule of banking is: never lend money to anyone who needs it. Easy money has little or no effect in ending a recession 14-48 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

63. The Fed’s Effectiveness in Fighting Inflation and Recession Federal Reserve policy in fighting inflation and recession has been likened to pulling and then pushing on a string –Like pulling on a string, when the Fed fights inflation, it get results – provided of course, it pulls hard enough –Fighting a recession is another matter. Like pushing on a string, no matter how hard the Fed works, it might not get anywhere 14-49 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

64. This Act is clearly the most important piece of banking legislation passed since the 1930s Under this Act: –All depository institutions are now subject to the Fed’s legal reserve requirements –All depository institutions are now legally authorized to issue checking deposits that may be interest bearing –All depository institutions now enjoy all the advantages that only Federal Reserve member banks formerly enjoyed –including check clearing and borrowing from the Fed (discounting) 14-50 The Depository Institutions Deregulation and Monetary Control Act of 1980 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

65. Another important consequence of this law is that by the end of the 1990s, intense competition reduced the 40,000-plus financial institutions that existed at the beginning of the 1980s to a little 20,000 today The lifting of the prohibition against interstate banking combined with further advances in electronic banking will create greater consolidation, perhaps with just 30 to 40 giant financial institutions doing most of the business The Depository Institutions Deregulation and Monetary Control Act of 1980 14-51 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

66. The Banking Act of 1999 In 1980 the jurisdiction of the Federal Reserve had been extended to all commercial banks and thrift institutions In 1999 it was further extended to insurance companies, pension funds, investment companies, securities brokers, and finance companies This new law allows banks, securities firms and insurances companies to merge and sell each other’s products 14-52 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

67. Fiscal and Monetary Policies Should Mesh In 1990s there was little coordination in the making of fiscal and monetary policies –Fiscal policies are made by the federal government –Monetary policy is determined by the Fed –Fiscal policy at best is described as a series of compromises between Congress and the President –Monetary policy is determined by the Fed –Fiscal and monetary policy should mesh, but obviously different people with different objectives cause these to work at cross-purposes all too often –A step in the right direction could be to allow every President to appoint the Chairman of the Board at the Fed when he begins his term What about doing away with the Fed and allow the elected leaders of the federal government to determine both fiscal and monetary policy? 14-53 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

68. Current Issue: Who Controls Our Interest Rates? What can we expect over the next decade? –The Federal Budget annual deficit will probably exceed $500 billion every year –Americans will continue to spend not only all their incomes but continue to spend more than they earn with credit cards –The U.S. Treasury will become still more dependent on the kindness of foreigners to finance our debt Who does control our interest rates? –While the Fed is still the biggest kid on the block, it no longer calls all of the shots –If our financial dependency on foreigners continue to grow Our monetary policy will originate more and more in Shanghai, Tokyo,, London,, Frankfort, and other financial capitals 14-54 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.