29 Monetary Policy and the National Economy Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it meant.

29

Monetary Policy and the National Economy

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

● 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

ContentsContents

Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

● 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)Contents (continued)


Copyright© 2003 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 DifferenceMoney and Income: The Important Difference


Money and Income: The Important DifferenceMoney 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.


America’s Central Bank: The Federal Reserve SystemAmerica’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



● 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


● 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.



● The Fed can increase the money supply by buying government securities on the open market.♦ It pays for these securities by creating new bank

reserves.♦ These additional reserves multiple expansion

of the money supply

● To reduce the money supply, the Fed sells securities.

● The Fed can increase the money supply by buying government securities on the open market.♦ It pays for these securities by creating new bank

reserves.♦ These additional reserves multiple expansion

of the money supply

● To reduce the money supply, the Fed sells securities.

Implementing Monetary PolicyImplementing Monetary Policy

TABLE 29-1 Effects of an Open-Market Purchase of Securities

TABLE 29-1 Effects of an Open-Market Purchase of Securities



Implementing Monetary PolicyImplementing 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

● 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

FIGURE 29-1 Open-Market Sales and Bond Prices

FIGURE 29-1 Open-Market Sales and Bond Prices


Quantity of Bonds

P1

P0

S 0

S0

S1

S1

D

D

B

A

Pri

ce

of

a B

on

d


● 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 ControlOther Methods of Monetary Control


● 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 ControlOther Methods of Monetary Control

TABLE 29-2 Balance Sheet Changes, Borrowing from Fed

TABLE 29-2 Balance Sheet Changes, Borrowing from Fed



● 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 Other Methods of Monetary Control


Supply-Demand Analysis of the Money MarketSupply-Demand Analysis of the Money Market

Interest rates Profit opportunities for banks Excess reserves Volume of loans

Interest rates Profit opportunities for banks Excess reserves Volume of loans


● However, the Fed can shift the relationship between the money supply and interest rates by employing any of its principal weapons of monetary control.♦ Open-market operations reserve requirements lending policy to banks

● However, the Fed can shift the relationship between the money supply and interest rates by employing any of its principal weapons of monetary control.♦ Open-market operations reserve requirements lending policy to banks


FIGURE 29-2 (a) The Supply Schedule for Money

FIGURE 29-2 (a) The Supply Schedule for Money


0

7

5

3

1

830 850 820 800 Money Supply

(a)

M

S

Inte

res

t R

ate

FIGURE 29-2 (b, c) The Supply Schedule for Money

FIGURE 29-2 (b, c) The Supply Schedule for Money


M0

S0

0

7

5

3

1

850 800 Money Supply

Contractionary Policy Change

(c)

Inte

rest

Rat

e

0

7

5

3

1

850 800 Money Supply

Expansionary Policy Change

(b)

Inte

rest

Rat

e

M2

S2

M1

S1

M0

S0



● The Money Supply Mechanism♦ Money supply curve: slightly positive slope

♦ Indicates a weak sensitivity to changes in the interest rate

● The Money Supply Mechanism♦ Money supply curve: slightly positive slope

♦ Indicates a weak sensitivity to changes in the interest rate


● The Demand for Money♦ Money is demanded for transactions. nominal GDP

Spending Demand for money

● The Demand for Money♦ Money is demanded for transactions. nominal GDP

Spending Demand for money




● The Demand for Money♦ Interest = opportunity cost of holding money

Interest rates Money demand

♦ Demand curve for money curve■Negatively sloped■Shifts as nominal GDP changes

● The Demand for Money♦ Interest = opportunity cost of holding money

Interest rates Money demand

♦ Demand curve for money curve■Negatively sloped■Shifts as nominal GDP changes

FIGURE 29-3 (a) The Demand Schedule for Money

FIGURE 29-3 (a) The Demand Schedule for Money


M

D

Inte

rest

Rat

e

Quantity of Money Demanded

(a)

FIGURE 29-3 (b, c) The Demand Schedule for Money

FIGURE 29-3 (b, c) The Demand Schedule for Money


D0

M0 M0

D0

Inte

res

t R

ate

Inte

res

t R

ate


Lower Y or P (c)


Higher Y or P (b)

D2

M2

M1

D1



● Equilibrium in the Money Market♦ The interest rate equilibrates the demand and

supply of money.

♦ The Fed can lower (raise) interest rates by increasing (reducing) the money supply.

● Equilibrium in the Money Market♦ The interest rate equilibrates the demand and

supply of money.

♦ The Fed can lower (raise) interest rates by increasing (reducing) the money supply.

FIGURE 29-4 Equilibrium in the Money Market

FIGURE 29-4 Equilibrium in the Money Market


5

830

D

M 8

7

6

4

3

2

0

1

850 800 Money Stock

M

S In

tere

st R

ate

For given Y and P

For given Fed policy

E

FIGURE 29-5 Effects of Monetary Policy on the Money Market

FIGURE 29-5 Effects of Monetary Policy on the Money Market


Contractionary Monetary Policy Expansionary Monetary Policy

Money Stock

(b)

Inte

rest

Rat

e M0

S0

Money Stock

(a)

Inte

rest

Rat

e

M0

S0

D

M

D

M

M1

S1

M2

S2

E

A E

B


● 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 WorksHow Monetary Policy Works


● 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


FIGURE 29-6 Effect of Interest Rates on Total Expenditure

FIGURE 29-6 Effect of Interest Rates on Total Expenditure


C + I + G + (X – IM )

45

Real GDP

Rea

l E

xpen

dit

ure

C + I + G + (X – IM ) (higher interest rate)

C + I + G + (X – IM ) (lower interest rate)



● 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

FIGURE 29-7 Expansionary Policy on Money Supply & Interest Rate

FIGURE 29-7 Expansionary Policy on Money Supply & Interest Rate


M

D

900 880 850 830

7

5

3

S0

M0

1

800

Money Stock

Inte

rest

Rat

e E0

S1

M1

E1

How Monetary Policy Affects GDP

How Monetary Policy Affects GDP


Federal Reserve Policy

1

M and r

2

I

3

C + I + G + (X - IM)

4

GDP

FIGURE 29-8 Expansionary Policy on Total Expenditure

FIGURE 29-8 Expansionary Policy on Total Expenditure


$200 billion

7,000 6,500 6,000

45

5,500

C + I0 + G + (X – IM)

Re

al

Ex

pe

nd

itu

re

Real GDP

E0

C + I1 + G + (X – IM) E1


● 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 ModelMoney and the Price Level in the Keynesian Model

FIGURE 29-9 The Inflationary Effects of Expansionary Policy

FIGURE 29-9 The Inflationary Effects of Expansionary Policy


$500 billion

103

6,400

S

S

D0

D0

6,000

100

Real GDP

Pri

ce

Le

ve

l

E

D1

D1

B



● 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.

Effect of Monetary Policy on Output and Prices

Effect of Monetary Policy on Output and Prices


Federal Reserve Policy

1

M and r

2

I

3

C + I + G + (X - IM)

4

Y and P



● 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



● 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


From Models to Policy DebatesFrom 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.

29 Monetary Policy and the National Economy Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it meant.

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