Transcript Monetary Policy

Monetary Policy
Money, Interest & Money Supply
History of The Federal Bank
• First Bank of the United States (1BUS)
– Alexander Hamilton
– Objective was to create stability & provide young
nation with ability to deal with foreign entities.
– Charter was for 20 years (1791 - 1811)
• Second Bank of the United States (2BUS)
– Result on inflation during War of 1812
– Privately owned with public obligations.
– 20 year charter (1816 - 1836)
– President Jackson ended bank in 1833.
History of Federal Banks
• No National bank until 20th Century
• Panic of 1907
– Money supply got tight
– Pressure on banks
– Pyramid reserves
• Small banks reserves at larger banks
• Federal Reserve Act of 1913
• Created the “Fed”
The Federal Reserve
• Responsibilities include
– Supervising member banks
• Interesting point that member
banks technically own & control
Federal Reserve.
• Creates a political buffer.
• Reports to Congress
– Cash Reserves
– Money Supply
• Moves money in & out of
circulation.
The Federal Reserve
• What does the Fed do?
– Check Clearing
– Loans for banks
• Maintains reserves through
S-T loans & loans to banks
in trouble.
– Federal Government’s Bank
(The Treasury)
– Supervises Member Banks
• Reserves, Charters &
Mergers.
– Regulates the Money Supply
• Replaces old money &
monitors supply
What is Money?
• 3 Components
– Medium of exchange
• Usable for buying and selling of goods & services
– Unit of account
• Allows for easy accounting of value & comparisons
– Store of Value
• Retains value over time
What is the Money Supply?
• Money supply (MS)
– Measures amount of money in circulation
– 4 different Kinds
•
•
•
•
M1 – Most liquid
M2
M3
L – Least liquid
Federal Reserve
• Types of Monetary Measures
• M1
– Currency in circulation + Checking accounts + travellers
checks
• M2
– M1 + Money Market accounts & mutual funds + other S-T
saving deposits
• M3
– M2 + L-T savings deposits
• L
– M3 + Savings bonds + S-T treasuries
Money Supply & Interest Rates
Interest
rate
Money supply
Quantity (supply)
set by the Fed
r1
re
r2
Money demand
Md
1
Md
e
M d2
Quantity
of money
Money Supply & Interest Rates
Interest
rate
Money supply
Increases in demand:
MD shifts, MS constant
so results in r increases
r2
r1
MD2
MD1
M de
Quantity
of money
Money Supply & Interest Rates
Interest
rate
Money supply
Higher r leads to
Higher price levels
& lower outputs
P2
r2
MD2
r1
P1
AD
MD1
M de
Quantity
of money
Y2
Y1 Quantity of
output
Money Supply & Interest Rates
Interest
rate
Money supply
Increased MS
leads to
increase AD &
higher output
MS2
P1
r1
AD2
r2
MD1
Mde1 Mde2 Quantity
of money
AD1
Y1 Y2 Quantity of
output
How the Fed Can Change MS
•
Fed Tools
1.
2.
3.
4.
5.
Open Market Operations
Fed Funds Rate & Discount Rate
Reserve Requirements for investors
Regulation of consumer credit
Moral suasion
1. Open Market Transactions
• To Increase the money supply
– Fed buys US securities on the market
• Money exchanged for bonds which increases the
Money Supply. Money used by Fed to buy bonds was
not in circulation but now it is.
• Increasing supply known as Easy-money policy
• Consequences include
–
–
–
–
–
Easier credit
Lower interest rates initially
Higher aggregate demand
Leads to inflation
Tool for fighting recessionary times
1. Open Market Transactions
• To Decrease the money supply
– Fed sells US securities on the market
• Bonds exchanged for money which decreases the
Money Supply. Money used to purchase bonds in the
hands of Government so out of circulation.
• Decreasing supply known as Tight-money policy
• Consequences include
–
–
–
–
–
Tighter credit
Higher interest rates initially
Lower aggregate demand
Fights inflation
Greenspan used policy to manage growth
1. Open Market Transactions
• Effects of decreasing the money supply
–
–
–
–
–
–
Fed sells bonds for dollars
More bonds in market, fewer dollars
Fewer dollars = less loanable funds
Less $ available for loans = higher interest rates
Higher r = Lower C & I in GDP
Result is a shift in GDP results
• Khan video on increasing MS through open market
– http://www.khanacademy.org/humanities--other/finance/core-finance/v/fed-open-market-operations
2. Fed Funds Rate &
Discount Rate
• Fed Funds Rate
– Rate member banks charge each other
– Lower than Discount rate
• Discount rate
– Rate Fed Charges member banks
• Prime rate
– Rate commercial banks charge their best customers.
• Effects
– Lowering discount rate
• Encourages borrowing because the price of money or cost of borrowing
decreases
• Increases loans, investments & money supply.
– Raising discount rate
• Decreases amount of loans, investments & MS.
2. Effects of Rate Changes
• Effects
– Lowering Fed Funds Rate & Discount Rate
• Encourages borrowing because the price of money or cost of
borrowing decreases
• Increases loans, investments & money supply.
– Raising Fed Funds Rate & Discount Rate
• Decreases amount of loans, investments & MS.
• Khan Academy – Discount Rate
– http://www.khanacademy.org/humanities--other/finance/banking-and-money/v/the-discount-rate
2. Taylor Rule
• Economist John Taylor rules for the Fed’s
target Fed Funds Rate
• (assumes target of 2% inflation
• GDPreal = GDPpot + Inflation
• If GDPreal up 1%, then Fed Funds up ½ %.
• If Inflation 1% > target,
then Fed Funds up ½ %.
3. Reserve Requirements
• Amount of money banks must keep on hand.
• If reserve requirement changes, amount
available for loans change with it.
• Example
– if a bank has 10,000,000 in deposits & reserve
ratio is 10%, then bank must have $1,000,000 in
the bank.
– Rest can be used for loans. In this case
$9,000,000.
3. Reserve Requirements
• Lowering reserve requirement
– Increases amount available for loans
– Increases MS
– Reduces rates because of greater supply
– Increases investments
• Raising reserve requirement
– Decreases amount available for loans
– Decreases MS
3. Reserve Requirements
• Reserve ratio
= (Bank’s Required Reserves)
(Bank’s Liabilities {deposits})
• Monetary Multiplier
= 1 / (required reserve ratio)
.
Effects of multipier
• Beleagured State Bank (BSB)
–
–
–
–
.
Deposits
RR
Reserves
– Funds – Loans
10% RR
$100M
10%
$10M
25% RR
$100M
25%
$25M
$90M
$75M
– Effects of raising RR in this case is reduction in funds
available for loans of $15M for BSB alone.
• Multipler
1/.1 = 10X
1/.25 = 4X
Other Controls
• 4. Credit Card rates
– Revoked in 1952
– Set rates on consumer credit cards
• 5. Moral Suasion
– Unofficial pressures placed on banks
– “you don’t have to do this but …”
Limitations
• Forecasts
• If forecast is wrong, then so is the policy
• Timing
• Time lags with implementing changes in policy
• Trade-offs
• Monetary policy a tool to fight inflation or recession
Trade-Offs
• Growth – Good.
• Inflation – Bad.
Tight
Money
• Easy Money
– Increases growth (good)
– Increases inflation (bad)
• Tight Money
– Decreases growth (bad)
– Decreases inflation (good)
Easy
Money
Summary – Expansionary MP
• Problem: unemployment & recession
– Fed buys bonds, lowers RR, lowers DR
– Money supply
– Excess reserves up
– Fed Funds rate falls
– Interest rates falls
– Investment spending up
– Aggregate Demand up
– Real GDP up
• Opposite is true for restrictive MP
Expansionary Policy
Money
Supply
up
Interest
Rates
down
Exchange
rates
down
Investments
up
AD
up
GDPR
up
GDPN
up
Exports
up
Imports
down
Price
Level
up
Inflation
up
Unemploy
-ment
down
Determining Nominal Interest Rates
Rate of interest, i
MS
ie
MD
Me
Quantity Money
Determining Real Interest Rates
Rate of interest, r
S
If Quantity of funds
represents all funds,
Govt. debt affects
demand. If only
private funds, Govt.
debt affects supply
re
D
Qe
Quantity of funds
Annual rate of inflation, %
Phillip’s Curve
Trade-off between inflation
& unemployment. As
economy heats up,
unemployment drops &
inflation goes up
PClr
PCsr
Unemployment rate, %
Long-run unemployment
Set by LRAS & potential
GDP, therefore long-run
Phillip’s curve is vertical
Investment Demand
Rate of interest, r
Relationship between
Nominal interest rates
& Investment (GDP)
i
ID
I
Investment
Graph Relationships
i
Money Market
MS
i
Investment Demand
MS
i
i
i
i
MD
M
M
Contraction of MS
leads to higher i,
which reduces I,
causing GDP to fall
Graph reversed so
GDP is falling
M
Y
Y
GDPR
I
I
I
I
I
I
Laffer Curve
100
Tax rate, %
Shape of curve
subject of debate
Maximum
Tax Revenue
0
Tax revenue, $
Inflation & the Economy
• Khan Videos on Inflation & Economy
• Moderate inflation in a good economy
– Good visual presentation of relationships (3 minutes)
– http://www.khanacademy.org/humanities--other/finance/microeconomicsmacroeconomics/v/moderate-inflation-in-a-goodeconomy
• Stagflation
– Low growth with high inflation
– Short video (3 minutes) built on prior video
– http://www.khanacademy.org/humanities--other/finance/microeconomicsmacroeconomics/v/stagflation
Inflation & Deflation Tutorials
• Khan Academy
– Inflation, Deflation & Capacity Utilization, part 1 (12:32)
• http://www.khanacademy.org/humanities---other/finance/currenteconomics/v/inflation--deflation---capacity-utilization
– Inflation, Deflation & Capacity, part 2 (11:49)
• http://www.khanacademy.org/humanities---other/finance/currenteconomics/v/inflation--deflation---capacity-utilization-2
– Effects of Obama’s stimulus bill (13:20)
• http://www.khanacademy.org/humanities---other/finance/currenteconomics/v/inflation---deflation-3--obama-stimulus-plan