Transcript Central Bank - McGraw

Monetary Policy and the
Central Bank
Chapter 23
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.
Learning Objectives
1. Describe the structure and responsibilities of
the Central Banking System
2. Analyze how changes in the federal funds rate
and real interest rate affect planned aggregate
expenditure and short-run equilibrium output
3. Show how the demand for money and the
supply of money interact to determine the
equilibrium nominal interest rate
4. Discuss how the central bank uses its ability to
control the money supply to influence nominal
and real interest rates
Fed Watch
• Analysts attempt to forecast Fed (the U.S.
central bank) decisions about monetary policy
– Greenspan briefcase indicator
– Central bank decisions have significant effects on
financial markets and the macro economy
• Monetary policy is a major stabilization tool
– Quickly decided and implemented
– More flexible and responsive than fiscal policy
Central Banks of Selected Economies
Country/Economy
Central Bank
Australia
Canada
China
Hong Kong
Indonesia
Japan
Malaysia
Singapore
South Korea
United Kingdom
United States
Reserve Bank of Australia
Bank of Canada
People’s Bank of China
Hong Kong Monetary Authority
Bank Indonesia
Bank of Japan
Bank Negara Malaysia
Monetary Authority of Singapore
Bank of Korea
Bank of England
Federal Reserve System (Fed)
The Central Banking System
and the Federal Reserve
• Responsibilities of the central bank:
– Conduct monetary policy
– Oversee and regulate financial markets
• Central to solving financial crises
• The Federal Reserve System began
operations in 1914
– Does not attempt to maximize profit
– Promotes public goals such as economic growth,
low inflation, and smoothly functioning financial
markets
• www.federalreserve.gov/
The Federal Reserve
Organization
• 12 Federal Reserve Bank districts
– Assess economic conditions in their region
– Provide services to commercial banks in their
region
• Leadership is provided by the Board of Governors
– Seven governors are appointed by the President to
14-year terms
– President selects one of the seven as chairman for
a four-year term
• The Federal Open Market Committee (FOMC)
reviews economic conditions and sets monetary policy
– 12 members who meet eight times a year
Stabilizing Financial Markets
• Motivation for creating the central bank was to
stabilize the financial markets and the economy
• Banking panics occurred when customers believe
one or more banks might be bankrupt
– Depositors rush to withdraw funds
– Banks have inadequate reserves to meet
demand
• Banks close
• The central bank prevents bank panics by
– Supervising and regulating banks
– Loaning banks funds if needed
• Fed did not prevent the bank panics of 1930 – 1933
Bank Panics, 1930 - 1933
• One-third of the banks closed
– Increased the severity of the Great Depression
– Difficult for small businesses and consumers to
get credit
– Money supply decreased
• With no federal deposit insurance, people held
cash
– Feared banks would close and they would lose
their deposits
– Holding cash reduced banks’ reserves
• Lower reserves decreased the money supply by a
multiple of the change in reserves
Bank Panics, 1930 - 1933
• Banks increased their reserve – deposit ratio
– Further decreased the money supply
Currency Reserve –
Bank
Date
Held by
Deposit Reserves
Public ($B)
Ratio
($B)
12 / 1929
3.85
0.075
3.15
Money
Supply
($B)
45.9
12 / 1930
12 / 1931
3.79
4.59
0.082
0.092
3.31
3.11
44.1
37.3
12 / 1932
4.82
0.109
3.18
34.0
12 / 1933
4.85
0.133
3.45
30.8
Deposit Insurance
• U.S. Congress created deposit insurance in
1934
– Deposits of less than $100,000 will be repaid
even if the bank is bankrupt
• Decreases incentive to withdraw funds on rumors
• No significant bank panics since 1934
• With less risk, depositors pay less attention to
whether banks are making prudent
investments
– In the 1980s, many savings and loan
associations went bankrupt
• Cost the taxpayers hundreds of billions of dollars
The Central Bank and the
Economy
Eliminate output gaps by changing
the money supply
Changes in money supply cause
changes in nominal interest rate
Interest rates affect planned
aggregate expenditure, PAE
Can the Central Bank Control
The Real Interest Rate?
• The central bank controls the money supply to
control the nominal interest rate, i
– Investment and saving decisions are based on the
real interest rate, r
• The central bank has some control over r
r=i-
where  is the rate of inflation
• The central bank has good control over i
• Inflation changes relatively slowly
– Changes in nominal rates become changes in real
rates
Role of the Federal Funds Rate
• The federal funds rate is the rate commercial
banks in the United States charge each other on
short-term (usually overnight) loans
– Banks borrow from each other if they have
insufficient funds
– Market determined rate
– Targeted by the Fed
• To decrease the federal funds rate the Fed
conducts open market purchases
– Reserves increase
• Interest rates tend to move together
Year
2012
2009
2006
2002
1999
1996
1992
1989
1986
1983
1979
1976
1973
1970
Percent per year
The Federal Funds Rate,
1970-2013
25
20
Federal Funds Rate
15
10
5
0
Planned Spending and Real
Interest Rate
• Planned aggregate expenditure has components
that are affected by r
– Saving decisions of households
• More saving at higher real interest rates
• Higher saving means less consumption
– Investment by firms
• Higher interest rates mean less investment
– Investments are made if the cost of borrowing is less
than the return on the investment
• Both consumption and planned investment
decrease when the interest rate increases
Interest in the Keynesian Model –
An Example
• Components of aggregate spending are
C = 640 + 0.8 (Y – T) – 400 r
IP = 250 – 600 r
G = 300
NX = 20
T = 250
• If r increases from 0.04 to 0.05 (that is, from 4% to 5%)
– Consumption decreases by 400 (0.01) = 4
– Planned investment decreases by 600 (0.01) = 6
• A one percentage point increase in r reduces planned
spending by 10 – before the multiplier is considered
Planned Aggregate Expenditure
PAE = C + IP + G + NX
PAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r + 300
+ 20
PAE = 1,010 – 1,000 r + 0.8 Y
• In this example, planned aggregate expenditure
depends on both the real interest rate and the level of
output
– Equilibrium output can only be found once we know
the value of r
Planned Aggregate Expenditure
•
•
•
•
PAE = 1,010 – 1,000 r + 0.8 Y
Suppose the real interest rate is 5%, or 0.05
Planned aggregate expenditure becomes
PAE = 1,010 – 1,000 (0.05) + 0.8 Y
PAE = 960 + 0.8 Y
Short-run equilibrium output is PAE = Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800
The graphical solution is the same as before
Monetary Policy
Recessionary Gap
r
C, IP 
PAE 
Y  via the
multiplier
PAE 
Y  via the
multiplier
Expansionary Gap
r
C, IP
Monetary Policy for a
Recessionary Gap
•
•
•
•
•
PAE = 1,010 – 1,000 r + 0.8 Y
The real interest rate, r, is 5%
– Short-run equilibrium output is $4,800
Potential output is $5,000
– Recessionary gap is $200
Multiplier is 5
Monetary policy can be used to increase PAE
– The first change in spending required is 200 / 5 = 40
1,000 (change in r) = 40
Change in r = 40 / 1,000 = 0.04
The central bank should decrease the real interest rate
to 1%
Planned aggregate expenditure (PAE)
The Central Bank Fights a
Recession
Y = PAE
Expenditure line (r = 1%)
Expenditure line (r = 5%)
F
E
4,800 5,000
Y*
A reduction in r shifts the
expenditure line upward and
closes the recessionary gap
Output (Y)
The Fed’s Response to 9/11
• Economy began slowing in late 2000
• Terrorist attack led to contraction in travel,
financial, and other industries
• The federal funds rate is the interest rate banks
charge each other for overnight loans
– This interest rate is the one the Fed targets when
changing the money supply
• In late 2000, the fed funds rate was 6.5%
– January, 2001, the Fed cut the rate to 6.0%
– More rate cuts followed
– July, 2001, the rate was less than 4%
The Fed Response to 9/11
• After the 9/11 attacks
– Fed immediately worked to restore normal
operation of the financial markets and institutions
– The Fed temporarily lowered the rate to 1.25% in
the week following the attack
• In the aftermath, the Fed grew concerned that
consumers would decrease spending
– Interest rate was 2.0% in November, 2001
• 4.5 percentage points lower than a year before
• Combination of tax cuts and aggressive
monetary policy helped keep the 2001 recession
shallow and short
The Central Bank Fights Inflation
• Expansionary gap can lead to inflation
– Planned spending is greater than normal output
levels at the established prices
– Short-run unplanned decreases in inventories
– If gap persists, prices will increase
• The central bank attempts to close expansionary
gaps
–
–
–
–
Raise interest rates
Decrease consumption and planned investment
Decrease planned aggregate expenditure
Decrease equilibrium output
Monetary Policy for an
Expansionary Gap
•
•
•
•
•
PAE = 1,010 – 1,000 r + 0.8 Y
The real interest rate, r, is 5%
– Short-run equilibrium output is $4,800
Potential output is $4,600
– Expansionary gap is $200
Multiplier is 5
Monetary policy can be used to decrease PAE
– The first change in spending required is 200 / 5 = 40
1,000 (change in r) = 40
Change in r = 40 / 1,000 = 0.04
The central bank should decrease the real interest rate
to 9%
Planned aggregate expenditure (PAE)
The Central Bank Fights Inflation
Y = PAE
Expenditure line (r = 5%)
Expenditure line (r = 9%)
E
G
4,600 4,800
Y*
An increase in r shifts the
expenditure line down and
closes the expansionary gap
Output (Y)
Interest Rates Increased in
2004 and 2005
• With slow recovery beginning in November, 2001 in the
United States, the Fed continued to decrease interest
rates until it reached 1.0% in June 2003
• Real GDP growth was nearly 6% in the 2nd half, 2003
– Growth was 4.4% in 2004
– Unemployment was 5.6% in June 2004
• Inflation increased in 2004, mainly due to oil prices
– Fed began tightening in June, 2004
– Fed funds rate increased from 1.0% to 1.25%
– Continued gradually raising the fed funds rate
– August, 2005, the rate was 3.5%
Inflation and the Stock Market
• Bad news about inflation causes stock prices to
decrease
• Investors anticipate the central bank will
increase interest rates
– Slows down economic activity, lowering firms' sales
and perhaps profits
• Lower profits mean lower dividends which mean
lower stock prices
– Higher interest rates make non-stock financial
instruments more attractive
• Reduces the demand for stocks and the stock prices
Fed and the U.S. Stock Market
• Fed gets credit for sustained economic growth
and rising asset prices in the 1990s
– S&P 500 increased 233% between January 1995,
and March 2000
– Stocks buoyed consumption; supported growth
• Possible stock speculation led to sharp
decreases
– If the Fed had acted sooner, the run-up would have
been curtailed and the crash moderated
– Greenspan's response is
• Separating speculation from growth is difficult
• The Fed could not have timed the stock market
Monetary Policy and the Stock Market
• The central bank has limited ability to manage the stock
market
– The central bank does not know the "right" prices
• Information available to the central bank is publicly
available
– Monetary policy is not well suited to addressing an
asset bubble (a speculative increase in asset prices
over their underlying market value)
• The central bank can raise interest rates and slow
the economy
• Could result in a recession and rising unemployment
• The debate over the Fed's role in asset prices got new
attention after the mortgage meltdown in the United States
in 2007 - 2008
The Central Bank and Interest Rates
• In the United States, controlling the money supply is the
primary task of the FOMC
– Money supply and demand determine the interest
rate
– The central bank manipulates supply to achieve its
desired interest rate
• Portfolio allocation decisions allocate a person's
wealth among alternative forms
– Diversification is owning a variety of different assets
to manage risk
• The demand for money is the amount of wealth held in
the form of money
Demand for Money
• Demand for money is sometimes called an
individual's liquidity preference
– The Cost – Benefit Principle indicates people will
balance the marginal cost of holding money versus
the marginal benefit
• Money's benefit is the ability to make transactions
– Quantity of money demanded increases with
income
– Technologies such as online banking and ATMs
have reduced the demand for money
• M1 in the United States has decreased from 28% of
GDP in 1960 to 12% in 2004
Demand for Money
• The marginal cost of holding money is the
interest foregone
– Most forms of money pay little or no interest
• Assume the nominal interest rate on money is 0
• Alternative assets such as stocks or bonds have a
positive nominal interest rate
• The higher the nominal interest rate, the smaller
the quantity of money demanded
• Business demand for money is similar to
individuals'
– Businesses hold more than half of the money stock
Demand for Money
• Demand for money depends on:
– Nominal interest rate (i)
• The higher the interest rate, the lower the quantity of
money demanded
– Real income or output (Y)
• The higher the level of income, the greater the
quantity of money demanded
– The price level (P)
• The higher the price level, the greater the quantity of
money demanded
The Money Demand Curve
Nominal interest rate (i)
• Interaction of the aggregate demand for money and the
supply of money determines the nominal interest rate
• The money demand curve shows the relationship
between the aggregate quantity of money demanded, M,
and the nominal
interest rate
– An increase in the
nominal interest rate
increases the
opportunity cost of
MD
holding money
Money (M)
• Negative slope
The Money Demand Curve
Nominal interest rate (i)
• Changes in factors other than the nominal interest rate
cause a shift in the money demand curve
• An increase in demand for money can result from
– An increase in output
– Higher price levels
– Technological advances
– Financial advances
– Foreign demand for
MD'
dollars
MD
Money (M)
Demand for Dollars in Argentina
• The average Argentine holds more dollars than the
average U.S. citizen
• In the 1970s and 1980s, Argentina had high rates of
inflation
– Real returns on assets in pesos declined
– Argentines switched to dollars as a store of value
• In 1990, the U.S. dollar and Argentine peso traded 1:1
– Both were accepted for transactions
• By 2001, inflation in Argentina caused the system to
break down
– Peso was worth less than the dollar
International Demand for U.S.
Dollars
• Political instability in some countries also
increases the demand for dollars
– Avoids confiscation and taxes
• Largest U.S. bill is $100, popular with drug
dealers
– The Euro is available in €500 bills, worth more than
$500
• More compact way of storing a given amount of
wealth
– If drug dealers switch to holding their cash in Euros,
the demand for the U.S. dollar will decrease
Supply of Money
Nominal interest rate (i)
• The central bank primarily controls the supply of money
with open-market operations
– An open-market purchase of bonds by the central
bank increases the money supply
– An open-market sale of
bonds by the central bank
MS
decreases the money
supply
E
• Supply of money is vertical
i
MD
• Equilibrium is at E
M
Money (M)
Equilibrium in the Money Market
Nominal interest rate (i)
• Bond prices are inversely related to the interest rate
• Suppose the interest rate is at i1, below equilibrium
– Quantity of money demanded is M1, more than the
money available
– To get more money, people
MS
sell bonds
• Bond prices go down,
E
interest rates rise
i
i1
MD
– Quantity of money
demanded decreases
from M1 to M
M M1 Money (M)
The Central Bank Controls the
Nominal Interest Rate
Nominal interest rate (i)
• Central bank policy is stated in terms of interest rates
– The tool they use is the supply of money
• Initial equilibrium at E
• The central bank increases
MS
MS'
the money supply to MS'
– New equilibrium at F
E
i
– Interest rated decrease to i'
F
i'
to convince the market
MD
to hold the new, larger
amount of money
M M'
Money (M)
The Central Bank (CB) Controls
the Nominal Interest Rate
To Decrease the Money Supply
CB sells
bonds to
the
public
Supply of
bonds
increases
Price of
bonds
decrease
Interest
rate
increases
To Increase the Money Supply
CB buys
bonds
from the
public
Demand
for bonds
increases
Price of
bonds
increase
Interest
rate
decreases
The Central Bank Targets the
Interest Rate
• The central bank cannot set the interest rate and
the money supply independently
• Central bank policy is announced in terms of
interest rates because
– Public is not familiar with the size of the money
supply
– Interest rate changes affect planned spending and
the level of economic activity
– Interest rates are easier to monitor than the money
supply
Federal Funds Rate
• The federal funds rate is the interest rate that
banks in the United States charge each other for
very short-term loans
– Closely watched in financial markets
• The Fed targets this interest rate because it is
closely tied to the level of bank reserves
• Changes in the federal funds rate indicate the Fed's plans
for monetary policy
• Other interest rates could be used to indicate the Fed's
intentions
Additional Controls over the
Money Supply
• Open market operations are the main tool of money
supply
• The central bank offers lending facility to banks, called
discount window lending
– If a bank needs reserves, it can borrow from the
central bank at the discount rate
• The discount rate is the rate the central bank
charges banks to borrow reserves
• Lending increases reserves and ultimately increases the
money supply
• Changes in the discount rate signal tightening or
loosening of the money supply
Additional Controls over the
Money Supply
• The central bank can also change the reserve
requirement for banks
– The reserve requirement is the minimum
percentage of bank deposits that must be held in
reserves
– The reserve requirement is rarely changed
• The central bank could increase the money
supply by decreasing the reserve requirement
– Banks would have excess reserves to loan
• The central bank could decrease the money
supply by increasing the reserve requirement
Stabilizing the Economy: The
Role of the Central Bank
Stock
Market
Supply of
Money
Money
Market
Demand
for Money
Central
Bank
Interest Rates:
Real, Nominal,
Fed Funds
Stabilization
Policy
Keynesian
Model
Monetary
Policy
Open Market
Operations
Discount Rate
Reserve
Requirement