Chapter 17 Domestic and International Dimensions of...

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Chapter 17

Domestic and International Dimensions of Monetary Policy


17-2

Introduction

In recent months, the number of foreclosures on home mortgages is back up to nearly twice the norm.

Despite Federal Reserve efforts that have pushed down market interest rates and provided new sources of funds to U.S. financial institutions, banks are still reluctant to lend to businesses and consumers – and even each other.

How does today’s Fed conduct policies that operate through interest rates?


17-3

Learning Objectives

• Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run

• Understand the equation of exchange and its importance in the quantity theory of money and prices

• Discuss the interest-rate-based transmission mechanism of monetary policy


17-4

Learning Objectives (cont'd)

• Explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously

• Describe how the Federal Reserve achieves a target value of the federal funds rate

• Explain key issues the Federal Reserve confronts in selecting its target for the federal funds rate


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Chapter Outline

• Effects of an Increase in the Money Supply• Open Economy Transmission of Monetary

Policy• Monetary Policy and Inflation• Monetary Policy in Action: The Transmission

Mechanism


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Chapter Outline (cont'd)

• The Way Fed Policy is Currently Implemented

• Selecting the Federal Funds Rate Target


17-7

Did You Know That…

• At various times during the mid-2000s the Bank of Japan sought to keep an interest rate equal to 0%?

• Officials felt that varying the rate of money supply growth as necessary to keep the interest rate at 0% was consistent with broader objectives for “economic and price conditions.”

• What does varying the supply of money or the rate at which it grows have to do with interest rates such as the Japanese “overnight call-money” rate?


17-8

Effects of an Increase in The Money Supply

• What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter?

• People pick up the money and put it in their pockets, but how do they dispose of the new money?


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Effects of an Increase in The Money Supply (cont'd)

• Direct effect

– Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services.


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• Indirect effect

– Not everybody will necessarily spend the newfound money on goods and services.

– Some of the money gets deposited, so banks have higher reserves (and they lend the excess out).


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• Indirect effect

– Banks lower rates to induce borrowing. • Businesses engage in investment.• Individuals consume durable goods (like housing and

autos).

– Increased loans generate an increase in aggregate demand.• More people are involved in more spending (even those

who didn’t get money from the helicopter!).


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Graphing the Effects of an Expansionary Monetary Policy

• Assume the economy is operating at less than full employment

– Expansionary monetary policy can close the recessionary gap.

– Direct and indirect effects cause the aggregate demand curve to shift outward.


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Figure 17-1 Expansionary Monetary Policy with Underutilized Resources

• The recessionary gap isdue to insufficient AD

• To increase AD,use expansionary monetary policy

• AD increases and real GDP increases to full employment


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Graphing the Effects of Contractionary Monetary Policy

• Assume there is an inflationary gap

– Contractionary monetary policy can eliminate this inflationary gap.

– Direct and indirect effects cause the aggregate demand curve to shift inward.


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• The inflationary gap is shown• To decrease AD, use

contractionary monetary policy• AD decreases and real

GDP decreases

Figure 17-2 Contractionary Monetary Policy with Overutilized Resources


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Open Economy Transmission of Monetary Policy

• So far we have discussed monetary policy in a closed economy.

• When we move to an open economy, monetary policy becomes more complex.


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Open Economy Transmission of Monetary Policy (cont'd)

• The net export effect of contractionary monetary policy

• Boosts the market interest rate

• Higher rates attract foreign investment

• International price of dollar rises

• Appreciation of dollar reduces net exports

• Negative net export effect


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• The net export effect of expansionary monetary policy

• Lower interest rates

• Financial capital flows out of the United States

• Demand for dollars will decrease

• International price of dollar goes down

• Foreign goods look more expensive in United States

• Net exports increase (imports fall)


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• Globalization of international money markets

– How will global money markets impact the Fed's ability to control the rate of growth in the money supply?


17-20

Monetary Policy and Inflation

• Most theories of inflation relate to the short run and the price index in the short run can fluctuate due to– Oil price shocks, labor union strikes

• In the long run, there is a more stable relationship between growth in the money supply and inflation.


17-21

Monetary Policy and Inflation (cont'd)

• Simple supply and demand analysis can be used to explain – Why the price level rises when the money supply

is increased

• If the supply of money expands relative to the demand for money– It takes more units of money to purchase given

quantities of goods and services (i.e., the price level has risen)


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MsV = PY


• The Equation of Exchange

– The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP


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• The equation of exchange and the quantity theory: MSV = PY

– MS = actual money balances held by nonbanking public

– V = income velocity of money; the number of times, on average per year, each monetary unit is spent on final goods and services


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• Income Velocity of Money

– The number of times per year the dollar is spent on final goods and services; equal to the nominal GDP divided by the money supply.


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• The equation of exchange and the quantity theory: MSV = PY

– P = price level or price index

– Y = real GDP per year


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• The equation of exchange as an identity

– Total funds spent on final output MsV equals total funds received PY

– The value of goods purchased is equal to the value of goods sold

– MsV = PY = nominal GDP


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• Quantity Theory of Money and Prices

– The hypothesis that changes in the money supply lead to equiproportional changes in the price level


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• The quantity theory of money and prices

– Assume: V is constantY is stable

MsV = PY


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• The quantity theory of money and prices

– Increases in Ms must be matched by equal increases in the price level

MsV = PY


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Figure 17-3 The Relationship Between Money Supply Growth Rates and Rates of Inflation

Sources: International Monetary Fund and national central banks. Data are for latest available periods.


17-31

International Example: Paying Attention to Money Supply Growth Rates in Europe

• Ben Bernanke, chairman of the Fed, has argued that a “heavy reliance” on money supply growth as an indicator of U.S. inflation is unwise in light of unpredictable short-term effects of money growth on inflation.

• Officials in the European System of Central Banks and the Bank of England believe that growth in the money supply ultimately foreshadows future growth in the level of prices.


17-32

International Example: Paying Attention to Money Supply Growth Rates in Europe (cont’d)

• They credit this approach with keeping the average annual European inflation rates lower than the average annual U.S. rate.

• If the annual money growth rate is higher in the U.S. than in Europe but velocity and real GDP growth rates are the same, what will be true of the U.S. inflation rate compared with the European rate?


17-33

Monetary Policy in Action: The Transmission Mechanism

• Recall we talked about the direct and indirect effects of monetary policy

– Direct effect: implies increase in money supply causes people to have excess money balances.

– Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.


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Figure 17-4 The Interest-Rate-Based Money Transmission Mechanism


17-35

Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a and b)

At lower rates, a larger quantity of money will be demanded

The decrease in the interest rate stimulates investment


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Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c)

The increase in investment shifts the AD curve to the right


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Monetary Policy in Action: The Transmission Mechanism (cont’d)

The Fed’s Target Choice: Interest Rates or Money Supply?

• It is not possible to stabilize the money supply and interest rates simultaneously.

• The Fed has often sought to achieve an interest rate target.

• There is a fundamental tension between targeting interest rates and controlling the money supply.


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Figure 17-6 Choosing a Monetary Policy Target

If the Fed selects re, it must accept Ms

If the Fed selects M’s, it must allow the interest rate to fall


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• The Fed, in the short run, can select an interest rate or a money supply target but not both.


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• Choosing a policy target

– Money supply• When variations in private spending occur

– Interest rates• When the demand for (or supply of) money is unstable

• Interest rate targets are preferred


17-41

The Way Fed Policy is Currently Implemented

• At present the Fed announces an interest rate target.

• The rate referred to is the federal funds rate of interest.

• Or, the rate at which banks can borrow excess reserves from each other.


17-42

The Way Fed Policy is Currently Implemented (cont'd)

• If the Fed wants to raise “the” interest rate, it engages in contractionary open market operations.

– Fed sells more Treasury securities than it buys, thereby reducing the money supply.• This tends to boost “the” rate of interest.


17-43


• Conversely, if the Fed wants to decrease “the” rate of interest, it engages in expansionary open market operations.

– Fed buys more Treasury securities, increasing the money supply.• This tends to lower “the” rate of interest.


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Figure 17-7 The Market for Bank Reserves and the Federal Funds Rate, Panel (a)


17-45

Figure 17-7 The Market for Bank Reserves and the Federal Funds Rate, Panel (b)


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• FOMC Directive

– A document that summarizes the Federal Open Market Committee’s general policy strategy

– Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth


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• Trading Desk

– An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC


17-48

Policy Example: Reading the Tea Leaves of Fed Policy Statements

• After each Fed meeting, the FOMC issues a statement explaining the rationale for its Directive to the Trading Desk.

• Subtle changes in wording may provide hints about possible future changes in interest rate policy.

• Why do you suppose that members of the FOMC devote a considerable portion of their time to carefully crafting changes in the FOMC’s policy statement to the public?


17-49

Selecting the Federal Funds Rate Target

• The Neutral Federal Funds Rate– A value of the interest rate on interbank loans at

which the growth rate of real GDP tends neither to rise nor to fall relative to the rate of growth of potential, long-run, real GDP, given the expected rate of inflation


17-50

Selecting the Federal Funds Rate Target (cont’d)

• The value of neutral federal funds rate varies over time. The potential rate of growth of real GDP is not constant.

• When the rate of growth rises or falls, so does the value of the neutral federal funds rate.

• The FOMC must respond by changing the target for the federal funds rate that it includes in the FOMC Directive transmitted to the Trading Desk.


17-51

Selecting the Federal Funds Rate Target (cont’d)

• Taylor Rule

– A suggested guideline for monetary policy

– An equation determining the Fed’s interest rate target based on • Estimated long-run real interest rate• Deviation of the actual inflation rate from the Fed’s

objective• Gap between actual real GDP and a measure of

potential GDP


17-52

Figure 17-8 Actual Federal Funds Rates and Values Predicted by a Taylor Rule

Source: Federal Reserve Bank of St. Louis; Monetary Trends, various issues.


17-53

Issues and Applications: The Fed Tackles a Credit Crisis

• Throughout the 2000s, as in previous years, various financial institutions, such as savings banks, extended mortgage loans to finance most households’ home purchases.

• Among these were loans to lower-income households, also known as subprime loansbecause these involved higher risk.


17-54

Issues and Applications: The Fed Tackles a Credit Crisis (cont’d)

• The depository institutions then sold most of these subprime loans to agencies like the Federal National Mortgage Loan Association, which then sold shares in the mortgages –called mortgage-backed securities – to individual investors.


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• In 2007 and 2008, market prices of houses dropped throughout the U.S, resulting in a wave of foreclosures.

• The houses became properties of the mortgage lenders but at this point were often worth less than the original loans, so investors experienced large losses.


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• Consequences: – Savings banks and other institutions cut back on

lending– Many private investors stopped purchasing

mortgage-backed securities– Financial institutions began to lose trust in each

other


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• The Fed Response:– Adjustment of 2 monetary policy tools

• Significant reductions in the target federal funds rate

• Reduction in the differential between the discount rate and the federal funds rate

– Temporary supplemental mechanism for dispersing reserves directly to depository institutions

– Broadened the scope of its lending activities


17-58

Summary Discussion of Learning Objectives

• How expansionary and contractionarymonetary policy affect equilibrium real GDP and the price level in the short run

– Expansionary monetary policy• Pushing up money supply, inducing a fall in interest

rates• Total planned expenditures rise, AD shifts rightward

– Contractionary monetary policy• Reduces the money supply increasing interest rates• Total planned expenditures fall, AD shifts leftward


17-59

Summary Discussion of Learning Objectives (cont'd)

• The equation of exchange and the quantity theory of money and prices

– Equation of exchange• MV = PY

– Quantity theory of money and prices• V is constant and Y is stable• Increases in M lead to equiproportional increases in P


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• The interest-rate-based transmission mechanism of monetary policy

– Operates through effects of monetary policy actions on market interest rates

• Bring about changes in desired investment and thereby affect equilibrium GDP via the multiplier effect


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• Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously

– To target the money supply the Fed must permit the interest rate to vary when the demand for money changes.

– To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes.


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• How the Federal Reserve Achieves a Target Value of the Federal Funds Rate– The interest rate at which banks can borrow

excess reserves from other banks is at an equilibrium level when the quantity of reserves demanded by banks equals the quantity of reserves supplied by the Fed.

– The Trading Desk conducts open market sales or purchases to alter the supply of reserves as necessary to keep the federal funds rate at the FOMC’s target


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• Issues the Federal Reserve Confronts in Selecting its Target for the Federal Funds Rate– The FOMC target is the neutral federal funds rate– The Taylor Rule specifies an equation for the

federal funds rate target based on• an estimated long-run real interest rate• the current deviation from the Fed’s inflation goal• the gap between actual real GDP and a measure of

potential real GDP


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Figure D-1 An Increase in the Money Supply

Chapter 17 Domestic and International Dimensions of...

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