Monetary Policy

Goals for the chapter:1. Learn the three principal tools that the Fed uses tocontrol the money supply plus know about the othertools well enough to recognize them in newspaper accounts.

2. Learn how monetary policy can and does work via the money market on until it shifts aggregate demand, AD.

3. Learn what the logical policy for Mr. Greenspan and theFed is when: a. we need to cure unemployment; b. weneed to control or actually reduce inflation.

The Tools of the Fed: How they control or try to control the money supply.

1. Open-Market Operationsa. buy bonds: put money back into thehands of the public--thus it increases themoney supply.b. sell bonds: replaces money in the hands of the public by giving them slips of paper (nonmoney)called bonds--thus it reduces the money supply.

2. Changes in Reserve Requirements.When the Fed raises the reserve requirement (thefraction of a bank’s demand deposits that it isrequired to hold in reserve (readily available in casethere is a run on the bank), then it has less money to lend out--thus, this action reduces the money supply.

More tools on next slide:

The Fed’s Tools continued:

3. Setting the Discount Rate When other banks borrow from the Fed, the interest ratethey pay is called the Discount Rate. These other bankstend to borrow less money from the Fed when the DiscountRate is higher--thus, less mony is lent out and circulated intothe money supply.

4. Other tools that have sometimes been used: “Moral suasion” (the Fed just tries to talk member banks into eitherexpanding or contracting their loans, sort of like it was the “moral” and responsible thing to do; “Selective credit controls”means that the Fed manages the distribution of credit as opposed to the total volume of credit; and “Margin Credit”requirements on the stock market are also picked by the Fed.

Targeting the Federal Funds Rate

The newspapers often say that the “Fed raised (or lowered)the federal funds rate today to .....”

In fact, the Fed does not directly control the federal fundsrate, instead it targets the federal funds rate. This means thatthe Fed uses open market operations (buys or sells bonds) until the federal funds rate ends up where the Fed wants it to be.

The newspapers usually get the rest correct, they define the“federal funds rate” as the interest rate that banks charge eachother on overnight loans (When banks need quick money likethis it’s usually keep their reserves sufficient).

How Monetary Policy Tools Work to Affect AD

The first step happens in the money market. Consider whatan increased money supply looks like in the “money market.”

Notes: 1. Why does money demand slope downward, ie, why do people choose to hold more of their assets in moneyjust because the interest rate is lower (as you move down thecurve)? Because they have lower opportunity costs of holdingmoney.

2. What happens to the interest rates (yields) in the bond andother lending markets when the money supply is increased?Answer: As shown on the graph (and in Fig 1 of Ruffin andGregory), the larger money supply M’ intersects the money demand curve at a lower equilibrium rate of interest.

Put it all together:We assume the following to get the model going:

1. There is a natural level of output in the long run, whichwe will call yn. The idea is that when GDP is higher thanthis it is theorized to be unsustainably inflationary.2. For the short run we have the usual AD and AS curves3. Monetary and fiscal policy work according to the theories in these past two money chapters and the previouschapters on the Aggregate Expenditure Model as well asthe AS and AD Model.

Then try some questions “as if you were in charge.”:

A. What monetary policy would you choose to cure aKeynesian (demand-led) recession?

B. What monetary policy to cure inflation? (Answer next).

Unfortunately, in practice the money supply growthhas been very volatile. (See R&G Fig 6.

Why it is difficult in practice to use monetary policyeffectively:

1. Lags (also applies to fiscal policy).a. recognition lagb. effectiveness lag

2. Limitations in the Fed’s ability to get the many banksto voluntarily do what the Fed wants them to do.

“You can lead a horse to water but you can’t make him drink.”

Monetarism:

It is a doctrine that monetary policy should follow a constant-monetary growth rule.

A “constant-monetary-growth rule” fixes the percentagegrowth of the money supply to a constant rate per year.

Milton Friedman is the inventor and most prominent proponent of this policy. Though experts describe therebeing clear drawbacks as well as advantages to this policy, nearly all agree that Friedman, in the process of his studies has become the world’s expert on the subjectof money.

Rational Expectations:

Definition: People have rational expectations, for exampleAbout future prices, when they make their guesses withoutAny biases.

(A “bias” in estimating is when you error disproportionatelyOften either on the high side or the low side.

Show on blackboard using the AS and AD context.