The Federal Reserve and Monetary Policy

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The Federal Reserve andMonetary Policy

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FERNANDO QUIJANO, YVONN QUIJANO,

AND XIAO XUAN XU

P R E P A R E D B Y

Little did Ben S. Bernanke know when he took over the reins as chairman of the

Federal Reserve on February 1, 2006, that he would face a novel and complex crisis

brought on by the fall in housing prices and its reverberations throughout the entire

financial system in 2007 and 2008.


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The Federal Reserve and Monetary Policy

A P P L Y I N G T H E C O N C E P T S

1

2

3

Why did the Federal Reserve introduce new mechanisms for institutions to borrow money from it?

New Ways to Borrow from the Fed

What happens to interest rates when the economy recovers from a recession?

Rising Interest Rates during an Economic Recovery

Is it better for decisions about monetary policy to be made by a single individual or by a committee?

The Effectiveness of Committees


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• money marketThe market for money in which theamount supplied and the amountdemanded meet to determine thenominal interest rate.

• transaction demand for moneyThe demand for money based on the desire to facilitate transactions.

The Demand for Money

INTEREST RATES AFFECT MONEY DEMAND

THE MONEY MARKET14.1


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FIGURE 14.1Demand for Money


P R I N C I P L E O F O P P O RT U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.

As interest rates increase from r0 to r1, the quantity of

money demanded falls from M0 to M1.


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The Demand for MoneyTHE PRICE LEVEL AND GDP AFFECT MONEY DEMAND

FIGURE 14.2Shifting the Demand for Money


R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income— its purchasing

power—not the face value of money or income.

Changes in prices and real GDP shift the demand for money.


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OTHER COMPONENTS OF MONEY DEMAND

• illiquidNot easily transferable to money.

• liquidity demand for moneyThe demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs.

• speculative demand for moneyThe demand for money that arises because holding money over short periods is less risky than holdingstocks or bonds.



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• open market operationsThe purchase or sale of U.S.government securities by the Fed.

Open Market Operations

• open market purchasesThe Fed’s purchase of governmentbonds from the private sector.

• open market salesThe Fed’s sale of government bonds to the private sector.

HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY14.2


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• discount rateThe interest rate at which banks can borrow from the Fed.

Other Tools of the Fed

• federal funds marketThe market in which banks borrow and lend reserves to and from one another.

• federal funds rateThe interest rate on reserves that banks lend each other.

CHANGING RESERVE REQUIREMENTS

CHANGING THE DISCOUNT RATE

HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY14.2

If the Fed wishes to increase the supply of money, it can reduce banks’ reserve requirements so they have more money to loan out.


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NEW WAYS TO BORROW FROM THE FED

APPLYING THE CONCEPTS #1: Why did the Federal Reserve introduce new mechanisms

for institutions to borrow money from it?

Banks might need funds but be reluctant to borrowfrom the Fed, because the Fed is also their regulator and could become concerned about the banks’ solvency. These concerns limit the amount banks wanted to borrow from the Fed.

To provide more liquidity directly to the banking system, the Fed developed a number of new ideas. The first was the Term Auction Facility, in which the Fed auctioned off loans in the market to banks and other eligible depository institutions.

The next was a Term Securities Lending Facility that provided loans to 20 different banks and financial institutions that were major dealers in government securities.

As a response to the deepening of the financial crisis in October 2008, the Fed also developed two additional means of providing funding to the economy. The Commercial Paper Funding Facility allows the Fed to indirectly purchase short term corporate debt—commercial paper—from firms. In addition, the Fed developed the Money Market Investor Funding Facility to provide a mechanism to support money market funds that came under stress during the financial crisis in 2008.

A P P L I C A T I O N 1


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FIGURE 14.3Equilibrium in the Money Market

HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY

14.3

Equilibrium in the money market occurs at an interest rate of r*, at which the quantity of money demanded equals the quantity of money supplied.


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FIGURE 14.4Federal Reserve and Interest Rates


14.3

Changes in the supply of money will change interest rates.


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Interest Rates and Bond Prices

HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES

GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES


14.3

Bond prices rise as interest rates fall.

Increased money demand will increase interest rates.


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RISING INTEREST RATES DURING AN ECONOMIC RECOVERY

APPLYING THE CONCEPTS #2: What happens to interest rates when the economy

recovers from a recession?

Economists have often noticed that as an economy recovers from a recession, interest rates start to rise.

Some observers think this is puzzling because they associate higher interest rates with lower output. Why should a recovery be associated with higher interest rates? The simple model of the money market helps explain why interest rates can rise during an economic recovery. One key to understanding this phenomenon is that the extra income being generated by firms and individuals during the recovery will increase the demand for money. Because the demand for money increases while the supply of money remains fixed, interest rates rise.

Another factor is that the Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy. In this case, the Fed cuts back on the supply of money to raise interest rates. In both cases, however, the public should expect rising interest rates during a period of economic recovery and rapid GDP growth.



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FIGURE 14.5The Money Market and Investment Spending

INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP)14.4

The equilibrium interest rate r* is determined in the money market. At that interest rate, investment spending is given by I*.


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FIGURE 14.6Monetary Policy and Interest Rates


As the money supply increases, interest rates fall from r0 to r1. Investment spending increases

from I0 to I1.


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FIGURE 14.7Money Supply and Aggregate Demand


When the money supply is increased, investment spending increases, shifting the AD curve to the right. Output increases and prices increase in the short run.


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Monetary Policy and International Trade

• exchange rateThe rate at which currencies trade for one another in the market.

• depreciation of a currencyA decrease in the value of a currency.



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Monetary Policy and International Trade

• appreciation of a currencyAn increase in the value of a currency.



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Lags in Monetary Policy

Influencing Market Expectations: From the Federal Funds Rate to Interest Rates on Long-Term Bonds

MONETARY POLICY CHALLENGES FOR THE FED14.5

Inside lags are the time it takes for policymakers to recognize and implement policy changes. Outside lags are the time ittakes for policy to actually work.

It is important to recognize that the Fed directly controls only very short-term interest rates in the economy, not long-term interest rates.

For the Fed to control investment spending, it must also somehow influence long-term rates. It can do this indirectly by influencing short-term rates.


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THE EFFECTIVENESS OF COMMITTEES

APPLYING THE CONCEPTS #3: Is it better for decisions about monetary policy to be made by a single individual or

by a committee?

When Professor Alan Blinder returned to teaching after serving as vice-chairman of the Federal Reserve from 1994 to 1996, he was convinced that committees were not effective for making decisions about monetary policy. With another researcher, Blinder developed an experiment to determine whether in fact individuals or groups make better decisions.

The results of the experiment showed that committees make decisions as quickly as, and more accurately than, individuals making decisions by themselves. Moreover, it was not the performance of the individual committee members that contributed to the superiority of committee decisions—the actual process of having meetings and discussions appears to have improved the group’s overall performance.

In later research, Blinder also found that it did not really matter whether the committee had a strong leader. His findings suggest it is the wisdom of the group, not its leader, that really matters. And to the extent the leader has too much power—and the committee functions more like an individual than a group—monetary policy will actually be worse!



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Looking Ahead: From the Short Run to the Long Run

MONETARY POLICY CHALLENGES FOR THE FED14.5

Monetary policy can affect output in the short run when prices are largely fixed, but in the long run changes in the money supply affect only the price level and inflation.

In the long run, the Federal Reserve can only indirectly control nominal interest rates, and it can’t control real interest rates—the rate after inflation is figured in.

In the next part of the book, we will explain how output and prices change over time, and how the economy makes the transition by itself from the short to the long run regardless of what the Fed does.


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appreciation of a currency

depreciation of a currency

discount rate

exchange rate

federal funds market

federal funds rate

illiquid

liquidity demand for money

money market

open market operations

open market purchases

open market sales

speculative demand for money

transaction demand for money

K E Y T E R M S

The Federal Reserve and Monetary Policy

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