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Prepared By Brock Williams

Chapter 17Monetary Policy

and InflationLittle 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-2

1. Explain the role of demand and supply in the money market.

2. List the tools that the Fed can use to change short-term interest rates.

3. Demonstrate using supply and demand curves how the Fed can determine short-term interest rates.

4. Describe both the domestic and international channels through which monetary policy can affect real GDP.

5. Assess the challenges the Fed faces in implementing monetary policy.

Learning Objectives


• 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

17.1 THE MONEY MARKET


The Demand for Money

FIGURE 17.1Demand 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 TThe 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.

17.1 THE MONEY MARKET (cont.)


The Demand for MoneyTHE PRICE LEVEL AND GDP AFFECT MONEY DEMAND

FIGURE 17.2Shifting 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.



BEYOND PURCHASING TREASURY SECURITIES

APPLYING THE CONCEPTS #1: How has the Fed recently expanded its role in financial markets?

Traditionally, to expand the money supply, the Fed purchased Treasury Securities. The Fed did not intervene directly in security or credit markets.

After the financial crisis of 2008, they changed their policies.

The Fed increased its assets from less than $1 Trillion to over $2 Trillion.

In 2010 The Fed held over $1 Trillion in mortgage-backed securities.

The Fed designed a wide variety of programs to channel funds to particular credit markets.

Critics are worried the Fed crossed a political threshold that may pose a risk to its long-term independence.

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


The Demand for MoneyOTHER 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.



• 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.

17.2 HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY


• 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

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

17.2 HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY (cont.)


DID FED POLICY CAUSE THE COMMODITY BOOM

APPLYING THE CONCEPTS #2: What is the link between a dollar depreciation and increases in commodity prices?

Starting in the summer of 2010, there was a rise in prices of commodities such as oiland food worldwide. These increases in prices helped some economies—producersof these commodities—but hurt others. Some economists suggested that monetarypolicy in the United States was the cause of the worldwide commodity boom. Theynoticed that commodity prices rose when the U.S. dollar depreciated. And theynoticed that the U.S. dollar fell largely because monetary policy in the U.S. had driven interest rates down very low because the Fed was using quantitative easing to further stimulate the economy.

Vice-Chair of the Board of Governors, Janet L. Yellen, gave her own perspective in a speech in April 2011 to the Economic Club of New York. She noted that the sharp rise in commodity prices was many times larger than the dollar depreciation. Moreover, she pointed to increases in worldwide demand and shortages of supply that were the primary cause of these price increases.

Yellen did note that when the U.S. lowered interest rates, other countries alsofollowed for fear that too much capital would flow into their countries if their interestrates were higher than those in the U.S.



FIGURE 17.3Equilibrium in the Money Market

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.

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


FIGURE 17.4Federal Reserve and Interest Rates

Changes in the supply of money will change interest rates.

17.3 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY (cont.)


FIGURE 17.5The Money Market and Investment SpendingThe equilibrium interest rate r* is determined in the money market. At that interest rate, investment spending is given by I*.

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


FIGURE 17.6Monetary Policy and Interest RatesAs the money supply increases, interest rates fall from r0 to r1. Investment spending increases from I0 to I1.

17.4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont.)


FIGURE 17.7Money Supply and Aggregate DemandWhen the money supply is increased, investment spending increases, shifting the AD curve to the right. Output increases and prices increase in the short run.



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.



Monetary Policy and International Trade

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



THE EFFECTIVENESS OF COMMITTEESAPPLYING 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 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!



Lags in Monetary Policy

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

Outside lags are the time it takes for policy to actually work.

17.5 MONETARY POLICY CHALLENGES FOR THE FED


Expectations of Inflation

No “magic” inflation rate is necessary to sustain full employment.

In the long run, changes in aggregate demand only affect prices and not output.

If the Fed increased the money supply 5 percent a year and we had 5 percent inflation long term, people would come to expect this inflation.

Expectations of inflation affect all aspects of economic life.

Continued inflation becomes normal and is built in to decision making.

17.5 MONETARY POLICY CHALLENGES FOR THE FED (cont.)


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

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