powerpoint presentationthe central bank: cb the federal reserve system, commonly known as “the...

15CHAPTERMonetary Policy

The Central Bank: CB

The Federal Reserve System, commonly known as “the

Fed”, is the central bank of the United States.

A Central Bank (CB) is the public authority that, typically,

regulates a nation’s depository institutions and controls the

quantity of the nation’s money. The degree of

independence the central bank has from the government

of the day varies a great deal from one country to another.

The Central Bank: CB

The CB’s Goals and Targets

The CB conducts the nation’s monetary policy, which means that,

among other things, it adjusts the quantity of money in circulation.

The CB’s goals are to keep inflation in check, maintain full

employment, moderate the business cycle, and contribute to

achieving long-term growth.

In pursuit of its goals, in the U.S., the Fed pays close attention to

interest rates and sets a target for the federal funds rate that is

consistent with its goals. The federal funds rate is the interest rate

that commercial banks in the U.S. charge each other on overnight

loans of reserves [“federal funds”]. In Canada, this rate is called the

“Overnight lending rate”. In Bangladesh, it is called the “Call Money

Rate”.

Controlling the Quantity of Money

The CB’s Policy Tools

In theory, the CB could use three monetary policy tools:

Required reserve ratios

The discount rate

Open market operations


The CB sets required reserve ratios, which are the

minimum percentages of deposits that depository

institutions must hold as reserves.

The CB does not change these ratios very often.

The discount rate is the interest rate at which the CB

stands ready to lend reserves to depository institutions.

An open market operation is the purchase or sale of

government securities —Treasury bills and bonds — by

the CB in the open market.


How Required Reserve Ratios Work

An increase in the required reserve ratio boosts the reserves that

banks must hold, decreases their lending, and decreases the

quantity of money. However, this is a sudden discontinuous

change, so can be disruptive.

How the Discount Rate Works

An increase in the discount rate raises the cost of borrowing

reserves from the CB and decreases banks’ reserves, which

decreases their lending and decreases the quantity of money.

But banks try to avoid borrowing from the CB [why?], so discount

rate changes act mainly as a signal.


How an Open Market Operation Works

When the CB conducts an open market operation by buying a

government security, it increases banks’ reserves.

Banks loan the excess reserves.

By making loans, they create money.

The reverse occurs when the CB sells a government security.

Changing the supply of reserves to the banking system changes the

interbank lending/borrowing rate, the interest rate at which banks

lend and borrow reserves among themselves. So in practice, the CB

announces a target rate for the interbank lending rate, and then

uses Open Market Operations to get close to its target.

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The Demand for Money

This Figure illustrates the demand for money curve.

The demand for money curve slopes downward—a rise in the interest rate raises the opportunity cost of holding money and brings a decrease in the quantity of money demanded, which is shown by a movement along the demand for money curve.

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The Supply of Money

This Figure shows the supply of

money as a vertical line at the

quantity of money that is largely

determined by the CB. The money

supply is largely but not exclusively

determined by the CB because

both banks and the public are

important players in the money

supply process (as explained in

earlier chapters). For example,

when banks do not lend their entire

excess reserves, the money supply

is not as large as it is when they

do.

Money market equilibrium

determines the interest rate.

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Interest Rate Determination

An interest rate is the percentage yield on a financial security such

as a bond or a stock [or savings account].

The price of a bond and the interest rate are inversely related.

If the price of a bond falls, the interest rate on the bond rises.

If the price of a bond rises, the interest rate the bond yields falls.

We can study the forces that determine the interest rate in the

market for money.

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Money Market Equilibrium

This Figure

illustrates the

equilibrium

interest rate.

12


If the interest rate is above the equilibrium interest rate, the quantity of money that people are willing to hold is less than the quantity supplied.

They try to get rid of their “excess” money by buying financial assets.

This action raises the price of these assets and lowers the interest rate.

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If the interest rate is below the equilibrium interest rate, the quantity of money that people want to hold exceeds the quantity supplied.

They try to get more money by selling financial assets.

This action lowers the price of these assets and raises the interest rate.

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Changing the Interest Rate

This Figure shows how the CB changes the interest rate.

If the CB conducts an open market sale, the money supply decreases, the money supply curve shifts leftward, and the interest rate rises.

15


If the CB

conducts an

open market

purchase, the

money supply

increases, the

money supply

curve shifts

rightward, and

the interest rate

falls.

Transmission Mechanisms

Changes in one market can often ripple outward to affect

other markets. The routes, or channels, that these ripple

effects travel are known as the transmission mechanism.

Monetary policy transmission mechanism: The routes,

or channels, traveled by the ripple effects that the money

market creates and that affect the goods and services

market (represented by the aggregate demand and

aggregate supply curves in the AD–AS framework).

In this chapter we discuss two transmission mechanisms:

the Keynesian and the Monetarist.

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The Money Market in the Keynesian Transmission

Mechanism: Indirect

If the CB increases money supply, the interest rate

decreases. Then, three events follow:

Investment and consumption expenditures increase.

The value of the dollar in terms of foreign currency falls

and net exports increase.

Aggregate demand increases (through a multiplier

effect).

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This Figure

summarizes these

ripple effects.

The final step

depends on the

shape of the

aggregate supply

curve

The Keynesian

Transmission

Mechanism: Indirect


The Keynesian

Mechanism May

Get Blocked

Interest-Insensitive

Investment

(a) If investment is totally

interest insensitive, a

change in the interest

rate will not change

investment; therefore,

aggregate demand and

Real GDP will not

change.


The Keynesian

Mechanism May

Get Blocked

The Liquidity Trap

(b) If the money market

is in the liquidity trap, an

increase in the money

supply will not lower the

interest rate. It follows

that there will be no

change in investment,

aggregate demand, or

Real GDP.


Bond prices, interest rates, and the liquidity trap

Remember that the price of a bond and the interest rate are

inversely related. So, when money supply increases, people

use the extra money supply to buy bonds, price of bonds

increases and interest rate falls.

However, when interest rate is very low, this relationship may

break down. At a low interest rate, the money supply

increases but does not result in an excess supply of money.

Interest rates are very low, and so bond prices are very high.

Would-be buyers believe that bond prices are so high that

they have no place to go but down. So individuals would

rather hold all the additional money supply than use it to buy

bonds.


The Keynesian View of Monetary Policy


The Monetarist

Transmission

Mechanism: Direct

The monetarist transmission

mechanism is short and

direct. Changes in the money

market directly affect

aggregate demand in the

goods and services market.

For example, an increase in

the money supply leaves

individuals with an excess

supply of money that they

spend on a wide variety of

goods.

Monetary Policy and the Problem of

Inflationary and Recessionary Gaps

Expansionary Monetary Policy: To reduce unemployment

Monetary Policy and the Problem of

Inflationary and Recessionary Gaps

Contractionary Monetary Policy: To reduce inflation

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