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Chapter 15 Monetary Policy To
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Editors Notes: A.
McConnell Economics Books, including the
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Book Summaries |
I The Demand for Money
II. Monetary policy
A. Monetary policy is the regulation of the money supply to
affect interest rates
and economic activity.
B. It is part of, but not the focal point of Keynesian economics.
C. Objective is noninflationary full employment.
D. One goal is to change economic activity by affecting interest rates and
investment.
1. The Federal Reserve determines the reserve requirement which
may affect the money supply which may
affect interest rates.
a. Reserve requirement is the amount of demand deposits that must be kept in cash with the Federal
Reserve
or in the bank.
b. Often expressed as a percent called the reserve ratio.
c. Excess reserve can be loaned as demand deposits.
d. Excess reserves determine the potential money supply (M1).
e. A change in the money supply changes interest rates which may change investment
causing a change in AD
which changes economic activity.
1) Increasing investment will increase economic activity.
a) The Federal Reserve increases the money supply which
may lower interest rates.
b) Low interest rates increase
investment which increases AD which causes an increase in Real GDP.
2) Decreasing investment
will decrease economic activity.
a) The Federal Reserve
decreases the money supply which may increase interest rates.
b)
High interest rates decrease investment which decreases AD
which causes a decrease in Real GDP.
2. Dollar values on this page are representative of amounts
prevalent during the late 1990's (billions of dollars).

E. Affecting the non-investment components of aggregate demand
1. Lower interest rates also increase C, G, and XN
a. Consumption increases as credit purchases become cheaper.
b. Refinancing existing debt at lower interest rates by
individuals,
businesses, and governments frees funds for spending.
c. Lower interest rates also decrease the international value of the dollar
as investors buy (demand) other currencies to
earn more interest. The lower
dollar increases XN as U.S. goods are less expensive and foreign
goods more expensive.
2. Higher interest rates have an opposite affect
F. Federal reserve balance sheet
1. Assets are held in
securities and loans to commercial banks.
2. Liabilities and net worth re
the reserves of commercial banks, treasury deposits, federal reserve notes, and
equity(accumulated profits).
3.
Federal Reserve Balance Sheet
III. Types of monetary policy
A. Quantitative controls affect the money supply.
1. Required Reserve Ratio
a. Lowering the reserve ratio creates excess reserves which banks
may loan as newly created money. This is expansionary.
b. Raising the reserve ratio eliminates excess reserve so banks
can not renew loans removing money and causing
a contraction.
2. Open-market operations
a. Buying and selling of U.S. government bonds by the Federal Reserve from
banks or in the open market to change
excess reserves thus affecting the supply
of M1 and interest rates is the primary tool.
b. Buying bonds is expansionary.
1) When buying from banks, the Federal Reserve pays with reserves providing
excess reserves banks can loan as
demand deposits.
2) When buying in the open market, increased demand
from the Federal Reserve pushes up prices sellers
receive,
lowering the effective
interest sellers pay.
c. Selling bonds contracts the economy.
d. Review of
Valuing bonds
1) Suppose you buy a twenty year, $10,000 bond paying 5% per year at face value
of $10,000. Face value is called par value.
a) A few years go by and you need money and one choice is to sell the bond.
b) If interest rates on this type bond have gone down, people will be very
anxious to buy, demand, will be high pushing price up and your will receive more
than $10,000.
c) If rate shave gone down, no one will give you $10,000, demand will be low, so
if you need the money, you will sell for less, below par.
d) You can hold for twenty years and get par and get the money some where else.
2) Therefore, interest rates and bond values (prices) go in the opposite
direction, if interest rates down, old bond price up because they are at the old
higher rate.
3) This is called the interest rate risk for bonds. Other risks have to do with
issuer default and monetary inflation.
e.
Federal
Open Market Committee minutes
make interesting reading.
f. It is the most powerful of the four tools.
3. Discount rate
a. This is the rate charged by the Federal Reserve for loans to member banks.
b. It strongly affects the prime
interest rate paid by a bank's best customers.
1) Lower the rate to expand economy as interest rates decrease.
2) Raise the rate to contract economy as interest rates increase.
3) Another important interest rate is the federal
funds rate which is the rate
at which banks loan funds to each other.
4. Term Auction
Facility
a. Initiated in 2007, it allows banks to add to their reserves at low rates.
b Done to increase bank liquidity which was low because of a loss in reserve
caused by a housing crisis.
B. Other controls affect the actions of market participants.
1. Moral suasion or jawboning
a. This social pressure by influential
people to encourage specific people to act in the public interest.
b. It is used to influence public opinion and political attitudes.
c. An example is when the Chairman of Board of Governors makes his
Semiannual
Report to Congress on the economy and
monetary policy.
2. Margin requirements,
the down payment required on stocks which is now 50%, is seldom changed.
3. Consumer credit controls, on items such as credit
cards, work so well it is seldom used.
C. Application:
It Really Is All Greenspan's Fault uses the Taylor Rule
as an example of how monetary policy maybe used to affect economic activity.
IV. The Federal Funds Rate
A. Most controllable interest rate
B. Targeted by monetary policy
C. It is the overnight interest rate banks with
excess fed reserve charge each banks short of fed reserve to keep the system in
balance.
D. By controlling reserves, the fed controls this
rate.
E. This allows them some control over short-term
rates.
F. For more information visit
Federal funds rate - Wikipedia, the free encyclopedia
V. Effectiveness of monetary policy
A. Strengths
1. Speedy and flexible
2. Somewhat isolated from political pressure
3. Hard money, restrictive policy by the Federal Reserve, has worked well recently.
B. Weaknesses
1. Easy money has not worked well.
a. In the early 1900's, it didn't stop a recession.
b. Low profit expectations by business and fears over possible employment loss
by workers make
lower interest rates ineffective.
c. Interest rate cuts in 2001 were not able to stop a recession.
2. Bank deregulation has made commercial banks a less important supplier of
investment funds thus
diminishing the effectiveness of monetary policy.
3. Changes in the velocity of money may negate some
of the effects of monetary policy.
C.
Monetary Policy, by James Tobin: The Concise Encyclopedia of Economics
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