Chapter 15 Monetary Policy
I. The Demand for Money
A. Transaction D, Dt results because people hold money, often in
a money market account, to use as a medium of exchange.
B. Asset Demand, Da results because people accumulate money,
often held in an investment account, to buy assets.
C. The demand for money, Dm= Dt + Dt
D For more information visit Demand for money - Wiki
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
3. Currency Exchange Rates and Economic Activity
a. Value of a currency determines price of import and export goods
b. Increase in money supply cause inflation lowering the value of currency
making exports cheaper and imports more expensive.
c. Exports increase as they are less expensive in real terms and imports
decrease as conversion to yen makes Toyota's more expensive
1. A strong dollar is always good except when it isn't. 1/24/15
2. U.S government has a problem with a strong high valued dollar 2/5/15
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).
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
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.
g. Historical Note on lender of last resort type actions before there was a central
bank began in response to the Panic of 1837 (U.S. first great depression. source
1. "The Secretary of the Treasury, Salmon P. Chase, bought $13.5 million in
National 5-20 bonds, but this tepid government response did little
to calm the markets (Juglar 95)." Tepid response would be used to describe
FED actions during Great Recession.
2. "The New York Clearing House had two tools at its disposal for combating
banking panics and liquidity crises, in the form of loan certificates and reserve pooling."
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.
4. 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
g. Taylor rule affected by Fed's QE policies. 2/3/14
5. Creating Money Cheap
C. The Brave New World of Monetary Policy SF FED explains policy change resulting
from the Great Recession 6/6/11
IV. Effectiveness of
1. Speedy and flexible
2. Somewhat isolated from political pressure
3. Hard money, restrictive Federal Policy, has worked well recently.
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 money velocity may negate some effects of monetary policy.
C. Additional Readings
1. The Great Recession had a monetary policy miscalculation
2. Monetary Policy, James Tobin: The Concise Encyclopedia of Economics
3. Monetary Policy Myths:
4. Learning tools from European Central Bank
a. Monetary Policy Game from the
b. Inflation Island another learning tool from ECB.
5. On the importance of sound money 6/16/13 Global Economic Intersection
6. On-definitions-of-money critiques modern monetary policy 11/01/13
7. What Caused the Recession of 1937 Global Economic Intersection 8/212/13
. Editors note: After WWI much of Europe had severe inflation cause severe
apprehension that existed today. The U.S. is apprehensive concerning high
persistent unemployment because of the Great Depression of 1930's.
8. Monetary Policy will never be the same 12/16/13
9. For Econ majors The Zero Interest-rate Bound and Optimal Monetary Policy
and When Is the Government Spending Multiplier Large?” 1/31/14
10. The Presidential Election Cycle Theory and the FED
11. Ignorance over productive make FED monetary policy difficullt
Keeps Money Loose Readings
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