University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
Views:

397

Pages:

21
Author:

Jared Bowers

Managing Aggregate Demand: Monetary Policy Part 1 Overview • • • • Money & Income Federal Reserve System Open Market Operations Other Methods of Monetary Control Money and Income: Difference • Money – At one point in time • How much money do you have right now? • E.g., money stock (M1) • Income – Over a period of time • What is your income? (per month or per year) • E.g., nominal GDP per year • Examine how interest rates and stock of money influence rate at which people earn income –or how monetary policy affects GDP 38 The Federal Reserve System • Federal Reserve System “The Fed” – U.S. central bank • Bank for banks – Created in 1907 • After four severe banking panics (1873-1907) – 12 central banks • Each is a corporation whose stockholders are member banks – Immense profits go to U.S. Treasury 39 The Federal Reserve System • (7 member) Board of Governors – Appointed by U.S. President • Chairman serves a 4-year term • Most powerful central banker in the world – Advice & consent of Senate • The Fed – Independent • Makes decisions without political interference – Sets monetary policy 40 The Federal Reserve System • Federal Open Market Committee (FOMC) – Determines short-term interest rates & size of U.S. MS – 12 voting members • 7 governors of the Fed • President of the NY Fed • 4 (of remaining 11) district bank presidents – Meets 8 times a year in Washington – Very limited access to meetings; no press – Decisions are announced at the meeting’s end 41 Implementing Monetary Policy • Fed normally relies on open-market operations to control interest rates – Fed’s purchase or sale of gov securities • Open market operations either give banks more reserves or take reserves away from them, thereby triggering a multiple expansion in MS • To see how open-market operations affect interest rates, we need to understand the market for bank reserves 42 Implementing Monetary Policy • Market for bank reserves – (upward-sloping) Supply curve • Fed decides how many dollars of reserves to supply – ∆Fed policy shifts the S curve – (downward-sloping) Demand curve • Banks are required to hold reserves – Required reserve ratio (m) = 0.10 in U.S. • Reflects the demand for bank deposits – People hold bank deposits to conduct transactions » GDP reflects the number of transactions & P level reflects the average price per transaction – ∆GDP or ∆P level will shift the D curve 43 Figure 1 The market for bank reserves S D Interest Rate For given Fed policy E ∆Fed policy will shift the S curve ∆GDP or ∆P level will shift the D curve For given Y and P S D Quantity of Bank Reserves 44 Implementing Monetary Policy • Market for bank reserves – Interest rate in Fig. 1 is the federal funds rate • Interest rate that banks pay/receive when they borrow reserves from one another – Banks lend or borrow from one another to maintain a desired level of reserves – D (S) for reserves slopes downward (upward) because as interest rates rise borrowing (lending) becomes more expensive (attractive) 45 Figure 2 The effects of an open-market purchase S0 S1 If Fed wants to lower federal funds rate, it provides additional reserves by purchasing T-Bills from banks. This shifts S curve outward. Interest Rate D E A S0 S1 D Quantity of Bank Reserves 46 Implementing Monetary Policy • Table 1 shows the bookkeeping behind the Fed’s open-market purchase of $100m worth of T-Bills. • Fed makes payment by giving banks $100m in new reserves. – These reserves are liabilities of Fed & assets of banks. – Bank deposits have not increased so required reserves are unchanged but actual reserves are $100m higher. • Now banks have $100m in excess reserves. 47 Table 1 Effects of an open-market purchase of gov securities on the balance sheets of banks and the Fed Federal Reserve System Banks Assets Reserves +$100 million U.S. government securities -$100 million Addendum: Changes in Reserves Actual Reserves +$100 million Required Reserves No Change Excess Reserves +$100 million Liabilities Assets Liabilities Bank Reserves U.S. government +$100 million securities +$100 million Bank gets Reserves Fed gets securities 48 Implementing Monetary Policy • Additional bank reserves can support a multiple expansion of MS. – Banks lend to rid themselves of excess reserves. – Estimate ultimate ↑MS = $100m ∕ “m” = $500m • If m = 0.20 • Difficult to estimate ultimate ↑MS because – People may want to hold more cash – Banks may want to hold excess reserves • Oversimplified money multiplier assumes that neither is true. 49 Implementing Monetary Policy • Fed controls the federal funds rate directly by buying just the right volume of securities. • Consider the case when Fed wants to increase interest rates (contractionary monetary policy) – Fed sells T-Bills in the open market – Banks pay with reserves • They draw down on their deposits at the Fed – Banks acquire reserves by curtailing their lending – Multiple contraction process ensues 50 Implementing Monetary Policy • Bond Prices & Interest Rates – always move in the opposite direction • Bonds (e.g., T-Bills) pay a fixed number of dollars of interest per year. – E.g., Bond pays $60/year. If P = $1,000 → interest rate = 6%. If P = $1,200 → interest rate = 5% – If ↑P of bond → ↓interest rate and vice versa. 51 Figure 3 Open-market purchases and treasury bill prices Price of a Treasury Bill S1 S0 D P1 B A P0 S1 Expansionary Monetary Policy: Fed buys T-Bills and S shifts in as number of T-Bills available to private investors falls. Price of T-Bills rises which lowers the interest rate. Figure 3 is another way to understand how Fed open-market operations influence interest rates. S0 D Quantity of Treasury Bills 52 Implementing Monetary Policy • Open-market purchase of T-Bills (expansionary monetary policy) – ↑MS → ↑P of T-bills → ↓interest rates • Open-market sale of T-Bills (contractionary monetary policy) – ↓MS → ↓ P of T-bills → ↑interest rates 53 Other Methods of Monetary Control • Fed is a “lender of last resort” – Occurred in summer & fall of 2007 when financial crisis made banks wary of lending – In 2008, Fed also began lending to securities firms –not done since 1930s • In Table 2, Fed loans $5m to a bank – Expands (actual & excess) reserves by $5m, which should lead to an expansion of the MS • Discount rate is the interest rate Fed charges on loans to banks – Fed can ↓discount rate to encourage banks to have more reserves (occurred in 2007 & 2008) 54 Table 2 Balance sheet changes for borrowing from the Fed Federal Reserve System Banks Assets Liabilities Reserves Loan from +$5 million Fed +$5 million Addendum: Changes in Reserves Actual Reserves +$5 million Required Reserves No Change Excess Reserves +$5 million Assets Liabilities Loan to Bank +$5 million Bank Reserves +$5 million Bank borrows $5 million And the proceeds are credited to its reserve account 55 Other Methods of Monetary Control • Minimum required reserve ratio • Decrease m – Increase banks’ excess reserves → money expansion – Lower the D for reserves & thereby lower interest rates • Increase m – Decrease banks’ reserves → money contraction – Raise the D for reserves & thereby raise interest rates • “m” has been 10% since 1992 – Infrequently used by Fed as a policy tool 56

Managing Aggregate Demand: Monetary Policy, Part 1

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