Macroeconomics Exam Unit 4 Monetary Policy

[ UNIT IV ] Monetary Policy The FED is the name of the central bank in the U.S. ▪ It is NOT part of the government or a government agency and does not receive 1 single dollar from the government for its operations. ▪ The government has some oversight regarding its operation through the Chairman of the FED, but the FED is NOT the GOV!!! The focus of monetary policy is captured by the ambiguous phrase: price stability. ▪ The FED attempts to promote price stability by keeping inflation in check and provide sufficient MS in order to facilitate a sustainable rate of growth. ▪ The FED and monetary policy can only ever affect the Money Supply (MS). ▪ MS then interacts with MD, resulting in an interest rate change. ▪ Money demand is independent of all FED activity. ▪ THREE distinct TYPES of MD exist: 1 transactions demand, 2precautionary demand, and 3speculative demand. ▪ These three demands are related to the THREE FUNCTIONS of MONEY: 1medium of exchange, 2unit of account, and 3store of value. Money has a number of PROPERTIES, as well, including durability, divisibility, acceptability, and many others in the Mort worksheet on money. Although the Treasury department prints money, money is actually created through the Deposit Expansion Multiplier Process. ▪ The FED is in charge of regulating the rate of the growth of the supply of money. Money Supply refers to M1, the stock of money— high power money. ▪ Money that is not as liquid is assigned higher numbers than 1, such as M2. ▪ These distinctions are more or less irrelevant for our class. ▪ M1 is the variety of money acceptable at Publix and includes demand deposits (checking accounts) + other demand deposits (other checking accounts) + currency & coin (cash) + traveler’s checks. ▪ The ratios are roughly 50% checks, 49% cash, and 1 % traveler’s checks. Monetary Policy FRQs come in TWO VARIETIES: Three L’s and Win & “Behroz Makes a Deposit”  AD    AD 10     AD  I  ,   I  r (the decrease in r leads to an increase in the quantity of interest sensitive investment demanded)  ,  r   MS     RR  (the decrease in r leads to an increase in the quantity of interest sensitive investment demanded)  I  ,  I  r   ,  I  ,    I  r  MS     discount rate B C r (the decrease in r leads to an increase in the quantity of interest sensitive investment demanded) A 1 ,  r  MS   OMO buy  UTION GRAPH AMONETARY POLICY Three L’s and Win: PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE) PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE) PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE) LUTION GRAPH C MONETARY POLICY OMO sale  MS  r A discount rate  MS  r 2 r I , , (the increase in r leads to a decrease in the quantity of interest sensitive investment demanded) B RR  C MS  r I , , (the increase in r leads to a decrease in the quantity of interest sensitive investment demanded) r  r I , , (the increase in r leads to a decrease in the quantity of interest sensitive investment demanded) I AD PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE) I AD PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE) I AD PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE) We label the money market’s vertical axis as interest rate and “r” rather than nominal interest rate and “i” as a tactic – unless some compelling reason in the question exists to do otherwise. This facilitates the linkage between the first and second L’s. “Behroz Makes a Deposit”: Step #1: Is the deposit a shift within the composition of MS or is it an infusion of new money in the system? Step #2: Find out the required reserve ratio (RR) and determine the amount of required reserves. Step #3: Does the question indicate anything about preexisting reserves or excess reserves ? Step #4: Make a chart that is an identity of all of the basic terms explicit and implicit in the question. Step #5: Calculate the effect of the deposit from this one bank and the maximum effect on the entire MS. Step #6: Be prepared to list the three limitations that could have kept the MS from reaching its maximum if they were not already incorporated in the question. 11 Behroz deposits $1,000 in cash into Happy Bank. The reserve requirement is 20%. Happy Bank has no excess reserves. a. b. c. d. a. What is the immediate effect on the MS? What is the maximum increase on MS that can be made by Happy Bank? What is the maximum effect on the MS by the entire banking system? Why won’t the MS be increased by its theoretical maximum amount? No immediate change in the quantity of the money supply, but its composition will shift to relatively less cash and relatively more demand deposits. MS = Cash -$1,000 + Demand Deposits +$1,000 + Traveler’s Checks … therefore, no change in MS. b. RR = 20% | $1,000 • 0.20 = $200 | $1,000 [deposit] – $200 = $800 [excess reserves available to loan] c. [Method 1] (initial deposit • multiplier) – initial deposit [ $1,000 • 5 = $5,000 – $1,000 = $4,000 ] [Method 2] initial loan • multiplier [ $800 • 5 = $4,000 ] Method 1is preferred because it requires the student to double-check if the initial deposit was a shift within MS or a new infusion of high-power money. d. if banks keep excess reserves, every dollar held in excess reserve represents [1 • multiplier dollars], not expanded if people hold money in the form of cash rather than redeposit funds the banks offer loans but customers are unwilling to take out loans at prevailing market rates.          [Other Monetary Stuff]: OMOs are undertaken every business day and considered to have a precise/fine tuning capability by monetary policy advocates. The discount window represents the portal through which the FED acts as a lender of last resort for banks in trouble. ▪ Negative social stigma is attached to using the discount window. Changes in the required reserve ratio/reserve requirement (RR) are considered to be as precise as surgery with a chainsaw and predictable as the geometry of a snowflake. Federal funds rate is the rate at which banks lend money to other banks for short term loans. ▪ another example: tricky language associated with monetary policy MV = PQ M = M1 = MS = stock of money V = income velocity of money P= average overall price level= GDP deflator Q = rGDP PQ = nominal GDP Winners and Losers from unanticipated inflation: People that pay with inflated money (TP) win those that get inflated money lose. Fixed income(contractors), Savers and Lenders are big losers; Borrowers, debtors, and mostly U.S. Gov “win”.