Macroeconomics: Monetary Policy

Ways in which the amount of the bond purchase could "leak out" of the multiplier process.

- If the proceeds of the purchase are held by the seller as cash (rather than deposited in a bank account), the injection of money into the economy will not multiply. is is sometimes called "currency drain." - The payment also will not multiply if the bank into which the proceeds of a bond purchase are deposited holds the payment as excess reserves (rather than loaning it out). is may be the case if banks cannot locate "creditworthy" borrowers.

Recessionary Situation

-In this situation, we want a loose money policy. To do this, we can 1) buy government securities, 2) decrease the reserve ratio, or 3) decrease the discount rate. All three of these will increase the supply of money. -If supply of money increases, then the rate of interest decreases. Then, when the rate of interest decreases, the amount of investment increases. -Then, since investment increases, aggregate expenditures (C+Ig+G+Xn) increases. That then shifts the GDP up by the change times the multiplier. Finally, when GDP increases, price level will stay about the same (since this economy most likely started in the horizontal range). Now since the GDP is increasing, we are out of a recession.

Inflationary Situation

-In this situation, we want a tight money policy. To do this, we can 1) sell government securities, 2) increase the reserve ratio, or 3) increase the discount rate. All three of these will decrease the supply of money. -If supply of money decreases, then the rate of interest increases. Then, when the rate of interest increases, the amount of investment decreases. -Then, since investment decreases, aggregate expenditures (C+Ig+G+Xn) decreases. That then shifts the GDP down by the change times the multiplier. Finally, when GDP decreases, price level will drop (since the economy most likely is in the vertical range of the aggregate supply curve) and therefore inflation will decrease.

Rational Expectations Theory

-It states that businesses, consumers, and workers understand how government policies will affect the economy and anticipate the impacts in their own decision making. In other words, everyone knows what's going to happen and they plan for it. -For example, when the government begins some expansionary polices, workers will anticipate that a result will be higher inflation which would cause a decrease in their real wages. So, the workers quickly ask for more money for their nominal wage. If things work out well, there will be no temporary increases in profit, output, or unemployment. -They also say that policies designed to push unemployment below its natural rate will quickly increase the rate of inflation, having no effect on unemployment.

Supply-Side Economists

-They believe that changes in aggregate supply are active forces in determining the levels of both inflation and unemployment. Economic disturbances can be generated on both the supply side and the demand side of the economy. They also contend that certain government policies have reduced the growth of aggregate supply over time, and if these policies were reversed, the economy could achieve low levels of unemployment without producing rapid inflation. -Supply-siders also say that the US tax-transfer system has "eroded" productivity and decreased incentives to work, invest, innovate, and assume entrepreneurial risks. If taxes were decreased, people would have more money after taxes and they would have more of an incentive to work. -Supply-siders also believe that reductions in marginal tax rates increase aggregate supply. They believe in the Laffer Curve, which says that up to a certain point in tax rate, tax revenue increases, and at that point, tax revenue is a maximum. However, when

If someone deposited $100 into a bank, and the required reserve ratio was 0.2... What would be the excess reserve and money supply increase?

...the bank's excess reserves would increase by $80, and since the money multiplier is 1/0.2=5, the money supply will be increased by 80*5=400.

Money Market Graph

Comes from the liquidity preference model of interest rates, and illustrates how actions by the Fed (and other central banks) lead to changes in interest rates in the economy in the short run.

Federal Reserve System raises interest rates...

Decrease investment Decrease interest-sensitive consumption LEADS TO Lower GDP Slowing of Economic Growth

Interest Rate Graph

Dm, or total demand for money, equals transaction demand plus asset demand. Sm is always vertical because quantity supplied doesn't vary with the rate of interest. When the money supply decreases (shifts to the left), the price for money (which is the same as the interest rate) rises. When the money supply increases (shifts to the right), the price for money decreases.

Net Export Effect

Easy money policy > decreased foreign demand for dollars > dollar depreciates > net exports increase (AD increases, strengthening the easy money policy) Tight money policy > increased foreign demand for dollars dollar appreciates > net exports decrease (aggregate demand decreases, strengthening the tight money policy)

Which of the following is included in M2 but not M1?

Feedback: balances and currency held by banks are not part of the money supply. Large time deposits are part of neither M1 nor M2. M1 includes coins, currency, and checkable deposits but not small-denominated time deposits. M2 consists of M1 (currency held by the public plus checkable deposits) plus savings deposits, money market mutual funds, and small-denominated time deposits.

Summary of Inflationary Situation

Fiscal policy: decrease government spending, increase taxes Monetary policy: tight money policy - sell government securities, raise reserve ratio, raise discount rate

Summary of Recessionary Situation

Fiscal policy: increase government spending, decrease taxes Monetary policy: loose money policy - buy government securities, lower reserve ratio, lower discount rate

Required Reserve Ratio

How much percent of a bank's reserves must be kept on deposit with the Federal Reserve Bank or as vault cash.

OMO Public VS. Bank (Buying securities): Let's assume that the required reserve ratio is 0.2. The money multiplier is then 5.

If the Fed buys $1000 worth of securities from commercial banks, the excess reserves will increase by $1000. Then, the money supply will increase by $1000*5=$5000. If they buy securities from the public, the public gets more money, and when they deposit it into banks (whether directly or indirectly), bank reserves increase. However, since the required reserve ratio is 0.2, the bank needs to put $200 of the money in the Federal Reserve Bank, and so excess reserves only increase by $800. Then, the money supply will increase by $800*5=$4000.

Open-market operations - What is the difference between buying/selling to the public and buying/selling to banks?

If the Fed buys or sells securities to the public, the money supply will increase/decrease less than if the Fed buys or sells them to banks.

OMO Public VS. Bank (Selling securities): Let's assume that the required reserve ratio is 0.2. The money multiplier is then 5.

If the Fed sells $1000 worth of securities to commercial banks, then excess reserves will decrease by $1000, so the money supply will decrease by $1000*5=$5000. If the Fed sells $1000 of securities to the public, then after the transaction is cleared, the bank will have $1000 less in securities. $200 of that money can be taken from Federal reserves, and so excess reserves only decrease by $800, causing the money supply to decrease by $800*5=$4000.

Federal Reserve System lowers interest rates...

Increase investment Increase interest-sensitive consumption LEADS TO Expansion of GDP

Money Supply M1

M1 is the narrowest definition of money supply. It includes currency (coins + paper money) and checkable deposits (demand deposits in banks or thrifts).

M3

M2 + large-time deposits

M2

M2 includes M1 plus near-monies (highly liquid financial assets which do not directly function as a medium of exchange but can be readily converted into currency or checkable deposits without risk of financial loss). Near-monies are noncheckable savings accounts, money market deposit accounts, small time deposits, and money market mutual funds.

Monetarist Equation of Exchange

MV = PQ , where M is the supply of money, V is the velocity of money (the number of times per year the average dollar is spent on final goods and services), P is the price level (average price at which each unit of physical output is sold), and Q is the physical volume of goods and services produced. The left side is the total amount spent; the right side is total amount received. Monetarists believe that V is stable, or that the factors altering velocity change gradually and predictably.

Monetarism

Monetarists believe that the economy is stable in the long run at the natural rate of unemployment, and the observed instability of the economy is caused by inappropriate monetary policy. Keynesians, on the other hand, believe that the economy is potentially unstable and observed instabilities are caused by fluctuations in AD and AS. They believe that changes in the money supply directly changes AD, which directly changes GDP. They do not think investment is an important issue. Monetarists also believe that without government interference, the economy would be very stable. The government caused the economy to become what it is today: downward wage inflexibility, business cycles, etc.

Open Market Operations

Most important means the Fed has to control the money supply. It refers to the buying and selling of government bonds (securities) by the Federal Reserve Banks. Buying bonds increases the money supply; selling them decreases it. Government securities represent loans to the U.S. government and include Treasury bills, Treasury notes and Treasury bonds.

Checking Account Money

Most of it comes from demand deposits, which are deposits in commercial banks that are meant to be checkable.

What are the three tools of monetary policy?

Open-market operations Reserve ratio Discount rate

Money Multiplier

Since banks lend their excess reserves, a system of banks will "magnify" original excess reserves into a larger amount of new demand-deposit money, causing the money supply to grow by more than the original excess reserves. It is equal to (1/Required Reserve Ratio). The maximum demand-deposit creation (money created) equals the excess reserves that can be lent out by commercial banks times the money multiplier.

Stagflation

Stagflation is increasing inflation and rising unemployment in an economy at the same time. It is usually caused by a decrease in supply (supply-shock inflation). Stagflation in the 1970s proved that the Phillips Curve didn't represent a stable inflation-unemployment relationship.

Describe the "Board of Governors."

The Board of Governors has 7 members, appointed by the President with confirmation of the Senate. It directs the activities of the 12 Federal Reserve Banks, which then control the nation's banks.

Who controls the banking system?

The Board of Governors of the Federal Reserve System ("Fed") is responsible for controlling the U.S banking system (and the money supply).

The Reserve Ratio

The Fed can also increase or decrease the Reserve ratio. Increasing the Reserve ratio decreases banks' excess reserves, causing the money supply to decrease. Decreasing it increases banks' excess reserves, increasing the money supply. This is really powerful, and so it is not used very often.

The Discount Rate

The discount rate is the rate that Federal Reserve Banks charge for loans to commercial banks. When commercial banks borrow from FRBs, their reserves increase. Therefore, if the discount rate increases, banks are less encouraged to borrow, keeping their excess reserves the same and therefore restricting the money supply.

Loanable Funds Market

The loanable funds market is a hypothetical market that illustrates how the demand for loanable funds (generated by those who want to borrow funds) and the supply of loanable funds (provided by lenders through saving) interact to determine the equilibrium price of loanable funds — the interest rate.

Phillip's Curve

The main concept of this is a stable, inverse relationship between inflation and unemployment. The short-run Phillips curve has a negative slope; the long-run Phillips curve is vertical. The Adaptive Expectations Theory predicts that there is a short-run tradeoff between inflation and unemployment but there is no long-run tradeoff. In the short run, the inverse relationship works, but in the long run, it seems that the graph will always shift back to a vertical line.

What other entities help the Board of Governors?

There are several entities that help the Board of Governors. The Federal Open Market Committee (FOMC) is made up of the 7 members of the BoG plus 5 of the presidents of the Federal Reserve Banks. It sets the Fed's monetary policy and directs open- market operations. There are also three Advisory Councils (made of private citizens) that meet with the BoG to give their views on banking and monetary policy.

Shorthand for LF and Money Market Graph

^$s > ^Slf > decrease i% decrease $s > ^Slf > ^i%

Contractionary Policy Short-hand

^i% > lower I/C > lower AD > lower GDP > lower PL

When the Fed buys bonds...

bonds are taken out of the economy and money is injected into the economy as a result of the Fed's paying bondholders for their bonds.

Money Multiplier

change in checkable deposits = 1/(RRR*change in excess reserves)

Contractionary policy is needed to

control inflation in the economy,

Both increased taxes and decreased government spending reduces consumption spending, which causes a ________ in aggregate demand.

decrease

Expansionary policy can be used to

increase employment and economic growth.

Other things equal, a dramatic decrease in the money supply would:

increase the purchasing power of each dollar. With fewer dollars available, the price level would drop. Lower prices mean that each dollar can be exchanged for a greater number of goods and services.

When the money supply decreases...

interest rates (the price of money) rise.

The purchasing power of the dollar:

is inversely related to the price level. A higher price level increases the number of dollars required to purchase a given quantity of goods and services, lowering the purchasing power of the dollar.

When the committee is concerned about the potential for recession in the economy,

it will pursue expansionary policy by lowering interest rates.

Money as a store of value

keeps purchasing power over time

Expansionary Policy Short-hand

lower i% > ^I/C > ^AD > ^GDP > ^PL

Representative money

money that can be exchanged for some commodity, like gold

Commodity money

money that has value apart from use as money

Fiat Money

money that some authority (government) has ordered to be accepted as a medium of exchange

Money as a unit of account

tells how much different goods and services are worth

To increase banks' willingness to lend,

the Fed cut its discount rate to make loans to commercial banks from the Fed cheaper and provide liquidity to the nancial system. is made credit easier for businesses and consumers to obtain, and helped reduce uncertainty and prevent an economic slowdown.

The U.S. money supply is "backed" by:

the ability of the government to maintain its value.

When the FOMC believes that action is needed to prevent inflation,

the committee will pursue contractionary monetary policy by raising interest rates

Money as a medium of exchange

used to buy goods and services