Macroeconomics Module 12

The Accord

1. During and after World War II, the Fed's main task was helping the Treasury finance the enormous debt incurred during the war at acceptably low interest rates 2. the Fed abandoned monetary targets in order to hold down interest rates to keep interest rates down, it expanded bank reserves 3. In 1951, the Fed and the Treasury reached an agreement-The Accord -stated that the Fed was no longer obliged to hold interest rates low to assist with the Treasury's debt financing 4. In 1952, the Fed was finally free to turn its monetary policy in the direction of stabilizing economic activity 5. for most of the rest of the 1950s, the Fed used free reserves as its policy target -free reserves consist of bank excess reserves-bank loans from the Fed -if free reserves were large, the Fed took that as a signal of too much slack in the credit market 6. The Fed defined its role during this time as "leaning against the wind" -that is, the Fed was assessing the direction of economic activity and trying to steer the economy back toward a middle ground of steady growth, stable prices, and high employment

monetary policy in the 2000s

1. February 2006, Ben Bernanke was appointed chairman of the Federal Reserve with a new era of monetary policy as the credit and housing markets experienced a bubble 2. Bernanke: increase interest rates in an effort to keep inflation in check 3. From 2007-2010: -the Fed extended credit to nonbank financial firms -the Fed purchased assets and loans from firms deemed "too big to fail" -the Fed used everything in its power to stabilize the financial system and prevent a more severe downturn in the US economy 4. In January 2012, the Federal Open Market Committee (FOMC) claimed the economy had been expanding moderately, with labor market conditions improving and the unemployment rate declining slightly 5. the housing sector was still depressed, but the committee that steers the Fed expected moderate economic growth. The committee maintained a "highly accommodative stance for monetary policy and kept the federal funds rate at 0 to 0.24% into 2015

the Fed and the Depression

1. Fed was created to prevent bank failures which continuously happened from 1929-1937 2. the money supply not the money base fell sharply. -the monetary base remained stable while the ratio of currency to deposits rose (as people withdrew cash from the banking system) and the ratio of deposits to reserves fell (as banks held more excess reserves) 3. cash withdrawals combined with excess reserves meant that the money multiplier was smaller 4. Milton Friedman and Anna Schwartz are the best known critics of the Fed's actions in this period -Friedman and Schwartz argued that the Fed was too passive, failing to pump up reserves to offset what was happening in the private sector 5. the fed did not shrink the monetary base, but didn't allow it to expand either -the Fed was constrained by the gold standard until 1934 6. the most controversial policy decision by the Fed during the Depression took place after the United States went off the gold standard -the Fed chose to raise reserve requirements in 1936, trying to "mop up" excess bank reserves -this contractionary action was widely blamed for sparking the economic downturn in 1937 7. once there was no gold standard the Fed was free to increase or decrease the money supply without restrictions 8. However, the money supply can change from either the Fed changing the amount of reserves in the system or from private citizens, businesses, and banks changing the amount of money they want to hold -if there is low return on investment and weak consumption demand, interest rates will fall. That fall will lead both individuals and banks to hold more cash and make less available to borrowers -the opportunity cost of holding currency and excess reserves will be low because of demand factors, which are largely outside the Fed's control

The choice of monetary targets

1. Keynesians argue that monetary policy works mainly through interest rates, while Monetarists place less emphasis on interest rates and more on the direct effects of changes in the money supply on spending -they believe the Fed should emphasize controlling the size of the money supply 2. interest rates and the money supply are alternative targets for monetary policy and there has been ongoing dispute about which policy works better 3. this dispute is important for two reasons 4. first, the Fed's impact on market interest rates is limited and temporary -if the Fed tries to reduce the interest rate by expanding the Money supply, there will eventually be upward pressure on the price level-> inflation expectations will spread-> since these expectations are an important influence on interest rates, market interest rates will rise 5. the second reason the dispute is important is that the Fed cannot pursue both targets at once -if the Fed tries to control the interest rate, it must adjust the money supply to whatever level is needed to maintain the desired rates. If interest rates rise above the desired level, the Fed must buy bonds and increase bank reserves to stimulate lending and bring interest rates back down -if interest rates fall below the desired level, the Fed must cut back on the money supply 6. Monetarists usually favor controlling the size of the money supply and its rate of growth 7. If the Fed tries to control the money supply, then it cannot control interest rates -Keynesians usually prefer interest rate target. This choice reflects the Keynesians belief that interest rates exert on important influence on business activity 8. Keynesians argue that it is difficult, if not impossible, for the Fed to control the growth of the money supply within narrow limits -the Fed only indirectly effects the money supply through its control of bank reserves and currency (Federal Reserve notes) -Bank's decisions about excess reserves and individuals' decisions about cash balances will affect how large a money supply a given money base supports -for this reason among others, US monetary policy is now typically described in terms of interest rates

Is monetary policy effective? Classical

1. Monetarists; modern macroeconomists in the classical tradition who focus their attention on monetary policy -Keynesians do not deny that monetary policy is important, but they think it clearly takes a back seat to fiscal policy 2. Milton Friedman was the Founder; this group of economists feels that monetary policy is very important in affecting the level of employment, output, and prices, especially prices 3. most monetarists regard recessions and depressions, as well as, inflation as results of bad monetary policy other than some sort of normal, regular fluctuations in a market economy 4. Monetarists argue Keynesians put too much emphasis on interest rates in money demand and not enough stress on the importance of the interest rate to investment decisions -interest is the price firms pay to use funds now rather than later. Firms compare that interest rate to the rate of return on the investment, when they're borrowing funds or using their funds that could be earning interest

Is monetary policy effective? Keynesians

1. Suppose banks do not lend, or the public holds cash, or interest rates do not fail very much, or investment demand does not respond to lower interest rates 2. if any one of these occurs, a very large increase in the money supply will be needed to bring about much change in aggregate expenditure, output, and employment 3. thus, the possibility that money demand is very sensitive to interest rates while investment demand is not, is a serious drawback to monetary policy 4. Keynesians argue that you can lead investors to money, but you cannot make them spend -in their view, monetary policy should play a supporting role for fiscal policy, keeping credit available and interest rates low when fiscal policy is expansionary and keeping credit tight when fiscal policy is contractionary

monetary policy in the global economy

1. a closed model assumes that there is no economic interaction with other countries 2. when the model was first developed, international interaction was small 3. now, international trade has grown; flows of money and financial assets between countries have also expanded 4. since 1973, when nations switched to floating exchange rates, monetary policy has been more closely tied to changes in the foreign sector 5. a tight monetary policy that drives up interest rates attracts funds from abroad and drives up the price of the dollar -exporting becomes harder -also importing competing firms find that their foreign competitors can more easily undersell them because their goods are cheaper in dollar terms -thus, the international sector of the economy has become increasingly sensitive to monetary policy 6. in the Keynesian model, monetary policy works mainly through interest rates

classical view: quantity theory

1. according to the quantity theory, when the money supply (Ms) expands, both individuals and private banks find that they are holding larger money balances than they want 2. demand for money to hold for transactions depends mainly on money income 3. when the Fed increases the money supply, then at the current level of money income, money supply will exceed money demand; people attempt to spend their excess cash balances 4. increased planned spending is represented by a rightward shift in the AD curve -either the price, or the output, or some combination of the two will rise, depending on the slope of the AS curve. -money income, which is P x Y, will rise -this process will continue until people are satisfied with their larger cash balances as a fraction of a larger money income 5. Thus, classical economists saw changes in the money supply as affecting spending directly, rather than working indirectly through interest rates 6. the process of translating money supply changes into changes in demand, output, and the price level happens through many different channels changes in money supply -> spending (shifts in AE and AD-> output and income

short lived

1. another problem when the Fed pursues expansionary policy is that the lower interest rates brought about by this monetary policy may be short lived, because market interest rates reflect expected inflation 2. if households, investors, and banks think that expansion of the money supply will increase the inflation rate, they will build a higher inflation rate into the interest rates that they ask from borrowers or are willing to pay on loans 3. this is shown in the Fisher equation In = Ir + pi E -I n = nominal interest rate -I r = real interest rate - pi E = expected inflation rate -the Fisher rate is often used in determining interest rates 4. expected inflation is added to the real interest rate instead of the current inflation rate. -this is because the loan will be paid back in the future and it is not known what the inflation rate will be over the course of the loan -so lenders and borrowers must make a "guess" about what they think the inflation rate will be. This guess is the expected inflation rate -when there is a great deal of volatility in monetary policy and therefore, in the interest rate, it is harder for lenders and borrowers to make an educated guess about the future inflation rate, and so lending and borrowing becomes much riskier 5. when this happens the expectations of higher inflation can weaken the impact of monetary policy a this stage

bank lending and excess reserves

1. banks might choose to hold excess reserves, especially if the economy is in recession, when interest rates are already low and potential borrowers look risky 2. if the fed buys bonds from the public rather than from banks, the individuals who sell the bonds might choose to hold currency instead of depositing the funds from selling the bonds in their checking accounts 3. if interest rates are low, the opportunity cost of holding money instead of interest-bearing assets is also low 4. both banks and individuals may hold on to their monetary assets, expecting that interest rates will go back up and not wanting to lock in their assets in bonds at low current interest rates 5. thus, currency drains and excess bank reserves can reduce the expansionary effect of open market operations on the money supply 6. Keynes believed that banks would more likely to hold excess reserves and households would be more likely to increase their money holdings when the money supply increases takes place under recessionary conditions of low interest rates and pessimistic expectations -these wouldn't be sensitive to interest rates, at least during recessions -this would negate the usefulness of using interest rates to stimulate the economy -this was seen during the Great Recession when precrisis levels of excess reserves spiked from 1.5B in september to above 900B in January 2009

how monetary policy affects aggregate demand

1. changes in money supply and interest rates affect household assets, the amount of funds available to borrow, the return on various assets, and the terms of new loans 2. through these changes in the credit market, the Fed influences consumer spending 3. changes in planned spending will shift aggregate expenditure (AE) and aggregate demand (AD) and affect output, employment, and the price level 4. The Fed's impact on the economy through the credit market operates through different channels 5. when consumer's have excess money they spend or save -classical theory: puts a strong emphasis on spending as the way to get rid of extra money. Classical economists point to the role of demand for cash balances (transactions demand) and the equilibrium between money supply and money demand -Keynesian theory: puts an equally strong emphasis on lending and emphasize the role of interest rates (asset demand for money), although US monetary policy is now usually described in terms of interest rate decisions (like those made during the Great Recession 6. Monetary Policy alone may not stimulate the economy directly, so it is often used in conjunction with fiscal policy 7. the impact of monetary policy on the economy tends to be stronger through the spending route than the lending route because there are so many more things that can go wrong on the longer lending route

Money demand and interest rates

1. even if some lend some of the newly created money in the form of bank loans or purchases of other financial assets, it is possible that the interest rate might not fall very much 2. negative relationship between money demand and interest rates -the demand curve is downward sloping 3. the real issue between Keynesians and monetarists is not the negative slope but the steepness of the money demand curve 4. the curve labeled Dk is a Keynesian money demand curve, on which the quantity of money demanded is very sensitive to interest rates 5. the curve labeled Dc is a money demand curve in the classical tradition, on which the quantity of money demanded does not respond much to interest rates 6. when the money supply expands from Ms1 to Ms2, interest rates fall much more along Dc than Dk 7. when money demand is highly sensitive to interest rates, a given expansion of the money supply will bring about a smaller decline in interest rates 8. a very small drop in interest rates is enough to induce banks and households to hold much more cash and fewer other financial assets, such as loans and bonds -the responsiveness of money demand to interest rates is a major point of disagreement between economists in the Keynesian tradition and economists in the classical tradition 9. these test results suggest that both the "spend it" and "lend it" channels of monetary policy are important channels through which monetary policy can affect output, employment, and prices

Keynesian view on monetary policy

1. in a keynesian model, financial markets are linked to aggregate supply and aggregate demand primarily through changes in planned investment, which is a highly volatile component of aggregate demand -other borrowing decisions by households and government also translated into changes in AD 2. an increase in the money supply will reduce interest rates, at least initially, because more funds will be available for banks to lend 3. the lower interest rates will stimulate investment depend (which Keynes emphasized) as well as other kinds of spending that depends on borrowed funds (which is much more important in the 2000s than it was in the 1930s) 4. changes in both kinds of spending shift the AE and AD curves, causing changes in output and income. Depending on the slope of the AS curve, perhaps there will be an increase in the price level as well changes in money supply -> interest rates -> investment -> output and income -lower interest rates lead to increased investment -higher investment causes output and national income to rise through the multiplier process, increasing employment

problems implementing monetary policy

1. in addition to theoretical difficulties in how monetary policy affects the economy, and the problems associated with a choice of targets, there are also some practical difficulties in implementing monetary policy 2. how borrowers and lenders behave changes the effectiveness of monetary policy 3. monetary policy is subject to lags, monetary policy impacts a few sectors of the economy more heavily 4. how lenders view the expected inflation that may occur with expansionary policy also can affect the effectiveness of monetary policy 5. and finally, the management of monetary policy has been complicated by the increasing globalization of financial markets

problems with the monetary process

1. in the Keynesian view, several things could go wrong in translating changes in the monetary supply 2. banks may not lend, interest rates may not fall, or borrowers may not respond to lower interest rates

yields and interest rates

1. in the international economy, the emphasis shifts from interest rates to yields on assets -most of the differences between yields and interest rates comes from the fluctuations in exchange rates -for countries with a common currency agreement, such as the members of the EU that have adopted the euro, yields and interest rates will be the same 2. as interest rates start to fall in an open economy, domestic firms will want to borrow more in response to the lower rates -lenders, however, are more likely to want to make loans in other countries where yields are offered 3. some of the newly created money goes abroad in search of higher yields 4. in addition, the inflow of funds from abroad shrinks as domestic interest rate fall. The net increase in loanable funds is fairly small, and there is little effect on investment

Monetary policy in the 1960s and 1970s

1. inflation rate rose steadily for most of the 1965 to 1979, the monetary policy was expansionary. The 1970s began with a financial crisis, a sharp drop in the stock market combined with the failure of Penn Central, a railroad that was a major borrower from commercial bank -the fed's response was to announce the discount window was open and lower reserve requires 2. drought and oil embargo led to low AS, high unemployment, and high inflation or stagflation 3. this type of situation did not fit the Keynesian theory. Stagflation lead to various forms of classical theory being developed to explain the situation and offer policy advice 4. "Saturday Night Special": an abrupt change of direction by the Fed -instead of interest rates, the Fed decided to make the growth of the various measures of the money supply, especially M1, the focus of its policy actions -the 1979 shift marked a firm's choice of money supply targets over interest rate targets which drove interest rates to all time rights. It did this to end inflation and inflationary expectation

goals of monetary policy

1. maximize employment 2. stabilize prices 3. moderate long term interest rates

domestic sectoral effects

1. monetary policy does not affect all sectors of the economy equally 2. when monetary policy is tight, economic activities that depend on borrowing are affected more heavily 3. business investment in plants and equipment, housing, consumer durables (especially) automobiles, and state and local government capital projects are very dependent on borrowing and sensitive to changes in monetary policy 4. adjustable-rate mortgages (ARMs) and other innovations in home financing have somewhat lessened the impact of monetary policy on housing 5. this and other parts of the private sector are still very sensitive to changes in interest rates and the availability of funds

taylor rule

1. one such method of monetary policy targeting is called the Taylor rule 2. the Taylor rule stipulates that for each 1% increase in inflation, the Fed should increase the nominal interest rate by more that 1% 3. the benefit of such a rule is to reduce uncertainty about how the Fed would choose to respond to inflation, thereby promoting price stability

lags in monetary policy

1. recognition, implementation, and impact lag 2. same recognition lag period as fiscal policy 3. shorter implementation lag than fiscal policy -the FOMC meets regularly and makes decisions about changes in the money supply -because of the Fed's independence from Congress and the executive branch, it can move quickly without asking 4. the recognition and implementation lags are combined and known as the inside lag 5. the time from action to impact-known as the outside lag in monetary policy-can be quite long -depends on how quickly people recognize and respond to a change in the money supply -it takes time for banks to increase or decrease their lending or for individuals to adjust their spending -because of the outside lag, it takes at least two quarters for monetary policy to have half its ultimate impact and 18 to 24 months for the full effect to be felt 6. lags can cause monetary policy to have the wrong effect -just as they can for fiscal policy -a policy that cannot be implemented quickly and have a rapid impact may be worse than no policy at all

the monetary base and the money multiplier

1. the Fed can influence bank lending by influencing bank reserves, but it cannot directly control lending and the money supply 2. the Fed does control the monetary base which consists of currency in the hands of the public plus reserves held by banks (currency in people's in banks) hands is part of the monetary base because it becomes bank reserves if it is deposited 3. thus, the monetary base is used either as cash holdings for the public or as reserves to support bank deposits. The monetary base can support a money supply up the maximum determined by the deposit multiplier -the actual money supply may be less than that amount, depending on currency withdrawals and bank excess reserves 4. the measure of the relationship between the monetary base and the actual money supply is given by a more detailed money multiplier, m, than the simple earlier multiplier which had assumed the public held no currency m = Ms/ B m: money multiplier Ms: money supply B: monetary base 5. there are different money multipliers that corresponds to the different measures of the money supply 6. both the size and the stability of the money multiplier are important because the Fed can control only the monetary base, not the money supply -changes in the money supply can result from changes in the monetary base, the money multiplier, or both 7. the value of m is influenced by the required reserve ratio but is really not under the Fed's control 8. part of an increase in the monetary base could result in increased holdings of currency, with a smaller increase in bank reserves. 9. in this case, the public's decision to hold more currency and coins instead of checkable deposits would keep Ms from rising as much as it would otherwise -the value of m would fall. If an increase in B goes entirely to reserves, banks could decide not to lend all these reserves, and again there would be a fall in m, partly frustrating the Fed's attempts to increase the money supply -if the money multiplier is not constant, changes in its value can affect the money supply even with no change in the monetary base -thus, a very small change in m has a large effect on Ms 10. if the money multiplier is fairly stable, controlling the money base can allow the Fed to control the money supplier fairly well

Classical view of monetary policy

1. the classical tradition stressed the effects of Monetary policy through excess money balances 2. in this view, when the Fed engages in open market operations, both bank reserves and the money supply increase -when the Fed buy's bonds from banks, there is an increase in bank reserves -when the Fed buys bonds directly from the public rather than from banks, the switch from bonds to money increases the money supply directly -if the public deposits payments from the Fed in checkable deposits, bank reserves will also increase

Interest rates as targets

1. the decision to target interest rates instead of the money supply was reinforced by the fact that the Treasury has to borrow by selling US government securities to the public 2. the government budget deficit is financed through these bonds sales, and the Treasury prefers low, stable interest rates as opposed to high, unstable ones 3. when the Fed pursues an interest rate target, the FOMC attempts to keep the Federal fund rate (the interest rate banks charge each other when lending and borrowing reserves) within a certain range -if banks want to borrow more reserves in the federal funds market than other banks have available to lend, there will be upward pressure on the interest rate, the federal funds rate

current debates over targets

1. the fed has also included GDP targeting in its range of policy targets 2. this policy calls for the Fed to aim at some level of nominal GDP by influencing a number of variables that affect it 3. these variables include the measures of the money supply as well as total credits and interest rates -however, even if changing GDP is the ultimate goal, the Fed must choose intermediate targets that are within its control to try to attain that goal -those targets are still some combination of money supply and interest rates

From interest rates to planned spending

1. the next step in the monetary process is going from interest rates to planned spending 2. investment by households and businesses is inversely related to interest rate 3. the interest rate is the price of borrowing money 4. this relation is shown in the downward sloping invest demand curve--only source of demand for borrowing 5. when the money supply increases, there will be more money available for the private sector to borrow for private investments 6. loanable fund market: shows the demand for loans or the investment demand curve, and the supply of money available to be lend out -the Federal reserve has a great deal of influence over the supply of money available for loans to the private sector 7. when the supply of available money for loans increases, the interest rate will decrease and the quantity of loanable funds demanded for investment purposes increases 8. Because investment is an important component of aggregate expenditure, the AE curve will shift from AE1 to AE2 increase in investment. The upward shift of AE leads to an rightward shift of AD 9. Thus, in the Keynesian version, monetary policy works through the channels of interest rates and investment demand to influence the levels of output and prices

inflation targeting

1. the practice of creating a specific action by a central bank in response to inflation 2. since 1982, the Fed has been using a mix of targets: a range of growth rates for the several measures of the money supply and a range of market interest rates 3. In 1993, after working with a changing array of targets for 6 years, then chairman Alan Greenspan announced that the policy of the Fed would emphasize real (inflation-adjusted) interest rates as a policy target -goal was to slow the growth of excess reserves and put the brakes on bank lending so that the expansion would continue but not at a rate that would accelerate inflation 4. this choice of targets was partly influenced by a weakening relationship between the M2 money supply and the price level

contractionary monetary policy in the Keynesian model

1. the same problem occurs with contractionary monetary policy in a Keynesian model 2. spending falls, but some of the decline is in spending for imports 3. thus, there is less impact on aggregate demand, output, and the price elvel 4. higher interest rates will attract an inflow of foreign funds, frustrating any attempts to reduce investment demand 5. thus, although Keynesians and Monetarists often disagree about the process, they concur that monetary policy is less effective in an open economy 6. regardless of whether monetary policy works directly through spending or indirectly through interest rates, it will be less effective in an economy that is very open (lots of international interaction) 7. small countries like Guyana, Taiwan, the Netherlands, and Costa Rica will find it virtually impossible to pursue an independent monetary policy because most of the effects may leak out of the economy

Monetary policy in the 1980s and 1990s

1. through the 1980s, the Fed, under chairman Paul Volcker, pursued a fairly restrictive Monetary policy 2. this policy was credited with helping to reduce both the inflation rate and nominal (but not real) interest rates 3. monetary policy in the 1980s was complicated by rapid growth of the federal debt an influx of foreign lending, changes in bank regulations, and more numerous bank failures. 4. 1982, the Fed Focused on interest rates again 5. in addition, M1 competed with other measures of money and creditor for the role of primary money supply target

when the Fed targets interest rates

1. when the Fed targets interest rates, the normal specific target is a range of values for the federal funds rate, such as 7%-7.5% 2. if the rate goes above, the Fed will buy government bonds. The price of bonds will rise, and their yields will fall -lower interest rates spread from bonds to other assets, making bank lending less attractive and banks less anxious to borrow reserves from other banks in order to expand their loans 3. if demand for reserves falls, and the federal funds rate seems likely to fall below 7%, the Fed will sell government bonds -open market sales of bonds will depress bond prices and put upward pressure on interest rates 4. an interest rate target requires the Fed to keep adjusting the monetary base to whatever is demanded in the market for loanable funds 5. the Fed received criticism from the monetarists who said there was too much focus on interest rates 6. the Fed shifted in the fall of 1979 to a money supply target under the leadership of chairman Paul Volcker, was regarded as a milestone in monetary policy and a victory for monetarist ideas 7. remained in place until 1982 but pressure pressure from the recession then forced the Fed to moderate that policy. In addition, changes in the banking system have made it more difficult to forecast and control relationships between the size of the monetary base and the money supply 8. Finally, the link between both M1 and M2 and GDP has weakened as more substitutes for traditional forms of money have developed, all leading the Fed to focus its monetary policy on interest rate decisions

monetary policy under the fed, 1914-2012

1. when the Fed was established in 1913, one of its primary functions was to keep the US in compliance with the international gold standard 2. the Fed had to allow the size of the US gold stock held by the treasury to set an upper limit on the size of the money supply -such a requirement severely limited the Fed's freedom to expand the money supply 3. the Fed's first challenge was helping the treasury finance the budget deficit during and after World War I -the Fed cooperated in keeping interest rates low and buying any government bonds that could not find a buyer (these actions were inflationary)

from money to interest rates

1. when the fed increases money supply by buying bonds, the initial effect is to create excess bank reserves 2. banks will want to lend those reserves in order to earn interest 3. banks will have to lower interest rates to entice borrowers 4. in fact, the process of monetary expansion itself will tend to lower interest rates, at least in the short run 5. Fed expands the money supply, it buys bonds -the increased demand for bonds drives their prices up and their yields down -as the lower yields (returns) spread to other assets and other financial markets, interest rates in general tend to fall 6. the response of banks and individuals to money creation is based on how they respond to changes in interest rates as the opportunity cost of holding money 7. if open market operations by the Fed result in banks holding more excess reserves than they would like to, bankers will be eager to lend those excess reserves even at lower interest rates 8. if individuals find themselves with larger cash balances than they need, they will make some of them available for lending in order to earn interest 9. both of these actions will increase the supply of loanable funds and tend to put downward pressure on the market interest rate

Module 12

Monetary Policy in Theory and Practice