CHAPTER 13 MONETARY POLICY: CONVENTIONAL AND UNCONVENTIONAL

Open-Market Operations

the Fed's purchase or sale of government securities through transactions in the open market.

Central Bank Independence

the central bank's ability to make decisions without political interference.

Discount Rate

the interest rate the Fed charges on loans that it makes to banks.

Federal Funds Rate

the interest rates that banks pay and receive when they borrow reserves from one another.

Monetary Policy and Total Expenditure This section outlines the linkages of monetary policy:

1. Fed actions change money supply and interest rates. 2. The interest rate affects investment. 3. Investment affects aggregate demand. 4. Aggregate demand affects GDP. The effect of monetary policy on aggregate demand depends on the sensitivity of interest rates to the money supply, on the responsiveness of investment spending to the rate of interest, and on the size of the multiplier.

Major Ideas

1. The Federal Reserve System is America's central bank. There are 12 Federal Reserve banks, but most of the power is held by the Board of Governors in Washington, D.C., and by the Federal Open Market Committee. 2. The Federal Reserve acts independently from the rest of the government. There is controversy over whether this independence is a good idea, and a number of reforms have been suggested that would make the Fed more accountable to the president or to Congress. 3. The Fed has three major weapons for control of the money supply: open-market operations, reserve requirements, and its lending policy to banks. But only open-market operations are used frequently. 4. The supply of reserves is controlled by Fed policy decisions. The demand for reserves depends primarily on the dollar value of transactions. The federal funds rate is the interest rate for reserves. 5. The Fed raises the money supply by purchasing government securities in the open market. When it pays banks for such purchases, the Fed provides banks with new reserves, which in turn lead to a larger money supply. Conversely, open-market sales of securities take reserves from banks and lead to a smaller money supply. 6. When the Fed buys bonds, bond prices rise and interest rates fall. When the Fed sells bonds, bond prices fall and interest rates rise. 7. The Fed can also increase the money supply by allowing banks to borrow more reserves, perhaps by reducing the interest rate it charges on such loans, or by reducing reserve requirements. 8. None of these weapons, however, gives the Fed perfect control over the money supply in the short run, because it cannot predict perfectly how far the process of deposit creation or destruction will go. 9. Investment spending (I), including business investment and investment in new homes, is sensitive to interest rates (r). Specifically, I is lower when r is higher. 10. This explains how monetary policy works in the Keynesian model. Raising the money supply (M) leads to lower r; the lower interest rates stimulate investment spending; and this investment stimulus, via the multiplier, then raises aggregate demand. 11. Prices are likely to rise as output rises. The amount of inflation caused by increasing the money supply depends on the slope of the aggregate supply curve. There will be much inflation if the supply curve is steep, but little inflation if it is flat. 12. In extreme cases such as the recession of 2007-2009, the Fed may have to resort to unconventional monetary policies including massive lending to financial institutions to prevent failure and open market purchases of assets other than Treasury bills.

Money and the Price Level

Expansionary monetary policy causes some inflation under normal circumstances. How much inflation it causes depends on the state of the economy, as represented by the slope of the aggregate supply curve.

America's Central Bank: The Federal Reserve System CENTRAL BANK INDEPENDENCE

Fed board members are appointed to 14-year terms and are quite independent of political pressures. In some other countries, the central banks are less independent. Countries without independent central banks often have less stable economies.

Investment and Interest Rates

Higher interest rates lead to lower investment spending. The change in investment has a multiplier effect, lowering GDP. Lower interest rates have the opposite effect.

The Mechanics of an Open Market Operation

If the Fed buys securities, it pays for securities by creating new bank reserves, and these additional reserves lead to a multiple expansion of the money supply. When the Fed sells securities, it receives payment for securities by reducing bank reserves, reducing the money supply.

Risk Premium (or "spread")

Increased market interest rate to compensate the lender for the probability of loss if the borrower fails to repay the loan in full or on time.

Money and Income: the Important Difference

Money is a stock; income is a flow.

How Monetary Policy Works in normal times

Of the four components of aggregate demand, investment and net exports are the most sensitive to monetary policy. We will study the effects of monetary and fiscal policy on net exports in detail in Chapter 19, after we have learned about international exchange rates. For now, we will assume that net exports (X - IM) are fixed and focus on monetary policy's influence on investment (I).

Implementing Monetary Policy in normal times: OPEN-MARKET OPERATIONS

The Fed can increase the money supply by buying government securities on the open market.

MONETARY POLICY - CHANGING RESERVE REQUIREMENTS

The Fed can increase the money supply by reducing the required reserve ratios. The Fed can decrease the money supply by increasing the required reserve ratios. In practice, the Fed seldom changes the reserve requirements.

unconventional monetary policies

The Fed cannot use conventional policies if the federal funds rate is already zero and the economy continues to suffer a recessionary gap. Other options include: (1) massive lending to banks (2) open-market purchases of items other than Treasury bills

The Market for Bank Reserves

The Fed controls the position of the supply of reserves. The demand for reserves depends on banks' need for reserves, based primarily on the dollar value of transactions. The interest rate for reserves is the federal funds rate.

MONETARY POLICY - LENDING TO BANKS

The Fed lends to member banks, occasionally as a "lender of last resort." The interest rate it charges is called the discount rate. A reduction in the discount rate may persuade member banks to borrow more reserves and expand the money supply. An increase in the discount rate may discourage member banks from borrowing more reserves and contract the money supply.

America's Central Bank: The Federal Reserve System ORIGINS AND STRUCTURE

The Federal Reserve System, established in 1914, is the U.S. central bank. It is comprised of 12 district banks and is governed by a seven-member Board of Governors. Principally the Federal Open Market Committee makes decisions on the money supply.

Which Interest Rate?

The Federal Reserve can easily control the federal funds rate and the Treasury bill rate but other interest rates are more difficult to control. Riskier borrowers pay higher interest rates than safer borrowers due to the higher risk of default.

From financial distress to recession

The failure of a major financial institution or a crash in an asset market will cause a loss of confidence with regard to the ability of various debtors to repay their loans. Greater fears lead to risk premiums and increased interest rates. Higher interest rates lead to a decrease in consumption and investment spending.

MONETARY POLICY - QUANTITATIVE EASING

The most controversial form of unconventional policy that the Fed used during the 2007-2009 financial crisis was its purchase of assets other than T-bills.

From Models to Policy Debates

We have done all the theory that is needed. The next chapters of the text turn to policy debates.

Open-Market Operations, Bond Prices, and Interest Rates

When the Fed buys bonds, it increases the demand for them and consequently raises their price. A rise in the price of bonds is equivalent to a fall in the interest rate. Similarly, when the Fed sells bonds, it lowers their price and raises the interest rate.

Application: Why the Aggregate Demand Curve Slopes Downward

When the price level rises, the demand for money rises, and this in turn causes interest rates to rise and investment to fall. The fall in investment has a negative multiplier effect on GDP. Thus a higher price level is associated with a lower GDP.

Central Bank

a bank for banks. The U.S. central bank is the Federal Reserve System.

Monetary Policy

actions that the Federal Reserve System takes in order to change interest rates and the money supply in an effort to affect the economy.

Quantitative Easing

open-market purchases of assets other than Treasury bills.

Risk of Default

risk that the borrower may not repay a loan or security on full or on time.

Unconventional Monetary Policy

unusual forms of central bank lending and unusual types of open market operations.