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The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?

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The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply? - PowerPoint PPT Presentation


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The Federal Reserve has a dual mandate to: Maintain stable prices (fight inflation/deflation) Maintain full employment (monetary policy to manage macroeconomic conditions). The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?. Monetary Policy.

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The Federal Reserve has a dual mandate to:Maintain stable prices (fight inflation/deflation)Maintain full employment (monetary policy to manage macroeconomic conditions)

the fed manages inter bank interest rates and regulates banks but does it control money supply
The Fed manages Inter-bank Interest Rates and Regulates Banks…but does it control money supply?
monetary policy
Monetary Policy

"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society."

--Milton Friedman

The Bank [of Canada] gave it a college try, it really did. It just doesn\'t work that way.

--John Crow, former governor of the Bank of Canada, on implementing Friedman\'s theories;

what is monetary policy
What Is Monetary Policy?
  • Central bank (as representative of government) manipulation of the
    • money supply,
    • interest rates
    • credit conditions

with an objective of achieving macroeconomic goals.

three theories of monetary policy
Three Theories of Monetary Policy
  • Strict Monetarist
  • Neo-classical/New Keynesian
  • Modern Monetary Theory (MMT)
equation of exchange
Equation of Exchange
  • M x V = P x Y
    • M: money supply
    • V: Velocity
      • (how fast money is spent)
    • P: Price Level
    • Y: Real Income
    • Note: sometimes shown as M * V = P * Q same concept, different notation
  • Identity: Must be true for any period of time
both monetarist and neo classical new keynesian theories
Both Monetarist and Neo-Classical/New Keynesian Theories:
  • Trade-off between unemployment and inflation exists
  • Controlling Inflation is higher priority
money supply concept classical or milton friedman monetarist version
Money supply concept: (Classical or Milton Friedman Monetarist version)

Money supply is ‘exogenous’

  • more bank reserves —>
  • more lending by banks –>
  • increased money supply –>
  • lower interest rates –>
  • borrowing by consumers/firms –>
  • more C and I spending –>
  • faster GDP growth & inflation
interest rates concept neoclassical version
Interest rates concept: (Neoclassical version)
  • central bank open market purchases of bonds –>
  • higher bond prices = lower interest rates –>
  • more borrowing by consumers/firms –>
  • more spending on C and I –>
  • faster GDP growth –>
but the equation of exchange
But, the Equation of Exchange
  • M x V = P x Y
    • M: money supply
    • V: Velocity (how fast money is spent)
    • P: Price Level
    • Y: Real Income
  • Note: sometimes shown as M V = P Q
    • same concept, different notation
  • Equation of Exchanges is an Identity: Must be true for any period of time after the fact..
quantity theory of money qtm
Quantity theory of money (QTM):
  • Based on equation of exchange with added assumptions about the behavior of variables.
    • assume V is constant
  • Conclusions:
    • Money supply growth is solely responsible for determining Inflation
crowding out theory
‘Crowding Out’ Theory
  • Assumptions:
  • Fixed amount of money in economy
  • QTM holds true
  • Theory: Gov borrowing takes $ away/raises interest rate for firm and household borrowers –> will reduce C and I unless
  • Central Bank increases M to fund deficit  inflation
  • Absolutely not supported by evidence or data in modern real world.
current neoclassical and new keynesian views on monetary policy
Current Neoclassical and New Keynesian Views on monetary policy
  • Support for ad hoc policy (policy makers should make it up as they go)
modern monetary theory mmt
Modern Monetary Theory (MMT)
  • Money growth (M1 – bank credit) is largely endogenous
  • Key is base money growth, not M1
    • government deficits enable the private sector (firms and households) to grow and yet still accumulate net financial assets
slide16
MMT Foundation: Fiat money system with floating exchange rates eliminates government budget constraint
  • Deficits effective in fighting unemployment
    • no financing constraint on deficits
    • deficits are limited by the availability of real, unemployed resources for the government to purchase
  • Inflation threat is at/near full employment is reached (AD- LRAS model)
limitations of monetary policy pushing on string
Limitations of Monetary Policy: ‘Pushing on string’
  • Central bank cannot force banks to make loans
limitations of monetary policy endogenous money supply
Limitations of Monetary Policy: Endogenous money supply
  • Banks, not central bank really determine supply of money and credit
limitations of monetary policy fiscal policy coordination
Limitations of Monetary Policy: Fiscal Policy Coordination
  • Fiscal and Monetary policy could work at cross-purposes
  • could expect ‘other’ to do it
limitations of monetary policy liquidity trap
Limitations of Monetary Policy: Liquidity trap
  • At ‘zero lower bound’
    • when interest rates approach zero but the economy is still weak, monetary policy is largely ineffective.
limitations of monetary policy globalization
Limitations of Monetary Policy: Globalization
  • If interest rates too low or inflation too high, then value of currency drops –> capital inflow drops and M drops, even though X rises
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