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Monetary Policy. Chapter 13. Fed Controls Reserves but not the M s. Banks may not want to lend. Public may not want to borrow. OMO: What can go wrong?. Loans are not deposited in the banking system. Fed buys bonds from the public or banks. Fed increases banking system reserves.

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Monetary policy

Monetary Policy

Chapter 13


Omo what can go wrong

Fed Controls Reserves but not the Ms

Banks may not want to lend

Public may not want to borrow

OMO: What can go wrong?

Loans are not deposited in the banking system

Fed buys bonds from the public or banks

Fed increases banking system reserves

Banks increase loans

Money Supply Increases

Interest Rates decrease

Deposits Increase

Credit easier to get

Loans Increase


Federal Funds Rate

Supply

Ms

i

ffro

Md

$

Demand

Reserves

Money

Price Level

AS

Reserves

i0

P0

Supply

Goods and Services

Bonds

AD

P0

GDP

GDP0

Demand


Ms

i

Md

$

Money

i0


Circular flow diagram

to

Government

Taxes

pay

Pay taxes

Imports

Consumption

Stocks, Funds

Bonds, CD’s,

Life Insurance

Saving

Investment

National Income

Circular Flow Diagram

Rest of World

Government Spending

Firms

Households

GDP

=300


Circular flow diagram1

to

pay

Stocks, Funds

Bonds, CD’s,

Life Insurance

Saving

National Income

Circular Flow Diagram

Firms

Households

Buy goods and services

Deposits and Cash

Need in liquid form

Consumption

Md


Gdp total income
GDP= Total Income

Earning interest

Not earning interest in checking accounts

Buy Stocks, Funds

Bonds, CD’s,

Life Insurance

Buy Goods and

Services

= Price x Quantity

How much money is saved depends on the interest rate on savings

Demand for money (liquidity) depends on Prices and Quantity purchased


Circular flow diagram2

to

pay

Saving

National Income

Circular Flow Diagram

Firms

Households

Buy goods and services

Deposits and Cash

Consumption

Interest Rate

Md

Prices and Quantity Purchased


What determines how much liquidity the public needs

Deposits and Cash

The higher prices and Income, the higher the need for cash/deposits

What Determines How Much Liquidity the Public needs?

The higher prices and GDP, the higher Deposits are.

We need more cash for more expensive transactions

Prices

+

The higher the interest rate, the lower the demand for cash/deposits

The higher the interest rate, the lower Deposits are.

We need more cash for more transactions.

Real Income

+

The higher the interest rate the less cash we want to hold.

Interest rate

-


Checking account deposits
Checking Account Deposits

  • Larger when we engage in more transactions

    • Real GDP is used as an indicator of the number of transactions (Q)

  • Larger when transactions are more expensive

    • Price Index is used as indicator of the average price per transaction (P)

  • Smaller when the opportunity cost of holding idle cash increases

    • Interest rate (i) is used as the indicator of opportunity cost of holding cash balances


Money market

Ms

Amount the public wants to hold in liquid form: Deposits & Cash

Interest Rate

Md

Amount the public actually holds in liquid form:Deposits & Cash

Money Market


Amount the public wants to hold in liquid form: Deposits & Cash

i

A movement up along Md

i0 =5%

Md

i0 =3%

$ Cash and checking accounts

500b

700b

The higher the interest rate, the less money the public WANTS to hold in checking accounts


Amount the public wants to hold in liquid form: Deposits & Cash

Md shifts right

i

i0 =3%

M0d

M1d

$ Cash and checking accounts

500b

700b

The higher prices/real incomes, the more money the public WANTS to hold in checking accounts


Amount the public actually holds in liquid form:Deposits & Cash

Ms

Ms

i

Ms shifts right

i0 =3%

$ Cash and checking accounts

500b

700b

Expansionary Monetary Policy: More Loans, More Deposits, Money Supply increases


Market for reserves

Federal Funds Rate

Supply

ffro

Demand

Reserves

Reserves

Federal Funds Rate

Market for Reserves


Demand for reserves

As fed funds rate rises bank’s want to borrow less

Demand for Reserves

Federal Funds Rate

Supply: banks + Fed

Amovementup(down)alongthe demand for funds resulting from higher(lower)interest rates

io

Demand: Banks short of reserves

Money


  • Movement Along:

  • Caused by a change

  • In interest rates

  • Change in

  • Quantity Demanded

  • of reserves.

Moving along Demand For Reserves

Shifting Demand for Reserves

Banks borrowmore (less) from other banks even though ffr is the same:

Deposits increase, banks need to hold more reserves

Deposits decrease, banks need to hold less reserves

  • Banks borrowmore (less) from other banks when ffr drops (rises)

ffr0

ffr0

ffr1

As ffr drops borrowing is cheaper and more reserves are demanded

Borrow more Reserves when deposits increase


Demand for reserves1

Banks need more reserves when Deposits increase

Demand for Reserves

Federal funds Rate

Supply= excess reserves + Fed changes

io

Demand: Banks + Public

Money


Demand for reserves depends on dollar value of transactions
Demand for Reserves depends on dollar value of transactions

Demand for Reserves depends on size of Deposits:

R = r*D

Size of Deposits depend on dollar value of transactions:

P*Q

Demand for Reserves depends on dollar value of transactions: P*Q


Shifts in demand for reserves

Deposits/ Demand for reserves increase with more transactions

Deposits/ Demand for reserves increase when GDP or Prices increase

Banks need more reserves when Deposits increase

Shifts in Demand for Reserves

Federal funds Rate

Supply= excess reserves + Fed changes

io

When Prices or GDP increase

Demand for reserves shift to the right

Demand = Banks in need of reserves

Money


  • Shift: transactions

  • Caused by a change

  • In prices or incomes

  • Change in

  • Demand for Reserves

Moving along Demand For Reserves

Shifting Demand for Reserves

Banks borrowmore (less) from other banks even though ffr is the same when:

Deposits increase, banks need to hold more reserves

Deposits decrease, banks need to hold less reserves

  • Banks borrowmore (less) from other banks when ffr drops (rises)

ffr0

ffr0

ffr1

Borrow more Reserves when ffr drops

Borrow more Reserves when deposits increase


Market for reserves1

Federal Funds Rate transactions

Supply

ffro

Demand

Reserves

Reserves

When GDP or Prices increase,

Demand for Reserves shifts right and ffr increases

ffr1

Federal Funds Rate

Market for Reserves


Market for reserves2

Federal Funds Rate transactions

Supply

ffro

Demand

Reserves

Reserves

Decrease in GDP or Prices

Demand for Reserves shifts left, ffr drops

ffr1

Federal Funds Rate

Market for Reserves


Moving along supply of reserves
Moving Along Supply of Reserves transactions

Banks lend more when the fed funds rate increases

Federal Funds Rate

Supply: banks with excess reserves

Banks increase lending as interest rates rise because it is more profitable

io

A movement up (down) alongthe supply of funds resulting from higher (lower)interest rates

Reserves


Shifting Supply of Reserves transactions

Federal Funds Rate

Supply: banks, Fed

The Fed manipulates the amount of reserves in the system.

Supply increases when the Fed injects reserves

io

A rightward (leftward)shiftin the supply of funds resulting from Fed injecting (destroying)reserves into (from) the system

Reserves


Market for reserves fed buys bonds
Market for Reserves: Fed Buys Bonds transactions

Federal funds Rate

Supply= excess reserves + Fed changes

ffro

ffr1

Demand: Banks + Public

Money


Open market operations fed buys bonds
Open Market Operations: Fed Buys Bonds transactions

Fed buys bonds from the public or banks

Fed increases banking system reserves

Banks increase loans

Money Supply Increases

Interest Rates decrease

Deposits Increase

Credit easier to get

Loans Increase


The money market fed buys bonds
The Money Market: Fed Buys Bonds transactions

Money plentiful: Everyone needs to lend money: willing borrowers only found at lower interest rate

Ms0

Money out of checking accounts and into interest bearing asset: look for willing borrowers who would pay interest

Ms1

i

Reserves, Loans, Deposits and the Ms increase

Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when i0 =3%

Amount of Money the Public holds in deposit accounts=Amount the public wants to hold when i0 =2%

Amount of Money the Public holds in deposit accounts>Amount the public wants to hold when i0 =3%

i0 =3%

i0 =2%

$

Ms1

Md0


Goods and services

Price Level transactions

AS

Price Level

P0

AD = C + I + G + NX

Goods and services

Goods and Services

AD

GDP

GDP0


Open market operations fed buys bonds1
Open Market Operations: Fed Buys Bonds transactions

Fed buys bonds to the public or banks

Fed increases banking system reserves

Banks increase loans

Aggregate demand Increase

Investment increases

Credit easier to get

Interest Rates decrease


Goods and services market fed buys bonds
Goods and Services Market: Fed Buys Bonds transactions

Price Level

AS

Prices Rise

AD1 = C0 + I1=G0+NX0

AD0 = C0 + I0=G0+NX0

GDP

GDP Increase


Inverse relationship between price of bonds and interest rate
Inverse transactionsRelationship Between Price of Bonds andInterest Rate

Price you paid for Bond

Amount you get at maturity

-

25%

11%

$90

$100

Interest rate

$80

=

Price you paid for Bond

$90

$80

The lower the price on the bond, the higher the interest rate.


Market for bonds

Price of Bonds transactions

Supply: Government and Fed

Market for bonds

Bonds

P0

Demand: Public


Bond market fed buys bonds
Bond Market: Fed Buys Bonds transactions

When the fed buys bonds it decreases the supply of bonds available to the public….


Bond market fed buys bonds1

P transactions1

Bond Market: Fed Buys Bonds

Supply of bonds

i1=4%

Bond Price rises: Interest Rates Decrease

P0

i0 =8%

Demand for bonds


Market for reserves fed sells bonds
Market for Reserves: Fed Sells Bonds transactions

Federal funds Rate

Supply= excess reserves + Fed changes

ffr1

ffro

Demand: Banks + Public

Money


Open market operations fed sells bonds
Open Market Operations: Fed Sells Bonds transactions

Fed sells bonds to the public or banks

Fed reduces banking system reserves

Banks decrease loans

Money Supply Decreases

Interest Rates increase

Deposits Decrease

Credit harder to get

Loans Decrease


The money market fed sells bonds
The Money Market: Fed Sells Bonds transactions

Money scarce: Everyone needs to borrow cash: willing lenders can be found only at higher interest rate.

Ms0

Ms1

Reserves, Loans, Deposits and the Ms decrease

i

Money into checking accounts: look for willing lenders

Amount of Money the Public holds in deposit accounts = Amount the public wants to hold when i0 =3%

i0 =5%

Amount of Money the Public holds in deposit accounts<Amount the public wants to hold when i0 =3%

Amount of Money the Public holds in deposit accounts=Amount the public wants to hold when i0 =5%

i0 =3%

$

Ms1

Md0


Open market operations fed sells bonds1
Open Market Operations: Fed Sells Bonds transactions

Fed sells bonds to the public or banks

Fed reduces banking system reserves

Banks decrease loans

Aggregate demand Drops

Investment Decrease

Credit harder to get

Interest Rates increase


Fed sells bonds
Fed Sells Bonds transactions

Price Level

AS

Prices Drop

AD0 = C0 + I0=G0+NX0

AD1 = C0 + I1=G0+NX0

Real GDP

GDP Decrease


Bond market fed sells bonds

P transactions1=80

Bond Market: Fed Sells Bonds

Supply of bonds: Fed, government

i =25%

Bond Price falls: Interest Rates Increase

i =11%

P0=90

Demand for bonds


Use expansionary monetary policy

Use transactionsExpansionary Monetary Policy

When the Fed Wants to Reduce Unemployment

Buy Bonds

Decrease d

Decrease r

Increase Reserves and Money Supply

Decrease the interest rate.

Increase Investment

Increase Aggregate Demand for goods and services


Use contractionary monetary policy

Use transactionsContractionary Monetary Policy

When the Fed Wants to Reduce Inflation

Sell Bonds

Increase d

Increase r

Decrease the Money Supply

Increase the interest rate.

Decrease Investment and Consumption?

Decrease Aggregate Demand for goods and services


Interest rate and velocity of money
Interest Rate and Velocity of Money transactions

As interest rate rise, public holds less cash for transactions: each dollar is used more times.

Velocity of money: Number of times a dollar bill is used

Ms = Deposits + currency

Dollar value of what we buy

Velocity = Nominal GDP/Ms

Contractionary Policy: interest rate rise, public holds less cash and deposits (Ms):Velocityincreases


Price = $100 transactions

i=10%

Get at maturity = $110

Price you paid for Bond

Amount you get at maturity

-

10%

100

110

Interest rate

=

Price you paid for Bond

100


Interest rates drop to 8% transactions

Price = $100

i=10%

Get at maturity = $110

-

Amount at maturity

Bond Price

10%

P?

110

100

8%

=

Bond Price

P?

100


Interest rates drop to 8% transactions

-

10%

P?

110

100

8%

=

P?

-

P?

110

0.08

=

P?

=

P + 0.08P

110

Bond Price rises

1.08P

=

110

P

P

110/1.08

$101.85

=

=


Federal Funds Rate transactions

Ms

Supply

i

ffro

Md

$

Demand

Quantity Bank Reserves

Price Level

AS

i0

P0

Supply of bonds

AD

GDP

P0

GDP0

Demand for bonds


Questions to prepare for the test
Questions to prepare for the test transactions

Use a diagram to show the effect on reserves, the money supply, the interest rate, the price of bonds and Aggregate Demand for the following events. Write a clear explanation of the process step by step.

  • The fed increases/decreases the required reserve ratio

  • The fed buys/sells bonds in the open market

  • Fed increases/decreases the (discount) primary credit rate.

  • Prices increase/decrease

  • Incomes increase/decrease


Federal Funds Rate transactions

Federal Funds Rate

Federal Funds Rate

Federal Funds Rate

Supply

Supply

Supply

Supply

ffro

ffro

ffro

ffro

Demand

Demand

Demand

Demand

Reserves

Reserves

Reserves

Reserves

A

B

Reserves

Reserves

Reserves

Reserves

C

D


M transactionss

Ms

Ms

Ms

i

i

i

i

Md

Md

Md

Md

$

$

$

$

B

A

Money

Money

Money

Money

i0

i0

i0

i0

D

C


A transactions

B

C

Supply

Supply

Supply

Supply

Bonds

Bonds

Bonds

Bonds

D

P0

P0

P0

P0

Demand

Demand

Demand

Demand


A transactions

B

Price Level

Price Level

Price Level

Price Level

AS

AS

AS

AS

P0

P0

P0

P0

C

D

Goods and Services

Goods and Services

Goods and Services

Goods and Services

AD

AD

AD

AD

GDP

GDP

GDP

GDP

GDP0

GDP0

GDP0

GDP0


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