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Monetary Policy

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

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  1. Monetary Policy Chapter 13

  2. 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

  3. 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

  4. Ms i Md $ Money i0

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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 -

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. Federal Funds Rate Supply ffro Demand Reserves Reserves Federal Funds Rate Market for Reserves

  16. 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

  17. 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

  18. Banks need more reserves when Deposits increase Demand for Reserves Federal funds Rate Supply= excess reserves + Fed changes io Demand: Banks + Public Money

  19. 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

  20. 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

  21. Shift: • 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

  22. Federal Funds Rate 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

  23. Federal Funds Rate Supply ffro Demand Reserves Reserves Decrease in GDP or Prices Demand for Reserves shifts left, ffr drops ffr1 Federal Funds Rate Market for Reserves

  24. Moving Along Supply of Reserves 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

  25. Shifting Supply of Reserves 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

  26. Market for Reserves: Fed Buys Bonds Federal funds Rate Supply= excess reserves + Fed changes ffro ffr1 Demand: Banks + Public Money

  27. Open Market Operations: Fed Buys Bonds 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

  28. The Money Market: Fed Buys Bonds 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

  29. Price Level AS Price Level P0 AD = C + I + G + NX Goods and services Goods and Services AD GDP GDP0

  30. Open Market Operations: Fed Buys Bonds 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

  31. Goods and Services Market: Fed Buys Bonds Price Level AS Prices Rise AD1 = C0 + I1=G0+NX0 AD0 = C0 + I0=G0+NX0 GDP GDP Increase

  32. InverseRelationship 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.

  33. Price of Bonds Supply: Government and Fed Market for bonds Bonds P0 Demand: Public

  34. Bond Market: Fed Buys Bonds When the fed buys bonds it decreases the supply of bonds available to the public….

  35. P1 Bond Market: Fed Buys Bonds Supply of bonds i1=4% Bond Price rises: Interest Rates Decrease P0 i0 =8% Demand for bonds

  36. Market for Reserves: Fed Sells Bonds Federal funds Rate Supply= excess reserves + Fed changes ffr1 ffro Demand: Banks + Public Money

  37. Open Market Operations: Fed Sells Bonds 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

  38. The Money Market: Fed Sells Bonds 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

  39. Open Market Operations: Fed Sells Bonds 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

  40. Fed Sells Bonds Price Level AS Prices Drop AD0 = C0 + I0=G0+NX0 AD1 = C0 + I1=G0+NX0 Real GDP GDP Decrease

  41. P1=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

  42. Use Expansionary 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

  43. Use Contractionary 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

  44. Interest Rate and Velocity of Money 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

  45. Price = $100 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

  46. Interest rates drop to 8% Price = $100 i=10% Get at maturity = $110 - Amount at maturity Bond Price 10% P? 110 100 8% = Bond Price P? 100

  47. Interest rates drop to 8% - 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 = =

  48. Federal Funds Rate Ms Supply i ffro Md $ Demand Quantity Bank Reserves Price Level AS i0 P0 Supply of bonds AD GDP P0 GDP0 Demand for bonds

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