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Monetary Policy

Monetary Policy. I. Federal Reserve System. 1913 12 District Reserve Banks (a la Federal District Courts) Janet Yellen (Chairman Federal Reserve Board of Governors)  monetary policy: actions Fed takes to influence level real GDP and rate of inflation. Goals of Monetary Policy.

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Monetary Policy

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  1. Monetary Policy

  2. I. Federal Reserve System • 1913 • 12 District Reserve Banks (a la Federal District Courts) • Janet Yellen (Chairman Federal Reserve Board of Governors) monetary policy: actions Fed takes to influence level real GDP and rate of inflation

  3. Goals of Monetary Policy • Not profit motivated • “assist in achieving a full-employment, noninflationary level of total output” • 1960s: focus full-employment • Post-1970s: focus inflation • Alters M by altering excess reserves to affect output and prices

  4. Theory of Monetarism • MV≡PY • Money supply x Velocity = Price Level x Output = nominal GDP • Velocity relatively fixed (slow, predictable change)

  5. II. Tools • 1) Open Market Operations • Buying and selling of bonds in open market • Buying • From C. Banks: increases banks’ reserves by amount of purchase (if fully “loaned up” $1000 bond w/20% RR $5000 increase lending + M) • From public: indirectly increases banks’ reserves (less the reserve requirement: $4000 in lending and $1000 in new demand deposit= $5000 increase M) • Selling: just the reverse

  6. 2) Reserve Ratio • Raise RR A) lose excess reserves diminish money creation through lending or B) reserves become deficient contract checkable deposits and therefore M • Lowering has opposite effect • ∆ RR: 1) ∆ excess reserves and 2) ∆ monetary multiplier (1/RR)

  7. 3) Discount Rate • Commercial Bank borrowing from Fed increase reserves extension credit • Discount rate: rate charged to borrow from Fed (cost of acquiring reserves) raise/lower discourages/encourages C. Bank borrowing to increase M

  8. 4) Moral Suasion • Speeches, interviews, etc.: try to persuade people to change behavior so Fed doesn’t have to act • “Irrational exuberance”

  9. Easy vs. Tight Policy • Expand M: buy securities, reduce RR, lower discount rate • Restrict M: sell, raise, raise

  10. Relative Importance of Tools • #1 Open market operations (bonds) • Discount rate: 1) C. Banks borrow only 2-3% of reserves from Fed (and OMO changes in borrowing); 2) DR effectiveness dependent on bank decisions (if banks unwilling, Fed unable) • But, discount rate as “announcement effect”; but often to keep in line w/other rates • Reserve ratio: used rarely bc impacts bank profits (reserves earn no interest)

  11. OMO: 1) flexible (scalpel > sledgehammer); 2) prompt (timing problems); 3) powerful: total sale could take reserves $22B $0 • Washington Baby-Sitter Co-op Redux

  12. III. Monetary Policy, Real GDP, Price Level Money Demand • Transaction demand: to use • Asset demand: to hold • Factors affecting: 1) cash needed on hand, 2) interest rates (opp’y cost of holding money), 3) price levels, 4) general level of income

  13. Investment Demand • Amount investment w/rate of return greater than real rate of interest •  ∆M ∆i.r. ∆I  ∆GDP + PL

  14. Effectiveness • 1) Speed and flexibility • 2) isolation from political pressure • 3) “Success” in 1980s + 1990s (Greenspan the “maestro”) monetary policy primary stabilization tool in US • Some now criticize Greenspan for allowing bubbles (stocks + housing) to form

  15. Shortcomings and Problems • 1) Less control? ∆ banking + globalization undermine Fed policy power • 2) Cyclical assymetry: easy money only works if willing to loan/borrow: Fed strong in expansions, weaker in recessions (when arguably most needed) • ∆ biz confidence (movement of investment demand curve) may require enormous exertions by Fed to offset • 3) Changes in velocity: total expenditures = M times velocity of money (how often spent) • 4) Investment Impact: in reality borrowing small source investment (mostly retained earnings) • 5) Interest as income: MP based on assumption expenditures inversely related i; but i also income, so direct relationship (probably only partly off-sets) • 6) Zero-lower bound: what if interest rates are 0%?

  16. Federal Funds rate • Rate banks charge other banks for short-term loans (cover reserve requirements) • “target”: not set by Fed (supply and demand), but buys/sells bonds to affect rate • Prime rate follows Federal Funds

  17. Policy Multipliers • Spending Multiplier: 1/MPS • Actual multiplier estimated at 2x • Taxing Multiplier: 1xMPC (=.95) • Balanced Budget Multiplier (equal tax hike and spending hike): 1x change G • Money Multiplier: Excess Reserves x 1/RRR • Monetarism: MV=PY ∆M x V = ∆GDP

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