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Chapter 16. Domestic and International Dimensions of Monetary Policy. Introduction. Today the total reserves that depository institutions hold with the Fed exceed $1 trillion, as compared to less than $45 billion in 2008.

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chapter 16

Chapter 16

Domestic and International Dimensions of Monetary Policy

introduction
Introduction

Today the total reserves that depository institutions hold with the Fed exceed $1 trillion, as compared to less than $45 billion in 2008.

What determines the quantity of reserves that depository institutions choose to hold with the

Fed? Why are they opting to hold so many more

reserves now than a few years ago?

This chapter will help you understand the answers to these questions.

learning objectives
Learning Objectives

Identify the key factors that influence the quantity of money that people desire to hold

Describe how Federal Reserve monetary policy actions influence market interest rates

Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run

Understand the equation of exchange and its importance in the quantity theory of money and prices

learning objectives cont d
Learning Objectives (cont'd)

Discuss the interest-rate-based transmission mechanism of monetary policy

Explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously

Describe how the Federal Reserve achieves a target value of the federal funds rate

Explain key issues the Federal Reserve confronts in selecting its target for the federal funds rate

chapter outline
Chapter Outline

The Demand for Money

How the Fed Influences Interest Rates

Effects of an Increase in the Money Supply

Open Economy Transmission of Monetary Policy

Monetary Policy and Inflation

Monetary Policy in Action: The Transmission Mechanism

chapter outline cont d
Chapter Outline (cont'd)

The Way Fed Policy is Currently Implemented

Selecting the Federal Funds Rate Target

did you know that
Did You Know That …

In late 2000s, Zimbabwe’s daily inflation rate some times exceeded 100 percent, meaning that the nation’s price level more than doubled within 24-hour periods?

Meanwhile, daily rates of money supply growth in Zimbabwe also exceeded 100 percent.

Why are higher rates of inflation associated with higher rates of money growth?

One objective of this chapter is to answer this question.

the demand for money
The Demand for Money

To see how Fed monetary policy actions have an impact on the economy by influencing market interest rates, we must understand how much money people desire to hold—the demand for money.

All flows of nonbarter transactions involve a stock of money.

To use money, one must hold money.

the demand for money1
People have certain motivation that causes them to want to hold money balances:

Transactions demand

Precautionary demand

Asset demand

The Demand For Money
the demand for money cont d
The Demand for Money (cont'd)

Money Balances

Synonymous with money, money stock, and money holdings

the demand for money cont d1
The Demand for Money (cont'd)

Transactions Demand

Holding money as a medium of exchange to make payments

The level varies directly with nominal GDP

the demand for money cont d2
The Demand for Money (cont'd)

Precautionary Demand

Holding money to meet unplanned expenditures and emergencies

the demand for money cont d3
The Demand for Money (cont'd)

Asset Demand

Holding money as a store of value instead of other assets such as certificates of deposit, corporate bonds, and stocks

the demand for money cont d4
The Demand for Money (cont'd)

The demand for money curve

Assume the amount of money demanded for transactions purposes is proportionate to income

Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate)

how the fed influences interest rates
How the Fed Influences Interest Rates

The Fed seeks to alter consumption, investment, and total aggregate expenditures by altering the rate of growth of the money supply

how the fed influences interest rates cont d
How the Fed Influences Interest Rates (cont'd)

The Fed has four tools at its disposal as monetary policy actions:

Open market operations

Changes in the reserve ratio

Changes in the interest rate paid on reserves

Discount rate changes

how the fed influences interest rates cont d1
How the Fed Influences Interest Rates (cont'd)

Open market operations

Fed purchases and sells government bonds issued by the U.S. Treasury

An open market operation causes a change in the price of bonds

figure 16 2 determining the price of bonds panel a
Figure 16-2 Determining the Price of Bonds, Panel (a)

Contractionary Policy

• Fed sells bonds

• Supply of bonds increases

• The price of bond falls

figure 16 2 determining the price of bonds panel b
Figure 16-2 Determining the Price of Bonds, Panel (b)

Expansionary Policy

• Fed buys bonds

• Supply of bonds falls

• The price of bond rises

how the fed influences interest rates cont d2
How the Fed Influences Interest Rates (cont'd)

Example

You pay $1,000 for a bond that pays $50 per year in interest

Bond Yield = $50 = 5%

$1,000

how the fed influences interest rates cont d3
How the Fed Influences Interest Rates (cont'd)

Example

Now suppose you pay $500 for the same bond (with $50 in interest)

Bond Yield = $50 = 10% $500

how the fed influences interest rates cont d4
How the Fed Influences Interest Rates (cont'd)

The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy

Implications:

A Fed open market sale that reduces the equilibrium price of bonds brings about an increase in the interest rate

A Fed open market purchase that boosts the equilibrium price of bonds generates a decrease in the interest rate

effects of an increase in the money supply
Effects of an Increase in The Money Supply

What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter?

People pick up the money and put it in their pockets, but how do they dispose of the new money?

effects of an increase in the money supply cont d
Effects of an Increase in The Money Supply (cont'd)

Direct effect

Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services

effects of an increase in the money supply cont d1
Effects of an Increase in The Money Supply (cont'd)

Indirect effect

Not everybody will necessarily spend the newfound money on goods and services

Some of the money gets deposited, so banks have higher reserves (and they lend the excess out)

effects of an increase in the money supply cont d2
Effects of an Increase in The Money Supply (cont'd)

Indirect effect

Banks lower rates to induce borrowing

Businesses engage in investment

Individuals consume durable goods (like housing and autos)

Increased loans generate an increase in aggregate demand

More people are involved in more spending (even those who didn’t get money from the helicopter!)

effects of an increase in the money supply cont d3
Effects of an Increase in The Money Supply (cont'd)

Assume the economy is operating at less than full employment

Expansionary monetary policy can close the recessionary gap

Direct and indirect effects cause the aggregate demand curve to shift outward

figure 16 3 expansionary monetary policy with underutilized resources
Figure 16-3 Expansionary Monetary Policy with Underutilized Resources
  • The recessionary gap isdue to insufficient AD
  • To increase AD,use expansionary monetary policy
  • AD increases and real GDP increases to full employment
effects of an increase in the money supply cont d4
Effects of an Increase in The Money Supply (cont'd)

Assume there is an inflationary gap

Contractionary monetary policy can eliminate this inflationary gap

Direct and indirect effects cause the aggregate demand curve to shift inward

figure 16 4 contractionary monetary policy with overutilized resources
Figure 16-4 Contractionary Monetary Policy with Overutilized Resources
  • The inflationary gap is shown
  • To decrease AD, use contractionary monetary policy
  • AD decreases and real GDP decreases
open economy transmission of monetary policy
Open Economy Transmission of Monetary Policy

So far we have discussed monetary policy in a closed economy

When we move to an open economy, monetary policy becomes more complex

open economy transmission of monetary policy cont d
Open Economy Transmission of Monetary Policy (cont'd)

The net export effect of contractionary monetary policy

Boosts the market interest rate

Higher rates attract foreign investment

International price of dollar rises

Appreciation of dollar reduces net exports

Negative net export effect

open economy transmission of monetary policy cont d1
Open Economy Transmission of Monetary Policy (cont'd)

Contractionary monetary policy causes interest rates to rise

Such a rise will induce international inflows of funds, thereby raising the international value of the dollar and making U.S. goods less attractive abroad

The net export effect of contractionary monetary policy will be in the same direction as the monetary policy effect, thereby amplifying the effect of such policy

open economy transmission of monetary policy cont d2
Open Economy Transmission of Monetary Policy (cont'd)

The net export effect of expansionary monetary policy

Lower interest rates

Financial capital flows out of the United States

Demand for dollars will decrease

International price of dollar goes down

Foreign goods look more expensive in United States

Net exports increase (imports fall)

open economy transmission of monetary policy cont d3
Open Economy Transmission of Monetary Policy (cont'd)

Globalization of international money markets

The Fed’s ability to control the rate of growth of the money supply may be hampered as U.S. money markets become less isolated

If the Fed reduces the growth of the money supply, individuals and firms in the United States can obtain dollars from other sources and more regularly conduct transactions using other nations’ currencies.

monetary policy and inflation
Monetary Policy and Inflation

Most media discussions of inflation focus on the short run when the price index can fluctuate due to such events as

Oil price shocks, labor union strikes

In the long run, empirical studies show that excessive growth in the money supply results in inflation

monetary policy and inflation cont d
Monetary Policy and Inflation (cont'd)

Simple supply and demand analysis can be used to explain why the price level rises when the money supply increases

If the supply of money expands relative to the demand for money:

People have more money balances than they desire, so their spending on goods and services increases (i.e., the price level has risen)

monetary policy and inflation cont d1
Monetary Policy and Inflation (cont'd)

The Equation of Exchange

The formula indicating that the number of monetary units (Ms) times the number of times each unit is spent on final goods and services (V) is identical to the price level (P) times real GDP (Y)

It shows the relationship between changes in the quantity of money in circulation and the price level

monetary policy and inflation cont d2
Monetary Policy and Inflation (cont'd)

MS= money balances held by nonbanking public

V = income velocity of money

P = price level or price index

Y = real GDP per year

MsV  PY

monetary policy and inflation cont d3
Monetary Policy and Inflation (cont'd)

Income Velocity of Money

The number of times per year the dollar is spent on final goods and services

Equal to the nominal GDP divided by the money supply

monetary policy and inflation cont d4
Monetary Policy and Inflation (cont'd)

The equation of exchange as an identity ()

Total funds spent on final output MsV equals total funds received PY

The value of goods purchased is equal to the value of goods sold

MsV  PY nominal GDP

monetary policy and inflation cont d5
Monetary Policy and Inflation (cont'd)

Quantity Theory of Money and Prices

The hypothesis that changes in the money supply lead to equiproportional changes in the price level

If we assume that V and Y are constant, than an increase in the money supply by, say 20%, can lead only to a 20% increase in the price level

international policy example north korea divides its money by 100
International Policy Example: North Korea Divides Its Money by 100

Inflation has been so rampant in North Korea that even the poorest individuals commonly have held thousands of won, the nation’s currency, and banks have routinely transferred single payments denominated in trillions of won.

To simplify matters, the North Korean government recently stripped two zeros from the currency.

figure 16 7 adding monetary policy to the aggregate demand aggregate supply model
Figure 16-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model

At lower rates, a larger quantity of money will be demanded

The decrease in the interest rate stimulates investment

slide48
The Fed’s target choice: The interest rate or the money supply?

The Fed has sought to achieve an interest rate target

There is a fundamental tension between targeting the interest rate and controlling the money supply

The Fed can attempt to stabilize the interest rate or the money supply, but not both

Monetary Policy in Action: The Transmission Mechanism

figure 16 8 choosing a monetary policy target
Figure 16-8 Choosing a Monetary Policy Target

If the Fed selects re, it must accept Ms

If the Fed selects M’s, it must allow the interest rate to fall

monetary policy in action the transmission mechanism cont d
Monetary Policy in Action: The Transmission Mechanism (cont’d)

Choosing a policy target

Money supply

When variations in private spending occur

Interest rates

When the demand for (or supply of) money is unstable

Interest rate targets are preferred

the way fed policy is currently implemented
The Way Fed Policy is Currently Implemented

At present the Fed announces an interest rate target

If the Fed wants to raise “the” interest rate, it engages in contractionary open market operations

Fed sells more Treasury securities than it buys, thereby reducing the money supply

This tends to boost “the” rate of interest

the way fed policy is currently implemented cont d
The Way Fed Policy is Currently Implemented (cont'd)

Conversely, if the Fed wants to decrease “the” rate of interest, it engages in expansionary open market operations

Fed buys more Treasury securities, increasing the money supply

This tends to lower “the” rate of interest

the way fed policy is currently implemented cont d1
The Way Fed Policy is Currently Implemented (cont'd)

In reality, “the” interest rates that are relevant to Fed policymaking:

Federal funds rate

Discount rate

Interest rate on reserves

the way fed policy is currently implemented cont d2
The Way Fed Policy is Currently Implemented (cont'd)

Federal Funds Rate

The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market

Federal Funds Market

A private market (made up mostly of banks) in which banks can borrow reserves from other banks that want to lend them

Federal funds are usually lent for overnight use

the way fed policy is currently implemented cont d3
The Way Fed Policy is Currently Implemented (cont'd)

Discount Rate

The interest rate that the Federal Reserve charges for reserves that it lends to depository institutions (through the “discount window”)

It is sometimes referred to as the rediscount rate or, in Canada and England, as the bank rate

the way fed policy is currently implemented cont d4
The Way Fed Policy is Currently Implemented (cont'd)

The interest rate on reserves

In October 2008, Congress granted the Fed authority to pay interest on both required reserves and excess reserves of depository institutions

If the Fed raises the interest rate on reserves and thereby reduces the differential between the federal funds rate and the interest rate on reserves, banks have less incentive to lend reserves in the federal funds market

figure 16 9 the market for bank reserves and the federal funds rate panel b
Figure 16-9 The Market for Bank Reserves and the Federal Funds Rate, Panel (b)

An open market purchase increases the supply of reserves, and thus lowers the equilibrium federal funds rate

the way fed policy is currently implemented cont d5
The Way Fed Policy is Currently Implemented (cont'd)

FOMC Directive

A document that summarizes the Federal Open Market Committee’s general policy strategy

Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth

the way fed policy is currently implemented cont d6
The Way Fed Policy is Currently Implemented (cont'd)

Trading Desk

An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC

selecting the federal funds rate target
Selecting the Federal Funds Rate Target

The Neutral Federal Funds Rate

A value of the interest rate on interbank loans at which the growth rate of real GDP tends neither to rise nor to fall relative to the rate of growth of potential, long-run, real GDP, given the expected rate of inflation

selecting the federal funds rate target cont d
Selecting the Federal Funds Rate Target (cont’d)

The value of neutral federal funds rate varies over time. The potential rate of growth of real GDP is not constant

When the rate of growth rises or falls, so does the value of the neutral federal funds rate

The FOMC must respond by changing the target for the federal funds rate that it includes in the FOMC Directive transmitted to the Trading Desk

selecting the federal funds rate target cont d1
Selecting the Federal Funds Rate Target (cont’d)

Taylor Rule

A suggested guideline for monetary policy

An equation determining the Fed’s interest rate target based on

Estimated long-run real interest rate

Deviation of the actual inflation rate from the Fed’s objective

Gap between actual real GDP and a measure of potential GDP

why not just follow the taylor rule
Why Not … just follow the Taylor rule?

After 2008, during the Great Recession, following the Taylor rule was not feasible for the Fed.

Figure 16-10 shows that the Taylor rule specified a negative value for the federal funds rate, which is not possible.

you are there how zimbabwe undercut collectors hopes of profits
You Are There: How Zimbabwe Undercut Collectors’ Hopes of Profits

During Zimbabwe’s periods of hyperinflation—an inflation rate so high that the Zimbabwe dollar often lost more than half its value in a single day, its government printed one-trillion-dollar notes.

As those notes were printed and distributed in very large volumes, their market values might never exceed what money collectors paid for them.

issues applications explaining the rise in the quantity of bank reserves
Issues & Applications: Explaining the Rise in the Quantity of Bank Reserves

Figure 16-11 shows that since the late summer of 2008, the total reserves of depository institutions have increased by nearly 25 times, to a level exceeding $1 trillion.

Most of this increase came from the rise in voluntary holdings of excess reserves because since October 2008, the Federal Reserve has paid interest on all reserves held at Federal Reserve district banks.

summary discussion of learning objectives
Summary Discussion of Learning Objectives

Key factors that influence the quantity of money that people desire to hold

When nominal GDP rises

People generally make more transactions

They require more money

They desire to hold more money

The interest rate is the opportunity cost for holding money as a precaution against unexpected expenditures

The quantity of money demanded declines as the market interest rate increases

summary discussion of learning objectives cont d
Summary Discussion of Learning Objectives (cont'd)

How the Fed’s Open Market Operations Influence Market Interest Rates

The market price of existing bonds and the prevailing interest rate are inversely related

The market interest rate rises when the Fed sells bonds

The market interest rate declines when the Fed purchases bonds

summary discussion of learning objectives1
Summary Discussion of Learning Objectives

How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run

Expansionary monetary policy

Pushing up money supply, inducing a fall in interest rates

Total planned expenditures rise, AD shifts rightward

Contractionary monetary policy

Reduces the money supply increasing interest rates

Total planned expenditures fall, AD shifts leftward

summary discussion of learning objectives cont d1
Summary Discussion of Learning Objectives (cont'd)

The equation of exchange and the quantity theory of money and prices

Equation of exchange

MsV = PY

Quantity theory of money and prices

V is constant and Y is stable

Increases in Ms lead to equiproportional increases in P

summary discussion of learning objectives cont d2
Summary Discussion of Learning Objectives (cont'd)

The interest-rate-based transmission mechanism of monetary policy

Operates through effects of monetary policy actions on market interest rates

Bring about changes in desired investment and thereby affect equilibrium GDP via the multiplier effect

summary discussion of learning objectives cont d3
Summary Discussion of Learning Objectives (cont'd)

Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously

To target the money supply the Fed must permit the interest rate to vary when the demand for money changes

To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes

summary discussion of learning objectives cont d4
Summary Discussion of Learning Objectives (cont'd)

How the Federal Reserve Achieves a Target Value of the Federal Funds Rate

The interest rate at which banks can borrow excess reserves from other banks is at an equilibrium level when the quantity of reserves demanded by banks equals the quantity of reserves supplied by the Fed

The Trading Desk conducts open market sales or purchases to alter the supply of reserves as necessary to keep the federal funds rate at the FOMC’s target

summary discussion of learning objectives cont d5
Summary Discussion of Learning Objectives (cont'd)

Issues the Federal Reserve Confronts in Selecting its Target for the Federal Funds Rate

The FOMC target is the neutral federal funds rate

The Taylor Rule specifies an equation for the federal funds rate target based on

an estimated long-run real interest rate

the current deviation from the Fed’s inflation goal

the gap between actual real GDP and a measure of potential real GDP

appendix e increasing the money supply
Appendix E: Increasing the Money Supply

According to the Keynesian approach, increasing the money supply:

Pushes interest rates down

Increases the level of investment spending

Causes real GDP to rise, which in turn causes real consumption to rise

Real GDP rises further (multiplier effect)

appendix e decreasing the money supply
Appendix E: Decreasing the Money Supply

According to the Keynesian approach, decreasing the money supply:

Pushes interest rates up

Decreases the level of investment spending

Causes real GDP to fall, which in turn causes real consumption to fall

Real GDP falls further (multiplier effect)

appendix e arguments against monetary policy
Appendix E: Arguments Against Monetary Policy

Many traditional Keynesians argue that monetary policy is likely to be relatively ineffective as a recession fighter because:

During recessions, people try to build up as much as they can in liquid assets to protect themselves from risks of unemployment and other losses of income

An increase in the money supply does not reduce interest rate as individuals are willing to allow most of it to accumulate in their bank accounts, preventing interest rates from falling