Transcript Slide 1

1. Monetary Policy Tools:
a. The Reserve Requirement
-reducing it encourages loans and
increases the money supply
-increasing it discourages loans
and decreases the money supply
Type of Deposit
Current
Checkable
0-$5.5 mil
0
$5.5-42.8 mil
3
over $42.8 mil
10
Savings
0
Legal Range
0-3
0-3
8-14
0-9
b. The Discount Rate
3 rates
1. Discount Rate
2. Federal Funds Rate
3. Prime Rate
federal reserve to
member banks
bank to bank
banks to best
customers
b. The Discount Rate
Raising Discount Rate
discourages bank borrowing
decreases money supply
Lowering Discount Rate
encourages bank borrowing
increases money supply
Federal Funds Rate Targeting, January 1998–September 2011
Note: The federal funds target for the period after December 2008 was 0
to 0.25 percent.
c. Open Market Operations
Buying and Selling Securities (Bonds)
-selling bonds puts bonds out and
take money out of circulation
What effect will this have on the economy??
-buying bonds puts money back in
circulation and takes bonds in
What effect will this have on the economy??
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
1. Price stability
2. High employment
3. Stability of financial markets
and institutions
4. Economic growth
1. Peaks in the 70s, deflation in 2009.
The Inflation Rate, January 1952–August 2011
Price stability and high employment are both
explicitly mentioned in the Employment Act of
1946.
Allows an efficient flow of funds from savers to
borrowers.
To ease liquidity problems facing investment
banks in 2008, the Fed temporarily allowed them
to receive discount loans.
Stable economic growth allows households and
firms to plan accurately and encourages the
long-run investment that is needed to sustain
growth.
Fiscal policy may be better able to promote
economic growth through changes in tax laws
that increase the return to saving and
investing.
Cash, not wealth
Transactions Demand
Bills
Assets Demand
Interest rate
Interest Rate
Transactions Demand
Assets Demand
The interest rate is the
opportunity cost, or what
you forgo, to hold money.
Quantity of Money
The money demand curve slopes downward
because lower interest rates cause households
and firms to switch from financial assets, such
as U.S. Treasury bills, to money.
All other things being equal, a fall in the
interest rate will increase the quantity of money
demanded.
An increase in the interest rate will decrease
the quantity of money demanded.
Shifts in the Money Demand Curve
An increases in real GDP or the price level will cause the
money demand curve to shift from MD1 to MD2.
A decrease in real GDP the price level will cause the
money demand curve to shift from MD1 to MD3.
Interest Rate
Determined by the FRS
Quantity of Money
Money
interest
rate
Money
Supply
Excess supply
at i2
i2
ie
At ie, people are willing
to hold the money supply
set by the Fed.
i3
Money
Demand
Excess demand
at i3
Quantity
of money
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
• Fed buys bonds – money supply increases
• The banks have new reserves.
both have downward pressure on
interest rates (a reduction to r2).
Money
interest
rate
S1
Real
interest
rate
S1 S2
i1
r1
i2
r2
S2
D1
Qs
Qb
Quantity
of money
D
Q1
Q2
Qty of
loanable
funds
Households and firms will initially hold more
money than they want, relative to other financial
assets.
Households and firms use the money they don’t
want to hold to buy Treasury bills and make
deposits in interest-paying bank accounts.
Banks and sellers of Treasury bills and similar
securities to offer lower interest rates.
Eventually, interest rates will fall enough that
households and firms will be willing to hold the
additional money the Fed has created.
As the real interest rate falls, AD increases (to AD2).
The expansion in AD leads to a short-run increase in
output (from Y1 to Y2) and an increase in the price
level (from P1 to P2) – inflation.
S1
Real
interest
rate
Price
Level
AS1
S2
r1
P2
P1
r2
D
Q1
Q2
Qty of
loanable
funds
AD2
AD1
Y1 Y2
Goods &
Services
(real GDP)
• Consumption. Lower interest rates lower the cost of
durable goods and reduce the return to saving, leading
households to save less and spend more.
• Investment. Lower interest rates increase the demand
for stocks and make it less expensive for firms and
households to borrow, thereby increasing investment.
• Net exports. If interest rates in the United States
decline relative to interest rates in other countries, the
value of the dollar will fall and net exports will rise.
Price
Level
LRAS
SRAS1
P2
P1
E2
e1
AD1
Y1 YF
AD2
Goods & Services
(real GDP)
• If the increase in AD is when the economy is below
capacity, the policy will help direct the economy
toward long-run full-employment equilibrium YF.
Price
Level
LRAS
SRAS1
P2
P1
e2
E1
AD2
AD1
YF Y2
Goods & Services
(real GDP)
If the increase is at full-employment YF, they will
lead to excess demand, higher product prices, and
temporarily higher output Y2.
Price
Level
LRAS
SRAS2
SRAS1
P3
E3
P2
P1
e2
E1
AD2
AD1
Y F Y2
Goods & Services
(real GDP)
In the long-run, the strong demand pushes up resource
prices, shifting short run aggregate supply (from
SRAS1 to SRAS2).
The price level rises (from P2 to P3) and output falls
back to YF from its temporary high,Y2.
Too Low for Zero: The Fed Tries “Quantitative Easing” and
“Operation Twist”
Quantitative easing - purchasing securities—including
certain mortgage-backed securities—beyond the short-
term Treasury securities that are usually involved in open
market operations. (Nov. 2008 and June 2011)
The economic recovery remained weak
Operation Twist - the Fed announced it would purchase
$400 billion in long-term Treasury securities while it
would sell an equal amount of shorter-term Treasury
securities. (Sept 2011)
Both tried to reduce interest rates on long-term Treasury
securities, which typically move closely with those on home
mortgage loans, in order to increase aggregate demand.
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
Restrictive monetary policy, will increase real
interest rates.
Higher interest rates decrease AD (to AD2).
Real output will decline (to Y2) and downward pressure
on prices will result.
S2
Real
interest
rate
Price
Level
AS1
S1
r2
P1
P2
r1
D
Q2
Q1
Qty of
loanable
funds
AD1
AD2
Y2 Y1
Goods &
Services
(real GDP)
Households and firms will initially hold less
money than they want, relative to other financial
assets.
Households and firms will sell Treasury bills and
other financial assets and withdraw money from
interest-paying bank accounts.
These actions will increase interest rates.
Eventually, interest rates will rise to the point at
which households and firms will be willing to hold
the smaller amount of money that results from
the Fed’s actions.
Price
Level
LRAS
SRAS1
P1
P2
e1
E2
AD1
AD2
YF Y1
Goods & Services
(real GDP)
If the demand restraint occurs during a period
of strong demand and an overheated
economy, then it may limit or prevent an
inflationary boom.
Price
Level
LRAS
SRAS1
P1
P2
E1
e2
AD2
Y2 YF
AD1
Goods & Services
(real GDP)
If the reduction in aggregate demand takes place
when the economy is at full-employment, then it
will disrupt long-run equilibrium, and result in a
recession.
• Consumption. Higher interest rates raise the cost of
consumer durables and increase the return to saving,
leading households to save more and spend less.
• Investment. Higher interest rates make it more
expensive for firms and households to borrow, thereby
decreasing investment.
• Net exports. If interest rates in the United States
rise relative to interest rates in other countries, the
value of the dollar will rise and net exports will fall.
M * V = P *Y
Money V
elocity
Y Output
Price
- the amount of money in circulation
- the number of times each $ is spent in a
year (considered to be stable)
- the level of prices
- the actual output of goods and services
M * V = P *Y
Money
• P
Y
Velocity
=
Y =output
Price
Total Sales (GDP)
*
• If V and P are constant, then an increase in M
will lead to a proportional increase in Y
GDP increases.
• but if V and Y are constant (at full
employment), then an increase in M will lead to
a proportional increase in P =Inflation.
Many economists who argue that the Fed should use the
money supply rather than an interest rate as its
monetary policy target belong to a school of thought
known as monetarism, founded by Nobel Laureate Milton
Friedman.
Skeptical about its ability to correctly time changes in
monetary policy, Friedman and his followers believed
that the Fed would greatly increase economic stability
by replacing its policy with a monetary growth rule,
Increase the money supply at a constant
rate that doesn’t change in response
to economic conditions
Because the relationship between movements in the
money supply and movements in real GDP and the
price level has become much weaker than it was
before 1980, there has been little pressure on the
Federal Reserve to adopt a monetary growth rule in
recent years.
the Fed should set the target for the federal funds rate
so that it is equal to the sum of the inflation rate, the
equilibrium real federal funds rate, and two additional
terms:
• The inflation gap—the difference between current
inflation and a target rate.
• The output gap—the percentage difference between
real GDP and potential real GDP.
With weights of 1/2 for both gaps, we have the following
Taylor rule:
Federal funds target rate =
Current inflation rate
+ Real equilibrium federal funds rate
+ ((1/2) × Inflation gap)
+ ((1/2) × Output gap)
Increasing the money supply from 3 to 8 %
• aggregate demand shifts to AD2
Money supply
growth rate
9
Price level
(ratio scale)
LRAS
8% growth
SRAS1
6
3
P100
3% growth
Time
periods
4
1
2
3
(a) Growth rate of the money supply.
E1
AD2
AD1
Real
GDP
YF
(b) Impact in the goods & services market.
Output may expand from YF to Y1
This creates upward pressure on wages and
other resource prices, shifting SRAS1 to
SRAS2.
• Output returns to its long-run potential YF,
and the price level increases to P105 (E2).
Money supply
growth rate
Price level
(ratio scale)
LRAS
SRAS2
9
8% growth
SRAS1
6
3
3% growth
Time
periods
4
1
2
3
(a) Growth rate of the money supply.
P105
E2
P100
E1
AD2
AD1
Real
GDP
YF Y1
(b) Impact in the goods & services market.
If it continues, then AD and SRAS will continue
to shift upward, leading to still higher prices
(E3 and points beyond).
The net result of this process is sustained inflation.
Money supply
growth rate
Price level
(ratio scale)
LRAS
SRAS3
SRAS2
9
P110
8% growth
E3
SRAS1
P105
6
E2
AD3
3
P100
3% growth
Time
periods
4
1
2
3
(a) Growth rate of the money supply.
E1
AD2
AD1
Real
GDP
YF
(b) Impact in the goods & services market.
With stable prices supply and demand in the loanable
funds market are in balance at a real & nominal
interest rate of 4%.
Loanable Funds
Market
Interest
rate
The nominal
interest rate is the
real rate plus the
inflationary premium.
rate
S2 (expected
of inflation = 5 %)
rate
S1 (expected
of inflation = 0 %)
i.09%
r.04%
rate
D2 (expected
of inflation = 5 %)
rate
D1 (expected
of inflation = 0 %)
Q
Quantity of
loanable funds
If monetary expansion leads to 5% inflation,
borrowers and lenders will build the higher inflation
rate into their decision making.
As a result, the nominal interest rate i will rise to 9%.
Price
Level
LRAS
SRAS2
SRAS1
P3
P1
E2
E1
Anticipated inflation leads
to a rise in nominal costs,
causing SRAS to shift left.
AD2
AD1
YF
Goods & Services
(real GDP)
When monetary expansion is anticipated, output is not
changed.
Suppliers build the expected price rise into their
decisions, causing aggregate supply to shift in.
Nominal wages, prices, & interest rates rise, but their real
values remain constant. Inflation results.
1. It would draw the public’s attention to the fact that the Fed can
affect inflation but not real GDP in the long run.,
2. The Fed would make it easier for households and firms to form
accurate expectations of future inflation, improving their
planning and the efficiency of the economy.
3. It get would help institutionalize good U.S. monetary policy that
is subject to fewer abrupt changes as members join and leave
the FOMC.
4. It would promote accountability for the Fed by providing a
yardstick against which Congress and the public could measure
the Fed’s performance.
1. A numeric target reduces the flexibility of monetary
policy to address other policy goals.
2. It assumes that the Fed can accurately forecast
future inflation rates, which is not always the case.
3. Holding the Fed accountable only for an inflation goal
may make it less likely that the Fed will achieve other
important policy goals.
In the long run (at full employment):
a. expansionary monetary policy leads
to inflation and high interest rates,
rather than low interest rates
b. restrictive monetary policy,
when pursued over a lengthy time
period, leads to low inflation and low
interest rates.
1. An unanticipated change in monetary
policy will temporarily stimulate or
retard output and employment.
2. The effects depend on the state of
the economy.
(Full employment or unemployment)
3. Persistent growth of the money
supply at a rapid rate will cause
inflation.
4. Money interest rates and the
inflation rate will be directly
related.
16
14
12
10
8
6
4
2
0
-2
% change in M2 money supply a
% change in real GDP b
1960
1965
1970
1975
a Annual
percent change in M2
1980
Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org.
1985
b
1990
1995
2000 2003
4-quarter percent change in real GDP
Decreases in Money Supply have generally
preceded reductions in real GDP and recessions
(indicated by shading).
Increases in the money supply, have often
been followed by a rapid growth of GDP.
Money Supply Changes & Inflation
14
Inflation rate, %
12
- lagged 3-years (left axis) b
% change in M2 (right axis) a
12
10
10
8
8
6
6
4
4
2
2
0
Δ M2 1960
Δ P 1963
a
1965
1968
1970
1973
1975
1978
4-quarter percent change in M2
1980
1983
b
1985
1988
1990
1993
1995
1998
2000
2003
inflation calculated as 4-quarter moving average
Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org. The CPI was used to measure the annual rate of inflation.
• This shows the growth rate of the money supply M2 and
the annual rate of inflation 3 years later.
• The data indicate that the periods of monetary
accelerationtend to be associated with an increase in the
rate of inflation about 3 years later.
• Similarly, a slower growth rate of the money supply is
associated with a reduction in the inflation rate.
16
Inflation rate, % a
Interest rate (3-mos. T-bill) a
12
8
4
0
1960
1965
1970
a
1975
1980
1985
1990
1995
2000 2003
annual rate of inflation calculated using the CPI
• The expectation of inflation . . .
Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org.
– reduces the supply of, and,
– increases the demand for loanable funds,
• Note how the short-term money rate of interest
has tended to increase when the inflation rate
accelerates (and decline as the inflation rate falls).
Fed Policies during the
2007–2009 Recession
The Inflation and Deflation of the Housing Market Bubble
Many economists believe that a stock market bubble can sometimes form
when the prices of stocks rise to levels that are unjustified by the
profitability of the firms issuing the stock.
Stock market bubbles end when enough investors decide stocks are
overvalued and begin to sell.
Subprime loans are loans granted to borrowers with flawed credit histories.
Some mortgage lenders that had concentrated on making subprime loans
suffered heavy losses and went out of business, and most banks and other
lenders tightened the requirements for borrowers.
This credit crunch made it more difficult for potential homebuyers to
obtain mortgages, further depressing the market.
Figure 15.12
The Housing Bubble
Sales of new homes in the United States went on a roller-coaster ride, rising by 60
percent between January 2000 and July 2005, before falling by 80 percent between
July 2005 and May 2010.
Note: The data are seasonally adjusted at an annual rate.
The Changing Mortgage Market
Many members of Congress believed that home ownership could be
increased by creating a secondary market in mortgages, where banks and
savings and loans could resell mortgages so individual investors could provide
funds for them to grant more mortgages.
One barrier to creating this secondary market was that most investors were
unwilling to buy mortgages because they were afraid of losing money if the
borrower stopped making payments, or defaulted, on the loan.
To reassure investors, Congress used two government-sponsored
enterprises (GSEs):
• The Federal National Mortgage Association (“Fannie Mae”)
• The Federal Home Loan Mortgage Corporation (“Freddie Mac”)
By the 1990s, a large secondary market existed in mortgages, with funds
flowing from investors through Fannie Mae and Freddie Mac to banks and,
ultimately, to individuals and families borrowing money to buy houses.
The Role of Investment Banks
By the 2000s, investment banks expanded their traditional advisory roles and
began buying mortgages, bundling large numbers of them together as bonds
known as mortgage-backed securities, and reselling them to investors.
By the height of the housing bubble in 2005 and early 2006, lenders had
greatly loosened the standards for obtaining a mortgage loan, issuing many
mortgages requiring very small down payments to subprime borrowers and
“Alt-A” borrowers who stated—but did not document—their incomes.
Lenders also created new types of adjustable-rate mortgages that allowed
borrowers to pay a very low interest rate for the first few years of the
mortgage
and then pay a higher rate in later years.
By mid-2007, the decline in the value of mortgage-backed securities and the
large losses suffered by commercial and investment banks began to cause
turmoil in the financial system.
Many investors refused to buy mortgage-backed securities, and some would
buy only bonds issued by the U.S. Treasury.
The Wonderful World of Leverage
During the housing boom, many people
purchased houses with down payments equal to 5 percent
or less of the price, as opposed to the 20 percent
traditionally expected.
In this sense, borrowers were highly leveraged, which
means that their investment in their house was made
mostly with borrowed money.
An investment financed at least partly by borrowing is
called a leveraged investment.
Making a very small down payment on
a home mortgage leaves a buyer
vulnerable to falling house prices.
Return on your Investment from . . .
Down Payment
A 10 Percent Increase in the
Price of Your House
A 10 Percent Decrease in the
Price of Your House
10%
−10%
20
50
−50
10
100
−100
5
200
−200
100%
The equity in your house is the difference between the market price of the house and
the amount you owe on a loan; if the latter is greater than the former, you have
negative equity, and are said to be “upside down” on your mortgage.
The Fed and the Treasury Department Respond
Initial Fed and Treasury Actions The Fed and Treasury took the
following actions in March 2008:
• The Fed announced it would temporarily make discount loans to primary
dealers—firms it participated with in regular open market transactions.
• The Fed announced that it would loan up to $200 billion of Treasury
securities in exchange for mortgage-backed securities.
• The Fed and the Treasury helped JPMorgan Chase acquire the
investment bank Bear Stearns, which was on the edge of failing.
In early September, the Treasury moved to have the federal government
take control of Fannie Mae and Freddie Mac, and they were placed under
the supervision of the Federal Housing Finance Agency.
Later that month, the investment bank Lehman Brothers went bankrupt
and the financial crisis significantly worsened.
Responses to the Failure of Lehman Brothers Some economists and
policymakers were concerned with the moral hazard problem, which is the
possibility that managers of financial firms might make riskier investments if
they believe that the federal government will save them from bankruptcy.
The adverse reaction in financial markets from the Fed and Treasury having
allowed Lehman Brothers to go bankrupt led them to reverse course two
days later.
In October 2008, Congress passed the Troubled Asset Relief Program
(TARP), under which the Treasury attempted to stabilize the commercial
banking system by providing funds to banks in exchange for stock.
Many of the Fed and Treasury’s actions were controversial because they
involved:
• Partial government ownership of financial firms.
• Implicit guarantees to large financial firms that they would not be allowed
to go bankrupt.
• Unprecedented intervention in financial markets.
These approaches were intended to achieve the traditional macroeconomic
policy goals of high employment, price stability, and stability of financial
markets.
1.
The velocity of money is
a. the rate at which the price index for consumer goods rises.
b. the multiple by which an increase in government
expenditures will cause output to rise.
c. set by the Board of Governors of the Federal Reserve.
d. the average number of times one dollar is used to buy final
goods and services during a year.
2. During 2001, the Fed injected additional reserves into the
banking system, which reduced the federal funds rate and
other short-term interest rates. Other things constant,
which of the following is most likely to result from this
policy shift?
a.
an increase in the rate of unemployment
b.
a reduction in the growth of employment
c.
an increase in aggregate demand and real GDP
d.
a reduction in the long-run rate of inflation
3.
The demand curve for money
a. shows the amount of money balances that individuals and
businesses wish to hold at various interest rates.
b. reflects the open market operations policy of the Federal
Reserve.
c. shows the amount of money that individuals and businesses
wish to hold at various price levels.
d. reflects the discount rate policy of the Federal Reserve.
4.
A shift to a more expansionary monetary policy will
a.
help bring inflation under control.
b.
exert a stabilizing impact on the economy if the
effects of the policy are felt during an economic downturn.
c.
exert a stabilizing impact if the effects of the policy
are felt when the economy is operating at its fullemployment capacity.
d.
reduce the natural rate of unemployment.
5.
Persistently expansionary monetary policy that
stimulates aggregate demand and leads to inflation will
a.
lead to higher rates of real output in the long run.
b.
fail to increase real output once decision makers fully
anticipate the inflation.
c.
lead to lower nominal interest rates once decision
makers fully anticipate the inflation.
d.
permanently reduce the rate of unemployment below
its natural rate.