Monetary policy

Gene H Chang

University of Toledo

The money multiplier again

Ms

• Money multiplier (m) = ---------

H

Ms

• Ms = m X H

Money Supply, February 2002

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

M2 = $5500 billion

M1 = $1183 billion

Money market mutual funds $972 billion

Savings deposits

$3345 billion

M1 $1183 billion

Checking deposits in commercial banks $324 billion

Other checkable deposits $268 billion

Currency outside banks $591 billion

Money and Income are differentMoney and Income are different

When you say “I want to make a lot When you say “I want to make a lot of money”, you actually mean of money”, you actually mean “income”“income”

A person can be wealthy but have A person can be wealthy but have little moneylittle money

Monetary baseMonetary base

Monetary baseMonetary base Also called High power money (H)Also called High power money (H) Consists of currencies and other Consists of currencies and other

reserves in the central bank.reserves in the central bank.

Who controls the monetary policy?Who controls the monetary policy?

Who controls H? Who controls H? Who is responsible for the monetary Who is responsible for the monetary

policy in the U.S.? policy in the U.S.? The Federal Reserve System (Fed)The Federal Reserve System (Fed) It is actually the central bank in the It is actually the central bank in the

U.S.U.S.

Federal Reserve Bank

Federal Reserve Bank

The Federal Reserve System (Fed)The Federal Reserve System (Fed)

Board of Governors of the FedBoard of Governors of the Fed Federal Open Market CommitteeFederal Open Market Committee Fed is independentFed is independent

America’s Central Bank: The America’s Central Bank: The Federal Reserve SystemFederal Reserve System

The Federal Reserve System, The Federal Reserve System, established in 1914, is the U.S. established in 1914, is the U.S. central bank.central bank.– Comprised of twelve district banksComprised of twelve district banks– Governed by a seven-member Board of Governed by a seven-member Board of

GovernorsGovernors– Decisions on the money supply made by Decisions on the money supply made by

the Federal Open Market Committeethe Federal Open Market Committee– Normally meet 8 times a year, but can Normally meet 8 times a year, but can

be more.be more.

The Federal Reserve SystemThe Federal Reserve System

Fed’s IndependenceFed’s Independence– Fed board members:Fed board members:

Appointed to fourteen-year termsAppointed to fourteen-year terms Independent of political pressuresIndependent of political pressures

– Federal Open Market CommitteeFederal Open Market Committee12 members. 7 governors + 5 presidents of 12 members. 7 governors + 5 presidents of

Fed district banks.Fed district banks.

Central Bank IndependenceCentral Bank Independence– In some other countries, the central In some other countries, the central

banks are less independent.banks are less independent.– They have to listen to the governmentThey have to listen to the government– Countries without independent central Countries without independent central

banks often have less stable macro-banks often have less stable macro-economies such as running a high economies such as running a high inflation.inflation.

America’s Central Bank: The America’s Central Bank: The Federal Reserve SystemFederal Reserve System

How does the Fed control money How does the Fed control money supply?supply?

Open Market Operation (OMO)Open Market Operation (OMO) Change in discount rateChange in discount rate Change in RRRChange in RRR

Fed changes M by OMOFed changes M by OMO The Fed can increase the money supply by The Fed can increase the money supply by

buying government securities on the open buying government securities on the open market.market.– It pays the commercial banks for these It pays the commercial banks for these

securities.securities.– This injects additional reserves to the This injects additional reserves to the

commercial banks commercial banks like you deposit cash in Bank Alike you deposit cash in Bank A– multiple expansion of the money supply.multiple expansion of the money supply.

Open Market Operation (OMO) Open Market Operation (OMO)

To reduce the money supply, the Fed To reduce the money supply, the Fed sells securities on the open market.sells securities on the open market.– The commercial banks pay their The commercial banks pay their

reserves for these securities from the reserves for these securities from the Fed.Fed.

– This reduces reserves the commercial This reduces reserves the commercial banks have banks have

multiple deduction of the money multiple deduction of the money supplysupply

Open Market Operation (OMO) Open Market Operation (OMO)

Open Market OperationOpen Market Operation

Open Market Operation (OMO)Open Market Operation (OMO)– Fed buys bonds ----- Ms risesFed buys bonds ----- Ms rises– Fed sells bonds ----- Ms fallsFed sells bonds ----- Ms falls

Open Market Operation is the most Open Market Operation is the most important measure to control money important measure to control money supply thus meeting the interest rate supply thus meeting the interest rate target.target.

Open Market OperationOpen Market Operation

Conducting OMO, the Fed can reach Conducting OMO, the Fed can reach its interest rate target:its interest rate target:– buy bonds ----- Ms rises --- interest buy bonds ----- Ms rises --- interest

rate downrate down– sell bonds ----- Ms falls --- interest sell bonds ----- Ms falls --- interest

rate uprate up

Change in discount rate Change in discount rate Discount Rate is the interest rate the Fed Discount Rate is the interest rate the Fed

charges on loans it makes to commercial charges on loans it makes to commercial banks.banks.

Increase in the discount rate will Increase in the discount rate will discourage banks to borrow money discourage banks to borrow money (reserve) from the Fed.(reserve) from the Fed.

Reduce in the discount rate will encourage Reduce in the discount rate will encourage banks to borrow money (reserve) from the banks to borrow money (reserve) from the Fed.Fed.

It directly affects the interest rate in the It directly affects the interest rate in the market.market.

Change in Required Reserve Ratio Change in Required Reserve Ratio (RRR) (RRR)

Changes in RRRChanges in RRR Money multiplier changes Money multiplier changes m = 1 / RRR

Ms = m X H Then money supply changesThen money supply changes

Inverse relationship between Inverse relationship between money supply and interest ratemoney supply and interest rate

Determination of the market interest Determination of the market interest raterate

The money market diagramThe money market diagram

The money market diagram

Money (M)0

Interest rate (r) Ms

Md

r*

M*

Money supply curve Money supply curve

Money supply curve.Money supply curve.– slopes upward, for simplicity, verticalslopes upward, for simplicity, vertical

What shifts the Money supply curve? What shifts the Money supply curve? (determinants of Ms)(determinants of Ms)

Mainly, the Fed's increase or Mainly, the Fed's increase or decrease of H. decrease of H.

Then changes Ms.Then changes Ms.

Money DemandMoney Demand Definition and clarification.Definition and clarification. That is your demand for liquidity.That is your demand for liquidity. It is very different from the ordinary It is very different from the ordinary

usage! usage! When you say “I want a lot of money” in When you say “I want a lot of money” in

the ordinary usage, you mean that you the ordinary usage, you mean that you want high income or to be wealthy.want high income or to be wealthy.

That is different from “demand for money” That is different from “demand for money” in economics!in economics!

Money DemandMoney Demand

Demand for money is demand for Demand for money is demand for medium of exchangemedium of exchange

Or, roughly, demand for cash for the Or, roughly, demand for cash for the transaction purposetransaction purpose

It is a portfolio decisionIt is a portfolio decision You have to weigh between two You have to weigh between two

options of holding money or holding options of holding money or holding bondsbonds

Money DemandMoney Demand

You have to weigh between holding You have to weigh between holding money or holding bondsmoney or holding bonds

Money gives you the convenience to Money gives you the convenience to buy things, but it does not yield buy things, but it does not yield interest. interest.

The opportunity cost of holding The opportunity cost of holding money is sacrificing the interest money is sacrificing the interest incomeincome. .

Money DemandMoney Demand

Government securities (bonds) are Government securities (bonds) are just opposite.just opposite.

You earn interest from holding bondsYou earn interest from holding bonds But bonds are not medium of But bonds are not medium of

exchangeexchange you cannot buy things or pay bills by you cannot buy things or pay bills by

bonds bonds

Money demand

Bonds

Given amount of Wealth

Money

Money Demand and interest rateMoney Demand and interest rate

If interest rate goes upIf interest rate goes up Bonds are more attractive and Bonds are more attractive and

holding money is more costlyholding money is more costly Quantity of money demanded goes Quantity of money demanded goes

downdown

Money Demand and interest rateMoney Demand and interest rate

If interest rate goes downIf interest rate goes down Bonds are less attractive Bonds are less attractive Holding money gives more Holding money gives more

convenienceconvenience Quantity of money demanded goes Quantity of money demanded goes

upup

Money Demand and interest rateMoney Demand and interest rate

Therefore an inverse relationship Therefore an inverse relationship between quantity of money between quantity of money demanded (Md) and interest rate (r)demanded (Md) and interest rate (r)

The money demand curve slops The money demand curve slops downwardsdownwards

Shifters of Money DemandShifters of Money Demand

What shifts the money demand curve?What shifts the money demand curve? Income levelIncome level

– Income goes up, needs more money to Income goes up, needs more money to buy things.buy things.

Price levelPrice level– Price goes up, for the same amount of Price goes up, for the same amount of

transactions, needs more money to buy transactions, needs more money to buy the same amount things.the same amount things.

The money market diagram

Money (M)0

Interest rate (r)

Md

r*

M*

Md

Clarifying the conceptsClarifying the concepts

Quantity of money demandQuantity of money demand Money demandMoney demand Movement versus shiftMovement versus shift

Equilibrium in the money marketEquilibrium in the money market

Intersection of Md and MsIntersection of Md and Ms

The money market diagram

Money (M)0

Interest rate (r) Ms

Md

r*

M*

Comments on the interest rate on Comments on the interest rate on the money marketthe money market

Intersection of Md and MsIntersection of Md and Ms Fed can control Ms but not MdFed can control Ms but not Md Fed can set a target for interest rate Fed can set a target for interest rate

by conducting OMO and amount of by conducting OMO and amount of money for the Fed funds rate.money for the Fed funds rate.

Because Md shifts, the market rate Because Md shifts, the market rate may deviate from the Fed target.may deviate from the Fed target.

Difference between market and Fed rates.

Federal Funds Data, 2006 

DATE DAILY1

RANGE

STD. DEV.TARGET

RATELOW HIGH

11/20/2006 5.25 5.19 5.5 0.05 5.25

11/17/2006 5.2 5 5.375 0.18 5.25

11/16/2006 5.25 5 5.375 0.02 5.25

11/15/2006 5.29 5 5.375 0.03 5.25

11/14/2006 5.25 5.125 5.375 0.02 5.25

11/13/2006 5.27 5.125 5.5 0.05 5.25

11/10/2006 5.23 5.0625 6 0.05 5.25

11/09/2006 5.23 5.15 5.375 0.02 5.25

11/08/2006* 5.22 5 5.75 0.04 5.25

11/07/2006 5.22 5 5.5 0.04 5.25

11/06/2006 5.24 5 5.375 0.03 5.25

The current rate

  This week Month ago Year ago

WSJ Prime Rate

3.25 3.25 3.25

Federal Discount Rate

0.75 0.75 0.50

Fed Funds Rate (Current target rate 0-0.25)

0.25 0.25 0.25

Equilibrium in the money marketEquilibrium in the money market

What happens if the economy is What happens if the economy is growing growing rapidrapidly?ly?– Money demand Money demand upup and interest rate and interest rate upup

What happens if the government What happens if the government spending increases rapidly?spending increases rapidly?– Money demand up and interest rate upMoney demand up and interest rate up

What happens if the price goes upWhat happens if the price goes up– Money demand up and interest rate upMoney demand up and interest rate up

The money market diagram

Money (M)0

Interest rate (r) Ms

Md

r*

M*

Md

r’

Equilibrium in the money marketEquilibrium in the money market

What happens if the Fed increase What happens if the Fed increase money supplymoney supply– Money supply goes upMoney supply goes up– Interest rate goes downInterest rate goes down

The money market diagram

Money (M)0

Interest rate (r) Ms

Md

r*

M*

Ms’

r’

CasesCases

The low interest rates in 1992-95 and 2002-The low interest rates in 1992-95 and 2002-20042004

1982-81982-833, the interest rate surged to 20%. , the interest rate surged to 20%. What was the reason? What was the reason? Reagan and Fed’s Reagan and Fed’s policiespolicies

Bush’s budget deficit adds pressure on the Bush’s budget deficit adds pressure on the interest rate. interest rate.

2008-2009, easy money and low interest rate. 2008-2009, easy money and low interest rate.

Fed discount rate: 0.75. Fund rate: 0.25%Fed discount rate: 0.75. Fund rate: 0.25% Nov. 2010, Fed buy 600b bondsNov. 2010, Fed buy 600b bonds

Fed funds rate (interest rate)

The case in 1982-83

Money (M)0

Interest rate (r)Ms

Md

r*

M*

Md

r’

Fed

Tax cut

Equilibrium in the money marketEquilibrium in the money market

What happens if the price goes up What happens if the price goes up moderatelymoderately– Money demand upMoney demand up

What happens if the inflation accelerates What happens if the inflation accelerates to a hyperinflation?to a hyperinflation?– Money demand goes down because people Money demand goes down because people

want to avoid the loss by holding moneywant to avoid the loss by holding money Difference between Price and InflationDifference between Price and Inflation Like the difference between distance and Like the difference between distance and

speedspeed

OMO: Relationships among Ms, bond price and interest rates

• When the Fed buys bonds: Money supply increases

demand for bonds

price of bonds

interest rate

• Opposite when Fed sell bonds

Goals of the monetary policyGoals of the monetary policyby the Fedby the Fed

Stable priceStable price Economic growth and full Economic growth and full

employmentemployment Stable interest rateStable interest rate

How the monetary policy affect the How the monetary policy affect the economyeconomy

Monetary expansionMonetary expansion Ms increases Ms increases r falls r falls Investment rises Investment rises AE shifts up AE shifts up AD shifts to rightAD shifts to right Y and P risesY and P rises

How the monetary policy affect the economy

Money (M)

0

Interest rate (r)

Ms

Md

r*

M*

Ms’

r’

How the monetary policy affect the economyMonetary expansion

(b)

Pri

ce (

P)

GDP (Y)

(a)

Ag

gre

gat

e E

xpen

dit

ure

(A

E)

GDP (Y) Y*0 Y*1

45

45

E0

E0

AE’ (I1)

E1

AE(I0)

I ↑

P0

AD

Y’1

E1

AD’

Y’0

AS

E2

How the monetary policy affect the economy

(b)

Pri

ce (

P)

GDP (Y)

E0

P0

AD

2

E1

AD’

Y’0

AS

E2

Y

P2

How the monetary policy affect the How the monetary policy affect the economyeconomy

Monetary contractionMonetary contraction Ms decreases Ms decreases r rises r rises Investment falls Investment falls AE shifts down AE shifts down AD shifts to leftAD shifts to left Y and P fallsY and P falls

Is monetary policy effective?Is monetary policy effective?

ControversyControversy Keynesian viewKeynesian view May not be effective in depression, May not be effective in depression,

as people are pessimisticas people are pessimistic– Liquidity trapLiquidity trap– Investment is insensitive to a lower Investment is insensitive to a lower

interest rateinterest rate

Is monetary policy effective?Is monetary policy effective?

In addition, a monetary policy may In addition, a monetary policy may be ineffective because:be ineffective because:– Time lag is longerTime lag is longer– Magnitude is unpredictableMagnitude is unpredictable

Is monetary policy effective?Is monetary policy effective?

The Monetary schoolThe Monetary school Milton FriedmanMilton Friedman