Macro
N. Intro Sheflin
ASSIGNMENT 7
NOTES: We introduce the Fed, discuss monetary theory (how money matters). and short-run monetary
policy in the Keynesian model
Dont worry about (ignore) any reference to long-run policy issues for now. Well come back to this in more
depth later in the course.
Also, well play a short run monetary policy game the Chairmans game
Investment Game Round 2 read, short, margin
LOTS OF IMPORTANT NOTES AT BOTTOM OF PAGE ON MONETARY POLICY
READING
Rittenberg Chapter 9 just the last section on the Fed THE FEDERAL RESERVE
SYSTEM and chapter 11 skip the last section (3) on MONETARY POLICY AND THE EQUATION
OF EXCHANGE well come back to this later. Ignore discussion of long-run for now and of rational
expectations.
A simple but a bit outdated intro to normal monetary policy at
http://www.frbsf.org/publications/federalreserve/monetary/index.html
Krugman, on the liquidity trap: http://krugman.blogs.nytimes.com/2010/03/17/how-much-of-the-world-isin-a-liquidity-trap/
Fed Actions in the 2007-2009 Crisis
http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm
And MAYBE
A very good, only somewhat dated introduction to Fed funds targeting Setting The Interest Rate
http://www.frbsf.org/publications/economics/letter/2002/el2002-30.html (the main change is that the Fed
adopted the passive discount rate policy mentioned, and in normal times, it is not set but rather moves with
the funds rate; also, the fed is now paying interest on reserves).
NY Feds Fedpoints at
http://www.newyorkfed.org/aboutthefed/fedpoints.html
Discount Window
Federal Funds
Open Market Operations
Primary Dealers
Repurchase and Reverse Repurchase Transactions
And more details on the Fed and Monetary Policy at:
http://www.frbsf.org/publications/federalreserve/monetary/index.html
MULTIPLE CHOICE QUESTIONS - ihw7
FIND CURRENT ARTICLES ON Fiscal/ Monetary policy, Goals, Tools, Targets of Fed Policy, Fed
Funds Market. Monetary policy lags, interest rates, liquidity trap
APPLICATIONS
1. Select and explain 4 points/terms made in the latest FOMC statement found through
http://www.federalreserve.gov/fomc/default.htm (goals, tools, targets, economic conditions)
2. Play the Chairmans Game at:
http://www.frbsf.org/education/activities/chairman/
a. click on learn more
b. look at the videos at policy in depth
c. look over the economic dictionary
d. play the game try to achieve the twin goals of stable prices and maximum employment
i.
what unemployment and inflation rates did you start with? End with?
ii.
What effect did raising the fed funds target rate have? Why? How quickly?
BIG QUESTIONS
1. How is monetary policy done? Why did we need it in this recession?
2. How does monetary policy affect the economy in the short-run?
3. What is the Fed, What does it do? How? Why?
4. Whats the structure of the Fed? Whats unusual about its structure?
5. What new actions has the Fed taken in the current crisis and why?
6. What is the liquidity trap idea, and why does it matter? Why cant the Fed push on a string?
-SECTION 2AMonetary Policy Objectives
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee
shall maintain long run growth of the monetary and credit aggregates commensurate with the
economy's long run potential to increase production, so as to promote effectively the goals of
maximum employment, stable prices, and moderate long-term interest rates.
[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of
October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat.
3028).]
KEY POINTS AND SUMMARY READ CAREFULLY BEFORE AND AFTER THE
HOMEWORK
THE FED
Originally decentralized, now single organization with 12 branches
Considerable independence created by Congress, can be changed by them
o Why? Independent Central Banks conduct better policies less inflation/ same
unemployment
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o Without independence, tendency to overexpand Ms -> inflation
o Much current debate on how independent Fed should be going forward
12 member banks, Board of Governors 7 members, 14 year, non-renewable terms, one is
appointed by President with consent of Senate for 4 year term as chair.
FOMC central policy group 7 BOG members, 5 Bank Presidents, rotating (NY Fed always on
FOMC)
Fed Balance Sheet why it matters?
o Shows how changes in Fed Assets (and some liabilities) changes reserves of banks, and
thus interest rates
Increases in assets (cet. par.) increases reserves
Key asset (normally) U.S. government bonds (bought used)
KEYNESIAN MONETARY THEORY How Money Matters to the Economy
Older Demand and Supply for Money Approach
Traditionally, Keynesians focused on the demand and supply of money determining interest rates which
determine Investment (in plant and equipment) which is part of, and thus changes, Aggregate Demand
which, given aggregate supply, determine prices and output. Think of interest rates as the price of money
and so the demand for money curve is downward sloping:
Downward sloping Md curve - at a higher interest rate, the quantity demanded of money is lower
since the opportunity cost of holding money is higher (the interest you lost by not selling your
money in return for an interest earning bond). Keynes called the Md function, the Liquidity
Preference curve and spoke of a transactions, precautionary and speculative demand for holding
money, the latter responding to interest rates inversely and reflecting the fact that bond prices move
inversely to interest rates.- less important
An increase in the Money Supply, caused by the Fed, will lower the interest rate (think of the
interest rate as the price of money). The Money Supply curve is drawn as vertical since the Fed
can make the Ms whatever it want this reflects the intro level assumption that the Ms doesnt
respond to interest rates (in fact, it does and should be upward sloping, but this wont change
anything much).
Newer (BUT ESSENTIALLY THE SAME) Bank Reserves Approach controls Fed the supply of
bank reserves through buying and selling bonds on the open market (open market operations). Together
with the demand for reserves by banks, this determines the fed funds rate and other rates move with it.
o Fed sets a target fed funds rate consistent with its goals
o Buys/sells bonds which results in changes in bond dealers bank deposits and bank reserves
o Changes in bank reserves changes the rate at which they are borrowed and lent by other banks
the fed funds rate
o Other interest rates move with this rate
o NOTE these open market operations to achieve the targeted fed funds rate result in changes in
the Money Supply (see above)
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Monetary transmission Mechanism - How changes in Ms and Interest rate impact the real
economy
o Many channels note Ms=money supply r=Interest rate P=price y=output X=exports
M=imports
interest rate effect Fed sets a lower target fed funds rate -> Fed buys bonds-> bank
reserves increase (and the money supply)-> actual fed funds rate down ->other interest
rates down ->I up, Cd up ->D up ->P,y up
that is: changes in the supply of money, cet.par., reduce interest rates,
increases investment and aggregate demand and thus output and
prices/inflation
exchange rate effect as above, buys bonds, fed funds rate down ->$ down ->X up,
Imports down ->D up ->P,y up
the dollar depreciates against other currencies (falls against them) since with
lower interest rates in U.S. foreigners want to buy less U.S. bonds and thus buy
less $
wealth effect
r down ->Stock Prices up -> W up ->C up ->D up ->P,y up
SHORT-RUN MONETARY POLICY
Normal Monetary Policy Fed use of open market operations, discount rate and other policies
to stabilize speed up or slow down the economy to achieve stable prices maximum employment
o Fed Goals they have two a dual mandate - stable prices and maximum employment in
that order (moderate long-run rates follow from these, and many believe the maximum
employment in the long-run follows from price stability)
o Fed Instruments/ Tools open market operations purchase and/or sales of outstanding
government bonds from private bond dealers; also discount rate which tends to passively
follow funds rate and control of reserve requirements not used.
o Fed operating target Fed Funds rate the Fed picks a target r the fed fund rate that is
thought to be consistent with their goals and uses open market purchases or sales to
nudge the actual funds ate to the target value.
Fed Procedures:
o FOMC meets every 6 weeks, discusses conditions and issues a directive to the manager of
the system open market desk, located at the NY Fed
o Manager of the OM Desk consults with staff and primary dealers daily, determines
magnitude of purchases or sales to hit target, confirms with FOMC member, and
electronically buys or sells securities from primary dealer via electronic auction
Most are thru repos repurchase agreements in which dealer agrees to buy or sell
back security at a fixed time and at a fixed price
Most transactions involve short term treasury bills or repos on these
o Funds electronically transferred to/from primary dealer and immediately affect their bank
deposits and the reserves of their bank
o Changes in the quantity of bank reserves are quickly reflected in rate banks charge one
another for short-term reserve loans i.e., market Fed Funds rate. Change in fed funds rate
spreads to other short-term (substitute) rates and eventually, to longer term rates
Normal Monetary Policy Issues
o Lags since it takes 6 months to a year for monetary policy to affect real variables (impact
lag), monetary policy may be too slow to help. The time it takes to decide on a put a policy
in place, the implementation lag, is quite short though. Long and variable lags in monetary
policy may lead to pro-cyclical policies policies that make the ups and downs of the
economy worse rather than better.
o Rules versus discretion should the Fed follow mechanical rules, perhaps inflation
targeting or use constrained discretion? Rules reduce political influences, and may reduce
pro-cyclical policies while discretion allows best judgment in an area which may be as
much art as science. More later
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Crisis (extraordinary) Monetary Policy and issues Undertaken in the current Financial
Crisis and Recession
o Back to Lender of Last resort Provider of Liquidity and Even of Capital
Expanded lending to banks, other financial institutions
Expanded lending to business and non-banks (AIG)
Provided direct finance to business
Purchase of long-term assets Treasury Bonds, Mortgage Securities
o Liquidity Trap/Zero Lower Bound the idea that at very low interest rates, in a recession,
the Md function might become horizontal (perfectly elastic) and thus increasing the Ms cant
lower rates further (sketch it).
o Pushing on a string related idea that in a depression/recession either the Fed will not be able
to get interest rates down because of the liquidity trap, or even if they can, business wont wish
to invest and thus the Fed will not be able to stimulate the economy..
o Feds Balance Sheet Issues
Through normal open-market operations and all the new facilities, Fed has bought lots
of assets and created lots of liabilities and increased the Ms enormously and incurred
potential risk of losses on these assets.
o Printing Money
Fed has essentially been buying new treasury debt which is in some sense equivalent to
printing (over expanding) the money supply with long-run implications (inflation)
Monetization of the Debt if the Fed bought NEWLY issued securities directly from
the Treasury, it will be the equivalent of the Treasury just printing money when they
needed it which would be inflationary. The Fed is not allowed to do this, although they
can in an indirect way we will discuss later
o Quantitative Easing/ Credit Easing
Even in liquidity trap, Fed might be effective by increasing MS and causing some
inflation, and easing credit conditions
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