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Monetary Policy - CHAPTER 17 MONETARY POLICY “Use of the...

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Unformatted text preview: CHAPTER 17 MONETARY POLICY “Use of the Money Supply to promote economic stability in the short run” Here we will use the supply and demand model yet again!! STABILIZING THE MACROECONOMY FISCAL POLICY MONETARY POLICY i C+I+G+Xn MONEY MARKET DENIAND wait it» ml- Md QM Demand for Money: Why downward sloping? Think of money as part of your wealth o If interest rates (r) are high: The “opportunity cost of holding money is high and people Will want to hold little money. 0 If interest rates (r) are low: The “opportunity cost if holding money is low and people will be willing to hold more money. KEY CONCEPT: OPPORTUNITY COST 0 OTHER FACTORS INFLUENCING MONEY DEMAND 0 Price levels: higher prices means more money is needed for normal transactions and visa- versa 0 GDP: higher GDP means more is being spent and more money is needed and visa-versa. - You should think of these as MS I‘ I Higher prices Lower price . ’ Higher GDP Lower GDP MONEY SUPPLY We will assume that the money supply is determined by actions of the Federal Reserves System and is unrelated to interest rates (r). f m ‘ Money Market MONEY MARKET SUPPLY AND DEMAND INTEREST RATE DETERMINATION ",9 0 If r > 14* then there is an excess supply of money. More money is available at that rate than is demand so r falls toward r* o If r < r* then there is a shortage of money. People want to hold more money than is available and r increases toward r*. MONETARY POLICY TOOLS QUESTION? HOW DOES THE FEDERAL RESERVE SYSTEM INFLUENCE THE MONEY SUPPLY? I é . OPEN MARKET OPERATIONS 0 CHANGING THE RESERVE REQUIREMENTS 0 CHANGING THE DISCOUNT RATE Lets look} at each of these in turn .................. OPEN MARKET OPERATIONS Through the Federal Open Market Committee the Fed can purchase or sell U.S. Government securities to the private sector (these are bonds etc. that represent the government debt.) The FOMC can decide to be a net buyer or a net seller of these securities. o If the FOMC is buying bonds in the open market, it is pulling bonds out the portfolio of banks (and other private entities) and paying for them with checks against the FED. This will increase bank reserves2 increase lending activity2 and increase the money supply ~ 0 If the FOMC is selling bonds in the open . market, it is putting bonds into the portfolio of banks (and other private entities) who will pay the Fed and reduce bank reserve, decrease lending activity and decrease the money supply . SUMMARY OPEN MARKET OPERATION FED BUYS -—+ RESERVES INCREASE ——> LOANS INCREASE —> DEMAND DEPOSITS INCREASE —+ MONEY SUPPLY (Ms! INCREASES FED SELLS —-> RESERVES DECREASE —> LOANS DECREASE ——> DEMAND DEPOSITS DECREASE ——> MONEY SUPPLY ngl DECREASES I“; M : “‘9 McfiRAPHS r _.y .. .. fir. - ‘ M‘ c.“ - " FED BUYS FED SELLS F-Fau! e r macaw} SECOND MONETARY POLICY TOOL CHANGING THE RESERVE REQUIREMENT 0 Remember: Reserve Requirement is the percent of demand deposit the commercial banks are required to hold in reserve (vault cash or deposits With the FED SO: 0 Decreasing the Reserve Requirement ——> increases excess reserves _——> increases loans ——> increases demand deposit —> Increases the money supply 0 Increasing the Reserve Requirement —) decreases excess reserves ——> decreases loans —> decreases demand deposits —-> Decreases the money supply r Decrease Reserve Req. Increase Reserve Req. rm: r mac-am THIRD MONETARY POLICY TOOL CHANGING THE DISCOUNT RATE 0 The discount rate is the interest the Federal Reserve System charges member banks to borrow reserves. SO: 0 Decreasing the Discount Rate —> encourages member banks to borrow reserves ——> increases loans by commercial banks—> increases demand deposit —+ Increases the money supply 0 Increasing the Discount Rate —-> discourages member banks from borrowing reserves ‘ —> decreases loans by member banks —-> decreases demand deposits —> Decreases the money supnly f G: . Cr 2 DecreaseD fie. Rate Increase Disc. Rate all; r int-205:5 LET’S TRY TO SIMPLIFY: 't'Buy on open mkt.——>—> 0:0Lower req. res. ——>—> T Ms ——>—> i r '2'Lower disc. rate —-—>——> '1'Sell on open mkt.——>—> 03°Increase req. res. —>——> i Ms —>—-> T 1‘ '3'Increase disc. rate —>——> THE NEXT QUESTION? How does changes in the interest rate (r) influence the real economy (GDP, Output) ? Answer: Connection between interest rate (r) and investment spending (I). Interest Rates (r) And Investment Spending (I) 1: Fl 1T Why? Given expected rate of return on various investment projects available in the economy, at lower interest rate (rl), more of these projects become worth While and total I (T) increases. (pages 414-41: text boOk) J LAST STEP INTEREST RATES (r) and Output (GDP) rl —> IT —-> Aggregate Demand T —> GDP T P SUMMARY OF MONETARY POLICY CAN WE PULL THIS STORY TOGETHER? EXPANSIONARY MONETARY POLICY DESIRE TO INCREASE GDP 03°Buy on open mkt.—>—> '2'Lower req. res. —>——> TMs ———> lr —> T1 '3'Lower disc. rate —>—-> ——> TAgg. Demand (C+l+G+Xn) —+ TGDP Also influence C (durables) and Xn (exports) (see text page 416) Appropriate policy during a recession CAN WE PULL THIS STORY TOGETHER? CONTRACTIONARY MONETARY POLICY DESIRE TO DECREASE GDP '3' Sell on open mkt.——>—> ’t'Increase req. res. —>—> iMs —> Tr —> i1 O:OIncrease disc. rate —>——> —> iAgg. Demand (C+l+G+Xn) —-> iGDP Also influence C (durables) and Xn (exports) (see text page 416) Appropriate policy during inflation Goal of Monetary Policy MACROECONOMIC STABILITY - PROBLEMS LAGS (JUST LIKE FISCAL POLICY) 0 INSIDE LAGS . OUTSIDE LAGS ...
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