Lecture Principles of economics (Asia Global Edition) - Chapter 23

Chapter 23 - Monetary policy and the central bank. When you finish this chapter, you should be able to: Describe the structure and responsibilities of the federal reserve system, analyze how changes in real interest rates affect planned aggregate expenditure and short-run equilibrium output, show how the demand for money and the supply of money interact to determine the equilibrium nominal interest rate, discuss how the fed uses its ability to control the money supply to influence nominal and real interest rates.

Monetary Policy and the

Central Bank Chapter 23

Learning Objectives

1. Describe the structure and responsibilities of the

Central Banking System

2. Analyze how changes in the federal funds rate

and real interest rate affect planned aggregate expenditure and short-run equilibrium output

3. Show how the demand for money and the

supply of money interact to determine the

equilibrium nominal interest rate

4. Discuss how the central bank uses its ability to

control the money supply to influence nominal and real interest rates

Fed Watch

• Analysts attempt to forecast Fed (the U.S

central bank) decisions about monetary policy

– Greenspan briefcase indicator

– Central bank decisions have significant effects on financial markets and the macro economy

• Monetary policy is a major stabilization tool

– Quickly decided and implemented

– More flexible and responsive than fiscal policy

Country/Economy Central Bank

Australia Reserve Bank of Australia

Canada Bank of Canada

China People’s Bank of China

Hong Kong Hong Kong Monetary Authority

Indonesia Bank Indonesia

Malaysia Bank Negara Malaysia

Singapore Monetary Authority of Singapore

South Korea Bank of Korea

United Kingdom Bank of England

United States Federal Reserve System (Fed)

Central Banks of Selected Economies

The Central Banking System

and the Federal Reserve

• Responsibilities of the central bank:

– Conduct monetary policy

– Oversee and regulate financial markets

• The Federal Reserve System began

operations in 1914

– Does not attempt to maximize profit

– Promotes public goals such as economic growth, low inflation, and smoothly functioning financial

markets

The Federal Reserve

Organization

• 12 Federal Reserve Bank districts

– Assess economic conditions in their region

– Provide services to commercial banks in their

region

• Leadership is provided by the Board of Governors

– Seven governors are appointed by the President to 14-year terms

– President selects one of the seven as chairman for

a four-year term

• The Federal Open Market Committee (FOMC)

reviews economic conditions and sets monetary policy

– 12 members who meet eight times a year

Stabilizing Financial Markets

• Motivation for creating the central bank was to

stabilize the financial markets and the economy

• Banking panics occurred when customers believe

one or more banks might be bankrupt

– Depositors rush to withdraw funds

– Banks have inadequate reserves to meet

demand

• Banks close

• The central bank prevents bank panics by

– Supervising and regulating banks

– Loaning banks funds if needed

• Fed did not prevent the bank panics of 1930 – 1933

Bank Panics, 1930 - 1933

• One-third of the banks closed

– Increased the severity of the Great Depression

– Difficult for small businesses and consumers to

get credit

– Money supply decreased

• With no federal deposit insurance, people held cash

– Feared banks would close and they would lose

their deposits

– Holding cash reduced banks’ reserves

multiple of the change in reserves

Bank Panics, 1930 - 1933

• Banks increased their reserve – deposit ratio

– Further decreased the money supply

Date Currency Held by

Public ($B)

Reserve – Deposit Ratio

Bank Reserves ($B)

Money Supply ($B)

Deposit Insurance

• U.S Congress created deposit insurance in

1934

– Deposits of less than $100,000 will be repaid

even if the bank is bankrupt

• No significant bank panics since 1934

• With less risk, depositors pay less attention to

whether banks are making prudent

investments

– In the 1980s, many savings and loan

associations went bankrupt

The Central Bank and the

Economy

Can the Central Bank Control

The Real Interest Rate?

• The central bank controls the money supply to

control the nominal interest rate, i

– Investment and saving decisions are based on the real interest rate, r

r = i -

where is the rate of inflation

• The central bank has good control over i

• Inflation changes relatively slowly

– Changes in nominal rates become changes in real rates

Role of the Federal Funds Rate

• The federal funds rate is the rate commercial

banks in the United States charge each other on short-term (usually overnight) loans

– Banks borrow from each other if they have

insufficient funds

– Market determined rate

– Targeted by the Fed

• To decrease the federal funds rate the Fed

conducts open market purchases

– Reserves increase

• Interest rates tend to move together

The Federal Funds Rate,

Planned Spending and Real

Interest Rate

• Planned aggregate expenditure has components that are affected by r

– Saving decisions of households

– Investment by firms

– Investments are made if the cost of borrowing is less than the return on the investment

• Both consumption and planned investment

decrease when the interest rate increases

Interest in the Keynesian Model –

– Planned investment decreases by 600 (0.01) = 6

• A one percentage point increase in r reduces planned

Planned Aggregate Expenditure

PAE = C + IP + G + NX

PAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r + 300

+ 20

PAE = 1,010 – 1,000 r + 0.8 Y

• In this example, planned aggregate expenditure

depends on both the real interest rate and the level of output

– Equilibrium output can only be found once we know the value of r

Planned Aggregate Expenditure

PAE = 1,010 – 1,000 r + 0.8 Y

PAE = 1,010 – 1,000 (0.05) + 0.8 Y

PAE = 960 + 0.8 Y

Y = 960 + 0.8 Y 0.2 Y = 960

Y = $4,800

Monetary PolicyRecessionary Gap

Expansionary Gap

Monetary Policy for a Recessionary Gap

PAE = 1,010 – 1,000 r + 0.8 Y

• The real interest rate, r, is 5%

– Short-run equilibrium output is $4,800

• Potential output is $5,000

– Recessionary gap is $200

• Multiplier is 5

• Monetary policy can be used to increase PAE

– The first change in spending required is 200 / 5 = 401,000 (change in r) = 40

Change in r = 40 / 1,000 = 0.04

• The central bank should decrease the real interest rate

to 1%

The Central Bank Fights a

5,000 Y*

Expenditure line (r = 1%) F

The Fed’s Response to 9/11

• Economy began slowing in late 2000

• Terrorist attack led to contraction in travel,

financial, and other industries

• The federal funds rate is the interest rate banks

charge each other for overnight loans

– This interest rate is the one the Fed targets when changing the money supply

• In late 2000, the fed funds rate was 6.5%

– January, 2001, the Fed cut the rate to 6.0%

– More rate cuts followed

– July, 2001, the rate was less than 4%

The Fed Response to 9/11

• After the 9/11 attacks

– Fed immediately worked to restore normal

operation of the financial markets and institutions

– The Fed temporarily lowered the rate to 1.25% in

the week following the attack

• In the aftermath, the Fed grew concerned that

consumers would decrease spending

– Interest rate was 2.0% in November, 2001

• Combination of tax cuts and aggressive

monetary policy helped keep the 2001 recession shallow and short

The Central Bank Fights Inflation

• Expansionary gap can lead to inflation

– Planned spending is greater than normal output

levels at the established prices

– Short-run unplanned decreases in inventories

– If gap persists, prices will increase

• The central bank attempts to close expansionary gaps

– Raise interest rates

– Decrease consumption and planned investment

– Decrease planned aggregate expenditure

– Decrease equilibrium output

Monetary Policy for an

Expansionary GapPAE = 1,010 – 1,000 r + 0.8 Y

• The real interest rate, r, is 5%

– Short-run equilibrium output is $4,800

• Potential output is $4,600

– Expansionary gap is $200

• Multiplier is 5

• Monetary policy can be used to decrease PAE

– The first change in spending required is 200 / 5 = 401,000 (change in r) = 40

Change in r = 40 / 1,000 = 0.04

The central bank should decrease the real interest rate

The Central Bank Fights Inflation

4,600 Y*

Expenditure line (r = 9%)

G

Interest Rates Increased in

2004 and 2005

• With slow recovery beginning in November, 2001 in the United States, the Fed continued to decrease interest

rates until it reached 1.0% in June 2003

• Real GDP growth was nearly 6% in the 2nd half, 2003

– Growth was 4.4% in 2004

– Unemployment was 5.6% in June 2004

• Inflation increased in 2004, mainly due to oil prices

– Fed began tightening in June, 2004

– Fed funds rate increased from 1.0% to 1.25%

– Continued gradually raising the fed funds rate

– August, 2005, the rate was 3.5%

Inflation and the Stock Market

• Bad news about inflation causes stock prices to decrease

• Investors anticipate the central bank will

increase interest rates

– Slows down economic activity, lowering firms' sales and perhaps profits

lower stock prices – Higher interest rates make non-stock financial

instruments more attractive

Fed and the U.S Stock Market

• Fed gets credit for sustained economic growth

and rising asset prices in the 1990s

– S&P 500 increased 233% between January 1995, and March 2000

– Stocks buoyed consumption; supported growth

• Possible stock speculation led to sharp

decreases

– If the Fed had acted sooner, the run-up would have been curtailed and the crash moderated

– Greenspan's response is

Monetary Policy and the Stock Market

• The central bank has limited ability to manage the stock market

– The central bank does not know the "right" prices

• Information available to the central bank is publicly available

– Monetary policy is not well suited to addressing an

asset bubble (a speculative increase in asset prices

over their underlying market value)

• The central bank can raise interest rates and slow the economy

• Could result in a recession and rising unemployment

• The debate over the Fed's role in asset prices got new

attention after the mortgage meltdown in the United States

in 2007 - 2008

The Central Bank and Interest Rates

• In the United States, controlling the money supply is the primary task of the FOMC

– Money supply and demand determine the interest rate

– The central bank manipulates supply to achieve its

desired interest rate

wealth among alternative forms

– Diversification is owning a variety of different assets

to manage risk

• The demand for money is the amount of wealth held in

the form of money

Demand for Money

• Demand for money is sometimes called an

individual's liquidity preference

– The Cost – Benefit Principle indicates people will

balance the marginal cost of holding money versus the marginal benefit

– Quantity of money demanded increases with

income

– Technologies such as online banking and ATMs

have reduced the demand for money

GDP in 1960 to 12% in 2004

Demand for Money

• The marginal cost of holding money is the

interest foregone

– Most forms of money pay little or no interest

positive nominal interest rate

• The higher the nominal interest rate, the smaller the quantity of money demanded

• Business demand for money is similar to

individuals'

– Businesses hold more than half of the money stock

Demand for Money

• Demand for money depends on:

– Nominal interest rate (i)

money demanded – Real income or output (Y)

quantity of money demanded – The price level (P)

money demanded

The Money Demand Curve

• Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate

• The money demand curve shows the relationship

between the aggregate quantity of money demanded, M, and the nominal

The Money Demand Curve

• Changes in factors other than the nominal interest rate

cause a shift in the money demand curve

• An increase in demand for money can result from

Demand for Dollars in Argentina

• The average Argentine holds more dollars than the

average U.S citizen

• In the 1970s and 1980s, Argentina had high rates of

inflation

– Real returns on assets in pesos declined

– Argentines switched to dollars as a store of value

• In 1990, the U.S dollar and Argentine peso traded 1:1

– Both were accepted for transactions

• By 2001, inflation in Argentina caused the system to

break down

– Peso was worth less than the dollar

International Demand for U.S

Dollars

• Political instability in some countries also

increases the demand for dollars

– Avoids confiscation and taxes

• Largest U.S bill is $100, popular with drug

Supply of Money

• The central bank primarily controls the supply of money with open-market operations

– An open-market purchase of bonds by the central

bank increases the money supply

– An open-market sale of

bonds by the central bank

decreases the money

M S

Equilibrium in the Money Market

• Bond prices are inversely related to the interest rate

• Suppose the interest rate is at i1, below equilibrium

– Quantity of money demanded is M1, more than the

The Central Bank Controls the

Nominal Interest Rate

• Central bank policy is stated in terms of interest rates

– The tool they use is the supply of money

• Initial equilibrium at E

• The central bank increases

the money supply to MS'

– New equilibrium at F

– Interest rated decrease to i'

to convince the market

to hold the new, larger

amount of money

Money (M)

MD MS

M

E i

M' MS'

The Central Bank (CB) Controls

the Nominal Interest Rate

To Decrease the Money Supply

To Increase the Money Supply

The Central Bank Targets the

Interest Rate

• The central bank cannot set the interest rate and the money supply independently

• Central bank policy is announced in terms of

interest rates because

– Public is not familiar with the size of the money

Federal Funds Rate

• The federal funds rate is the interest rate that

banks in the United States charge each other for very short-term loans

– Closely watched in financial markets

• The Fed targets this interest rate because it is

closely tied to the level of bank reserves

for monetary policy

intentions

Additional Controls over the

Money Supply

• Open market operations are the main tool of money

supply

• The central bank offers lending facility to banks, called

discount window lending

– If a bank needs reserves, it can borrow from the

central bank at the discount rate

• The discount rate is the rate the central bank

charges banks to borrow reserves

• Lending increases reserves and ultimately increases the money supply

• Changes in the discount rate signal tightening or

loosening of the money supply

Additional Controls over the

Money Supply

• The central bank can also change the reserve

requirement for banks

– The reserve requirement is the minimum

percentage of bank deposits that must be held in

reserves

– The reserve requirement is rarely changed

• The central bank could increase the money

supply by decreasing the reserve requirement

– Banks would have excess reserves to loan

• The central bank could decrease the money

supply by increasing the reserve requirement

Central Bank

Stabilizing the Economy: The

Role of the Central Bank

Keynesian Model

Open Market Operations Discount Rate

Reserve Requirement