Econ -Unit 4- Chap 15 Notes

Monetary Policy:

• Consolidated Balance Sheet of the Federal Reserve Banks
  
  • Assets
    
    • Two main assets are securities and loans to commercial banks
      
      • Securities:
        
        • Government bonds consists largely of Treasury bill, treasury notes, and treasury bonds issued by the gov
          
          • Part of public debt
            
        • Mainly bought and sold to influence size of commercial bank reserves and create money by lending
          
      • Loans to Commercial Banks
        
        • Commercial banks borrow from FED
          
          • IOUs are assets to FED because they are claims against the commercial banks
            
          • To the banks they are liabilities since they have to be repaid
            
          • Increase revenues
            
  • Liabilities
    
    • Reserves of Commercial Banks:
      
      • Fed requires commercial banks to hold reserves against checkable deposits
        
      • In FRB they are listed as a liability on the Fed's balance sheet
        
    • Treasury Deposits:
      
      • US Treasury keeps deposits in the FRB and draws checks on them to pay obligations
        
        • Assets to Treasury; liability on Fed's balance sheet
          
        • Treausry creates and replenishes these deposits by depositing tax reciepts and money borrows from the public
          
    • Federal Reserve Notes Outstanding
      
      • When money is circulating outside the FRB it constitutes claims against the assets of the FRB
        
        • Liability to Feds
          
• Tools of Monetary Policy
  
  • Fed influences money-creating abilities of the commercial banking system
    
    • Open-Market Operations:
      
      • Bond markets
        
      • The Fed's open-market operation consist of the buying of government bonds from, or selling of government bonds to commercial banks and the general public
        
    • Buying Securities
      
      • If the Fed decides to have FRB buy bonds from commercial banks or the public the reserves will increase
        
        • *From Commercial Banks*
          
          • The commercial banks give up part of their holdings of securities to the FRB
            
          • FRB increase the reserves of the commercial banks by the amount of the purchase
            
        • *From the Public*
          
          • Give up securities to the FRB and gets in payment a check drawn by the FRB on themselves
            
          • Deposits the check in its account with the Wahoo bank
            
          • Wahoo sends check against the FRB to a FRB for collection. Wahoo therefore has a increase in reserves
            
    • Selling Securities
      
      • Reserves decrease when FRB sells bonds
        
        • *To Commercial Banks*
          
          • FRB give up securities that banks acquire
            
          • Banks pay for those securities by drawing checks against their deposits. The Fed collects those check by reducing the banks reserves
            
        • *To the Public*
          
          • FRB sells bond to company, who pay with a check drawn on the Wahoo bank
            
          • FRB clear this check against the Wahoo bank, reducing Wahoo's reserves
            
          • Wahoo return canceled check to company reducing company's checkable deposit
            
  • The Reserve Ratio
    
    • Fed can manipulate reserve ratio to influence the ability of commercial banks to lend
      
      • Raising the Reserve Ratio
        
        • If reserve ratio increase:
          
          • Increase the amount of required reserves banks must keep
            
          • Banks lose excess reserves, diminishing ability to create money by lending or they find their reserves deficient and are forced to contract checkable deposits and the money supply
            
      • Lowering the Reserve Ratio:
        
        • If the reserve ratio decreased:
          
          • Bank's lending ability would increase and the banking system's money-creating potential would expand
            
            • Lowering reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending
              
          • A change in the reserve ratio affects money creating by:
            
            • Changing the amount of excess reserves
              
            • Changing the size of the monetary multiplier
              
              • Raising the reserve ratio forces banks to reduce the amount of checkable deposits they create through lending
                
  • The Discount Rate
    
    • FUNCTION OF CENTRAL BANK: " Lender of last resort"
      
      • Makes loans to commercial banks
        
      • FRB changes interest on loans, they charge at the discount rate
        
      • FRB increase the reserves of the borrowing commercial bank
        
        • Borrowing from the FRB by commercial banks increase the reserves of the commercial banks and enhances their ability to extend credit
          
    • Fed has the power to set the discount rate at which banks borrow
      
    • Fed may raise the discount rate when it wants to restrict the money supply
      
  • Easy Money and Tight Money
    
    • How to increase the excess reserves
      
      • Buy Securities:
        
        • Purchasing securities in the open market, the Fed can increase commercial bank reserves. When the checks are cleared against it, the commercial banks discover that they have more reserves
          
      • Lower the Reserve Ratio:
        
        • Lowering the reserve ratio changes the required reserves into excess reserves and increases monetary multiplier
          
      • Lower the Discount Rate:
        
        • Lowering the rate entices commercial banks to borrow more reserves from the Fed
          
    • These actions are called easy money policy
      
      • Makes loans less expensive and more available
        
    • How to reduce AD by limiting the supply of money:
      
      • Sell Securities:
        
        • Selling bonds in the market can reduce commercial bank reserves
          
      • Increase the Reserve Ratio:
        
        • An increase will strip commercial banks of their excess reserves and decrease the size of the monetary multiplier
          
      • Raise the Discount Rate:
        
        • A boost in the rate will discourage commercial banks from borrowing from FRB in order to build up their reserves
          
    • Actions are called a tight money policy
      
      • Objective is to tighten the supply of money to reduce spending
        
  • Relative Importance
    
    • Buying and selling securities in the open market is the most important of all
      
      • Has advantage of flexibility
        
      • Impact is prompt
        
      • Changing the reserve requirement is less important
        
        • Fed uses sparingly
          
        • Can accomplish goals easier through open-market operations
          
        • Has huge effect on bank profits
          
• Monetary Policy, Real GDP, and the Price Level
  
  • Money policy
    
    • Cause-Effect Chain
      
      • See fig 15.2
        
        • Money Market:
          
          • Transactions demand is directly related to the nominal GDP
            
        • Investment:
          
          • Curve shows relationship between the interest rate and the amount of investment spending
            
          • Changes in the interest rate mainly affect the investment component of total spending, although they also affect spending on durable consumer goods
            
          • Changes in the interest rate may affect investment spending by changing the relative attractiveness of purchases of capital equipment versus purchases of bonds
            
          • Impact of changing interest rates is mainly on investment
            
            • Investment spending varies inversely with the interest rate
              
        • Equilibrium GDP
          
          • Investment spending is one of the determinants of AD
            
          • The greater investment spending the farther to the right lies the AD curve
            
    • Effects of an Easy Money Policy
      
      • To increase the money supply the FRB will take some combination of the following actions:
        
        • Buy gov. securities from banks and the public in the open market
          
        • Lower the legal reserve ratio
          
        • Lower discount rate
          
    • Effects of a Tight Money Policy
      
      • AD is excessive relative to the economy's full-employment level of a real output
        
      • FRB will direct FRB to undertake some combination of the following actions
        
        • Sell gov. securities to banks and the public in the open market
          
        • Increase the legal reserve ratio
          
        • Increase the discount rate
          
• Monetary Policy in Action
  
  • Monetary policy has two key advantages over fiscal policy:
    
    • Speed and flexibility
      
    • Isolation from political pressure
      
  • Compared with fiscal it can be quickly altered
    
  • Focus on the Federal Fund Rate
    
    • Fed focuses monetary policy on altering the federal funds rate as needed to stabilize the economy
      
      • Interest rate the banks charge one another on overnight loans
        
      • Raise federal funds=tighter monetary policy
        
      • Lower federal funds=easier monetary policy
        
    • Prime interest rate is the benchmark rate that banks use as a reference point for a wide range of interest rates on loans to businesses and individuals
      
    • To increase the Federal fund interest rate the Fed sell bonds in the open market
      
    • Fed buys bonds from banks and the public when it wants to reduce the Federal funds rates
      
    • The money supply rises because the increased supply of excess reserves lead to more lending and thus greater creation of checkable-deposit money
      
  • Recent Monetary Policy
    
    • To counter potential inflation the Fed reduced reserves in the banking system to raise the interest rate
      
    • During the last quarter of 2000 the economy slowed and the Fed responded by cutting interest rates by a full percentage point in two increments in 2001
      
      • Economy went into recession
        
  • Problems and Complications
    
    • Limitations and faces real-world complication
      
      • Lags:
        
        • Monetary policy is hindered by recognition lag and an operational lag
          
      • Changes in Velocity:
        
        • Expenditures can be regarded as the money supply multiplied by the velocity of money
          
        • Velocity may move counter to changes in the money supply in come circumstances
          
          • May increase at the same time the Fed reduces the money supply to control inflation
            
          • AD and inflation may not be restrained by as much as the Fed wants
            
          • Velocity may decline at the same time the Fed takes measures to increase the money supply to combat recession
            
      • Cyclical Asymmetry
        
        • Monetary is highly effective in slowing expansions and controlling inflation, but less reliable in pushing the economy from a severe recession
          
        • Monetary policy may suffer from cyclical asymmetry
          
        • Tight money policy could deplete commercial banking to the point where banks would be forced to reduce the volume of loans
          
        • If commercial banks seek liquidity and are unwilling to lend, the effort of the Fed will be of little avail.
          
        • Severe recession may undermine business confidence that the investment demand curve is what shifts to the left and frustrates as easy money policy
          
  • "Artful Management" or "Inflation Targeting"?
    
    • Manage the money supply to avoid inflation on one hand and recession on the other
      
      • Emphasis on achieving multiple set of objectives:
        
        • Maintain price stability
          
        • Smooth business cycle
          
        • Maintain high levels of employment
          
        • Promote economic growth
          
          • Some think the 'artful' approach is unique to Greenspan and someone less insightful may not be as successful
            
          • Good to combine artful management with inflation targeting
            
            • Fed would undertake monetary policy to achieve goal
              
  • Monetary Policy and the International Economy
    
    • Linkages among the economies of the world complicate domestic fiscal policy
      
      • Net Export Effect:
        
        • US fiscal policy may increase domestic interest rate because the gov. competes with the private sector in getting loans
          
        • Higher interest rate causes the dollars to appreciate in the foreign market
          
          • Imports rise, exports fall
            
            • NET EXPORT EFFECT
              
        • Lower interest rate discourages the inflow of financial capital to the US
          
          • Demand for dollars in foreign exchange market falls
            
          • Dollar goes down in value
            
            • Expansionary monetary policy increases net exports and strengthens monetary policy
              
      • Macro Stability and the Trade Balance
        
        • US net exports should be zero
          
        • Easy money policy
          
          • The easy money policy is appropriate for the alleviation of unemployment anf sluggish growth, is compatible with the goal of correcting a balance-of-trade deficit
            
        • Tight money policy restrains inflation
          
          • Larger trade deficit
            
            • A tight money policy that is used to alleviate inflation conflicts with the goal of correcting a balance-of-trade deficit