13 Managing Managing Aggregate Aggregate Demand Demand Monetary Monetary Policy Policy Victorians Victoriansheard heardwith withgrave graveattention attentionthat thatthe theBank Bank Rate Ratehad hadbeen beenraised raised They Theydid didnot not know knowwhat whatitit meant meant But Butthey theyknew knewthat that ititwas wasan anact actof ofextreme extreme wisdom wisdom JOHN JOHNKENNETH KENNETHGALBRAITH GALBRAITH Contents Contents Money Money and and Income Income The The Important Important Difference Difference America s America s Central Central Bank Bank The The Federal Federal Reserve Reserve System System Implementing Implementing Monetary Monetary Policy Policy Open Open Market Market Operations Operations Other Other Methods Methods of of Monetary Monetary Control Control Copyright 2006 South Western Thomson Publishing All rights reserved Contents Contents continued continued Supply Demand Supply DemandAnalysis Analysis of of the the Money Money Market Market How How Monetary Monetary Policy Policy Works Works Money Money and and the the Price Price Level Level in in the the Keynesian Keynesian Model Model From From Models Models to to Policy Policy Debates Debates Copyright 2006 South Western Thomson Publishing All rights reserved Money Money and and Income Income The The Important Important Difference Difference Stock Stock variables variables are are measured measured at at aa moment moment in in time time Flow Flow variables variables are are measured measured over over time time Copyright 2006 South Western Thomson Learning All rights reserved Money Money and and Income Income The The Important Important Difference Difference Money Money isis aa stock stock income income aa flow flow Stock Stock of of money money influences influences the the rate rate at at which which people people earn earn income income Money Money affects affects GDP GDP Copyright 2006 South Western Thomson Learning All rights reserved America s America s Central Central Bank Bank The The Federal Federal Reserve Reserve System System The The Federal Federal Reserve Reserve System System established established in in 1914 1914 isis the the U S U S central central bank bank Comprised Comprised of of twelve twelve district district banks banks Governed Governed by by aa seven member seven member Board Board of of Governors Governors Decisions Decisions on on the the money money supply supply made made by by the the Federal Federal Open Open Market Market Committee Committee Copyright 2006 South Western Thomson Learning All rights reserved America s America s Central Central Bank Bank The The Federal Federal Reserve Reserve System System Central Central Bank Bank Independence Independence Fed Fed board board members members Appointed Appointed to to fourteen year fourteen year terms terms Independent Independent of of political political pressures pressures Copyright 2006 South Western Thomson Learning All rights reserved America s America s Central Central Bank Bank The The Federal Federal Reserve Reserve System System Central Central Bank Bank Independence Independence In In some some other other countries countries the the central central banks banks are are less less independent independent Countries Countries without without independent independent central central banks banks often often have have less less stable stable economies economies Copyright 2006 South Western Thomson Learning All rights reserved Implementing Implementing Monetary Monetary Policy Policy Market Market for for Reserves Reserves Supply Supply of of reserves reserves controlled controlled by by the the Fed Fed Demand Demand for for reserves reserves depends depends on on banks banks need need for for reserves reserves Required Requiredreserves reserves m m xx D D Dollar Dollar value value of of transactions transactions PPxx YY Copyright 2006 South Western Thomson Learning All rights reserved Implementing Implementing Monetary Monetary Policy Policy Market Market for for Reserves Reserves Federal Federal funds funds rate rate interest interest rate rate banks banks charge charge each each other other for for interbank interbank loans loans Banks Banks with with excess excess reserves reserves can can loan loanout out funds fundsto to other other banks banks and and charge charge the the federal federal funds funds rate rate Banks Banks with with aa shortage shortage of of reserves reserves can can borrow borrow funds funds from fromother other banks banks and and pay pay the the federal federal funds funds rate rate Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 1 1 The The Market Market for for Bank Bank Reserves Reserves Copyright 2006 South Western Thomson Learning All rights reserved Implementing Implementing Monetary Monetary Policy Policy Market Market for for Reserves Reserves Downward Downward sloping sloping demand demand federal federal funds funds rate rate cost cost of ofreserves quantity reserves quantity of of reserves reserves demanded demanded Upward Upward sloping sloping supply supply federal federal funds funds rate rate interest interest earned earned from from interbank interbank loans loans quantity quantity of of reserves reserves supplied supplied Equilibrium Equilibrium Quantity Quantity of of reserves reserves demanded demanded Quantity Quantity of of reserves reserves supplied supplied Copyright 2006 South Western Thomson Learning All rights reserved Implementing Implementing Monetary Monetary Policy Policy Mechanics Mechanics of of an an Open Market Open Market Operation Operation The The Fed Fed affect affect the the interest interest rate rate by by buying buying government government securities securities on on the the open open market market ItIt pays pays for for these these securities securities by by creating creating new new bank bank reserves reserves These These additional additional reserves reserves lower lower interest interest rate rate To To increase increase the the interest interest rate rate the the Fed Fed sells sells securities securities Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 2 2 Effects Effects of of an an OpenOpen Market Market Purchase Purchase Copyright 2006 South Western Thomson Learning All rights reserved TABLE TABLE 1 1 Effects Effects of of an an OpenOpen Market Market Purchase Purchase of of Securities Securities Copyright 2006 South Western Thomson Publishing All rights reserved