Topic 10 Monetary Policy University of Minnesota October 23 2012 U of M Topic 10 Monetary Policy October 23 2012 1 35 A Motivating Question We know that higher interest rates mean less investment and lower interest rates mean more investment But how does the Fed or central bank of another country change interest rates This topic builds off of our previous topics We ll do a brief review to jog your memory of what you learned the last two weeks U of M Topic 10 Monetary Policy October 23 2012 2 35 Last week Fiscal Policy We talked about what a GDP gap is and how fiscal policy can close that gap Today we will talk about Monetary policy as an alternative way to close a GDP gap Causes a change in Investment I rather than directly changing gov t spending G or changing consumption C through a tax change Changing I is just a different kind of CISOM Taking the AD multiplier into effect monetary policy can similarly expand or contract GDP in order close a GDP gap U of M Topic 10 Monetary Policy October 23 2012 3 35 Before that Money Initial deposits into the banking system multiply through a series of loans and deposits 1 Money Supply Initial Deposits Reserve Ratio Note this means that the only way to change the money supply is to either a change Initial Deposits or b change the Reserve Ratio Money market equilibrium sets the interest rate Today we will talk about what happens to this equilibrium when the Fed shifts the money supply U of M Topic 10 Monetary Policy October 23 2012 4 35 This week Monetary Policy Changes interest rates and Investment Spending I thus shifting Aggregate Demand Tools of Monetary Policy An Algebraic Example using either the RR or OMO to change RGDP Strengths and Weaknesses of Monetary Policy Should Monetary Policy be made by rule or discretion U of M Topic 10 Monetary Policy October 23 2012 5 35 Monetary Policy Intro Suppose we are in a recession and the Fed increases the money supply This will lower interest rates Why What exactly is happening U of M Topic 10 Monetary Policy October 23 2012 6 35 An increase in money supply First of all what do we mean by the Fed increases the money supply How does the Fed cause people to hold more money First the Fed causes banks to have excess reserves for example by decreasing the Reserve Ratio A series of loans and deposits are made remember that example so through the money multiplier effect the total amount of checkable deposits increases by even more than the excess reserves Thus the Fed has increased the money supply U of M Topic 10 Monetary Policy October 23 2012 7 35 Results of this increase in money supply 1 2 3 The Fed increases the money supply At the current interest rate money demand is now lower than money supply see graph above So some people have a surplus of money and want to put it in bonds or interest bearing bank accounts Bond issuers and banks prefer to borrow at lower interest rates so they respond to this surplus of money by lowering interest rates Lower interest rates make people more willing to hold higher amounts of money until at the equilibrium interest rate money demanded equals money supplied U of M Topic 10 Monetary Policy October 23 2012 8 35 Meanwhile in the loanable funds market Now look at this change from the perspective of the loanable funds market This market has the same y axis general interest rate because interest rates for loans move roughly in sync with interest rates for bonds and interest bearing bank accounts We will see that as money supply shifts right loan supply shifts right Why U of M Topic 10 Monetary Policy October 23 2012 9 35 At maximum money supply there are no excess reserves so banks just make new loans whenever old loans are paid off More money supply means this happens more frequently regardless of interest rates In other words loan supply shifts right To find enough firms and potential homeowners who might get mortgages to take out loans banks have to offer lower interest rates until at the equilibrium rate loan demand equals loan supply U of M Topic 10 Monetary Policy October 23 2012 10 35 The AD AS Diagram Finally let s think about what happens to Aggregate Demand and the new AD AS equilibrium We are in a recession meaning we are here U of M Topic 10 Monetary Policy October 23 2012 11 35 More loans means more investment For any given price level more firms choose to borrow to build new factories and buy new equipment so business investment investment spending rises More households are choosing to borrow to buy new and bigger houses so residential investment part of consumption spending also rises Thus AD shifts right U of M Topic 10 Monetary Policy October 23 2012 12 35 Two kinds of monetary policy Expansionary Monetary Policy Monetary Policy that increases money supply lowers interest rates and expands Aggregate Demand Contractionary Monetary Policy Monetary Policy that decreases money supply raises interest rates and contracts Aggregate Demand U of M Topic 10 Monetary Policy October 23 2012 13 35 Tools of Monetary Policy The Fed has 3 tools to work with 1 Reserve Ratio RR Regulations on the minimum amount of reserves that banks must hold against deposits Rarely used in the USA 2 Open market operations OMO The purchase or sale of US government bonds by the Fed 3 Discount Rate Discount Rate The rate that the Fed charges on the loans they make to banks and thrift institutions savings and loan associations These tools affect how much money banks have access to which in turn affects how much money is available in the economy as a whole U of M Topic 10 Monetary Policy October 23 2012 14 35 Reserve Ratio Reserve Ratio is pretty straightforward Changing the Reserve Ratio means banks can give out more or less loans which makes the Money Supply larger or smaller U of M Topic 10 Monetary Policy October 23 2012 15 35 Open Market Operations and the Discount Rate Suppose the demand for money on a particular day exceeds the supply in a particular bank What can the bank do Get an overnight loan from another bank the Fed at interest rate Federal Funds Rate Discount Rate When the media says the Fed is changing interest rates it means the Fed is targeting a new Federal Funds Rate using Open Market Operations U of M Topic 10 Monetary Policy October 23 2012 16 35 Open Market Operations A general definition of Open Market Operations Buying and selling of government securities by a Central Bank for the purpose of carrying out monetary policy Government securities do not count as banks
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