UB ECO 182 - Chapter 12 Monetary Policy (11 pages)

Chapter 12 Monetary Policy Monetary Policy Before and After the Crisis FFR History The Fed usually influences AD by setting a target for interest rates The interest rate that they influence is called the FFR Federal Funds Rate Although it s actually the rate that charge Some people blamed the low interest rates on the housing bubble that caused the recession of 08 09 Three Key points of Monetary Policy during Financial crisis I FFR Target current rate is 0 25 and has been this way since 01 09 II Lender of last resort III Quantitatiive Easing Quantitative Easing began first in Japan when their interest rates were almost zero However During the peak of the financial crisis in 2008 the Federal Reserve expanded its balance sheet dramatically by adding new assets and new liabilities without sterilizing these by corresponding subtractions QE QE2 QE3 QE infininity Since short term interest rates were already Fed began targeting and indirectly influenceing In the long run the interest rate is determined in the market for In the short run the interest rate is determined in the market for Money Market Money demand reflects how much wealth people want to hold in form For simplicity suppose household wealth includes only two assets Money liquid but pays Bonds pay interest but not People hold money for three reasons 1 Transactions Demand The amount of money people hold to The main determinant of Transactions demand is 2 Precautionary demand The amount of money people hold to make 3 Asset Demand The amount of money that people hold to serve as a The main determinant of both precautionary demand and asset demand is The money demand curve shows the relationship between the quantity of money demanded and the interest rate As r falls the of holding money falls so people hold money An increase in or would shift MD to the right while a fall in or would shift the curve to the left Equilibrium in the Money Market The Supply of money is determined by The primary way that the Fed can change the money supply is through the and of government securities r will adjust until Expansionary Monetary Policy If Y Yn the Fed wants to AD Monetary Policy works two ways I Indirect Effect Change the money supply to change the interest rate If they want to increase AD then they should try to the interest rates They can do this by the money supply This can be done by bonds from individuals or banks The Fed would Pay for the bonds and this would eventually the reserves in the banking system As a result of more reserves the banks will make loans which will the MS II Direct Effect Quantitative Easing Change the MS to directly change AD If people are holding more assets then they are more likely to Thus AD This is the policy that the Fed undertook once the interest rates were Monetary Policy in an Open Economy The net export effect of expansionary monetary policy The Fed Buys bonds which increases the MS and lowers interest rates This will encourage borrowing and discourage saving AD increases Lower interest rates cause s Capital outflows to increase the country capital inflows decrease This causes the demand for in the financial markets to decrease which cause the value of the to decrease This causes the costs of Exports to decrease while the costs of imports is rising Thus X increase M decrease NX increase and AD increase The international effect of monetary policy is the same direction as the domestic affect thus amplifies to effect of monetary policy With fiscal policy the international effect dampens the effect ie AD decrease Govt borrowing pushes up interest rate Not only crowd out I but also NX Tools of the Fed 1 Open Market Operations Used to affect the money supply and target the interest rate The main rate that they target is the which is the interest rate that depository institutions pay to reserves in the interbank federal funds market The reason this is so important is because most other are to the FFR Suppose the Fed finally pushes up the target FFR to 75 To raise the fed funds rate the Fed would govt bonds This reserves from the bankin system causing the supply to Thus banks would start charging each other II Change the relative to the Discount Rate the interest rate on loans the makes to banks to influence the amount of reserves banks borrow When banks are running low on they may reserves from the Fed To increase borrowing and the MS Fed should the differential To decrease borrowing and the MS Fed should the differential III Change the interest rate the Fed pays on Since 10 2008 the Fed has paid interest on reserves banks keep in accounts at the Fed This was done to entice banks to hold money so that the Fed had money to To increase the multiplier and increase MS the Fed should this rate IV Change the This would change the and thus the effect of a change in serves To increase the MS the Fed should the rr To decrease the MS the Fed should the rr Expansionary Policy Contractionary Policy Should be done if YN Y UN U Inflation is should be done if YN Y UN U Inflation is Bonds rr differential or rate Charged on reserves MS r C and I AD Bonds differential or rate Charged on reserves MS r C and I AD In the short run monetary policy can be used to fluctuations in the economy Long run effects of Monetary Policy However in the long run the only effect is Thus in the long run Money is Changing money only changes values not values since it does not change The Quantity Theory of Money The Quantity of Money determines the and the growth in money determines the A Mathematical Approach Velocity of Money V is the rate at which money change hands M The quantity of money P the Average price level Y real GDP Suppose The Y Real GDP 3000 pizzas and the average price of pizzas P 10 00 The nominal value of output 10 3000 30 000 If the quantity of money in the economy is 10 000 then V would be The average dollar was used in 3 transactions Historically V has been constant To find the relationship between money and prices The Quantity Equation is M V P Y 2 3 4 5 1 Velocity is constant if money changes 10 PY will also change 10 since both sides must equal and velocity is constant a change in M does not change Resources or Technology so it does not change y money is neutral Only change nominal values not real values P changes by the same percentage as the money supply if M increases 10 Prices will rise 10 if nothing happens to V or Y Rapid money supply growth causes inflation a PY 5 800 4 000 if M 2 000 then V 4 000 2 000 2 If MS