Carlos Andres Rodriguez Herrera 1 31 23 Principles of Macroeconomics ECON 2002 01 Chapter 16 Domestic and International Dimensions of Monetary Policy Introduction Since 2008 the Fed has provided a number of credit programs through which it transmitted funds directly to individual financial institutions This new Fed credit policy aimed to make banks and firms more liquid and to prevent insolvencies Another objective was to keep borrowing costs low At various time however the Fed failed to make sure that its monetary policy actions supported this latter goal To comprehend the source of this credit policy breakdown you must understand the implementation of monetary policy a key topic of this chapter Learning Objectives Identify the key factors that influence the quantity of money that people desire to hold Describe how Federal Reserve monetary policy actions influence market interest rates Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run Understand the equation of exchange and its importance in the quantity theory of money and prices Discuss the interest rate based transmission mechanism of monetary policy and explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously and describe how the Federal Reserve achieves a target value for the federal funds rate Explain how the Federal Reserve has implemented credit policy since 2008 Chapter Outline The Demand for Money Effects of an Increase in the Money Supply How the Fed Influences Interest Rates Open Economy Transmission of Monetary Policy Monetary Policy and Inflation Monetary Policy in Action The Transmission Mechanism Credit Policy at Today s Fed The Demand for Money To see how Fed monetary policy actions have an impact on the economy by influencing market interest rates we must understand how much money people desire to hold the demand for money All flows of nonbarter transactions involve a stock of money To use money one must hold money People have certain motivation that causes them to want to hold money balances The Ohio State University 1 Transactions demand Precautionary demand Asset demand Money Balances Transactions Demand Precautionary Demand Asset Demand Synonymous with money money stock and money holdings Holding money as a medium of exchange to make payments The level varies directly with nominal GDP Holding money to meet unplanned expenditures and emergencies Holding money as a store of value instead of other assets such as certificates of deposit corporate bonds and stocks The demand for money curve Assume the amount of money demanded for transactions purposes is proportionate to income Precautionary and asset demand are determined by the opportunity cost of holding money the interest rate How the Fed Influences Interest Rates The Fed seeks to alter consumption investment and total aggregate expenditures by altering the rate of growth of the money supply The Fed has four tools at its disposal as monetary policy actions Open market operations Changes in the reserve ratio Changes in the interest rate paid on reserves Discount rate changes Open market operations Fed is buying and selling bonds in the market Fed purchases and sells government bonds issued by the U S Treasury An open market operation causes a change in the price of bonds The market price of existing bonds and all fixed income assets is inversely related to the rate of interest prevailing in the economy Implications A Fed open market sale that reduces the equilibrium price of bonds brings about an increase in the interest rate A Fed open market purchase that boosts the equilibrium price of bonds generate a decrease in the interest rate Effects of an Increase in The Money Supply What if hundreds of million of dollars in just printed bills is dropped from a helicopter People pick up the money and put it in their pockets but how do they dispose of the new money Direct effect Aggregate demand rises because with an increase in the money supply at any given price level people now want to purchase more output of real goods and services Indirect effect Carlos Andres Rodriguez Herrera 1 31 23 Not everybody will necessarily spend the newfound money on goods and services Some of the money gets deposited so banks have higher reserves and they lend the excess out Banks lower rates to induce borrowing a Businesses engage in investment b Individuals consume durable goods like housing and cars Increased loans generate an increase in aggregate demand a More people are involved I more spending even those who didn t get money from the helicopter Quantitative easing Federal Reserve open market purchases intended to generate an increase in bank reserves at a nearly zero interest rate Assume the economy is operating at less than full employment Expansionary monetary policy can close the recessionary gap Direct and indirect effects cause the aggregate demand curve to shift outward Assume there is an inflationary gap Contractionary monetary policy can eliminate this inflationary gap Direct and indirect effects cause the aggregate demand curve to shift inward Open Economy Transmission of Monetary Policy So far we have discussed monetary policy in a closed economy When we move to an open economy monetary policy becomes more complex The net export effect of contractionary monetary policy Boosts the market interest rate Higher rates attract foreign investment International price of dollar rises Appreciation of dollar reduces net exports Negative net export effect Contractionary monetary policy causes interest rates to rise Such a rise will induce international inflows of funds thereby raising the international value of the dollar and making U S goods less attractive abroad The net export effect of contractionary monetary policy will be in the same direction as the monetary policy effect thereby amplifying the effect of such policy The net export effect of expansionary monetary policy Lower interest rates Financial capital flows out of the United States Demand for dollars will decrease International price of dollar goes down Foreign goods look more expensive in the United States Net exports increase imports fall Globalization of international money markets The Fed s ability to control the rate of growth of the money supply may be hampered as U S money markets become less isolated If the Fed reduces the growth of the money supply individuals and firms in the