Isues in economics today 6th by guell chapter10

Chapter 10
Monetary
Policy

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Chapter Outline
• Goals, Tools And A Model Of Monetary
Policy
• Central Bank Independence
• Modern Monetary Policy

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The Federal Reserve
• Nicknamed “The Fed”.
• Established in 1913 by Congress primarily as the
authority for bank regulation.
• The power to “coin money” was granted to Congress by
Article 1 Section 8 of the US Constitution but this power
was delegated to the Federal Reserve.
• The power to regulate the amount that exists in the

economy was granted to the Federal Reserve in an
attempt to avoid the boom and bust periods of the late
1800s.
• This power allows the Federal Reserve to alter interest
rates without political interference.
• There are 12 regional Federal Reserve Banks
• Boston, New York, Philadelphia, Richmond, Atlanta,
Cleveland, St. Louis, Kansas City, Chicago, Dallas,
Minneapolis, and San Francisco
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Goals of Monetary Policy
• Provide sufficient money to the economy
so that it may grow at a sustainable rate.
• Dampen the impact of the business cycle.
• Control Inflation.

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Measures of the
Amount of Money in the Economy
• Monetary Aggregate: a measure of the
quantity of money in the economy
• The commonly used ones are

• M1 =cash+coin and checking
accounts
• M2=M1+saving accounts+ small
CDs

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The Banking System
• When a bank takes a deposit into an
account on which a check can be written, it
must place a percentage of that deposit on
reserve at a Federal Reserve bank. That
percentage is called the reserve ratio.

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Traditional and Ordinary Tools of Monetary
Policy

• Open Market Operations

• A relatively fine tool that can be used to make
small adjustments. These adjustments can be daily
and often occur without much fanfare.

• Targeted Interest Rates
• A relatively blunt tool that can be used to make
large adjustments. In typical years, changes in
targeted interest rates a few times per year.

• Reserve Ratio
• A rather blunt tool that is only used when very
large adjustments are in order.

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Tools of Monetary Policy:
Open Market Operations
• The Fed buys US government debt in order
to get cash into the economy.
• The Fed sells US government Debt in order
to get cash out of the economy.
• More money in the economy puts
downward pressure on interest rates.

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Tools of Monetary Policy:
Targeted Interest Rates
• The Fed seeks to influence the Federal
Funds Rate (the rate at which banks borrow
from one another to meet reserve
requirements).
• Fed Loans Directly to Banks

• Banks with good credit pay the
primary credit rate and can
borrow unlimited amounts.

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Tools of Monetary Policy: The
Reserve Ratio
• The Fed directly controls the percentage of
deposits that banks must have at their
regional Fed bank.

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Money Creation
• The banking system can create more “money”
than physically exists in the form of coin and cash.
• The banking system creates money by a series of
loans.
• Person 1 makes a $1000 deposit at Bank 1
• Bank 1 loans Person 2 $900 who buys something
from Person 3

• Person 3 makes a $900 deposit in Bank 2.
• Bank 2 loans $810 to Person 4 who buys
something from Person 5….. and so on.
• In the end there are deposits totaling $10,000
($1,000+$900+$810+$729+....) that resulted
from that initial $1000.
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Modeling Monetary Policy
• If the Fed wants to expand the economy it can
•
•
•
•

buy bonds
decrease the Federal Funds or Discount Rate
lower the reserve ratio.
This increases the supply of loanable funds. This
lowers interest rates which increases aggregate
demand.

• If the Fed wants to contract the economy it can
•

•
•
•

sell bonds
increase the Federal Funds or Discount Rate
raise the reserve ratio
This decreases the supply of loanable funds. This
raises interest rates which decreases aggregate
demand.

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Expansionary Monetary Policy
Interest Rates

Price Level
S

AS
S’

r
r’

AD2
D

Loanable Funds
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AD1

RGDP

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Contractionary Monetary Policy
Interest rate

Price Level
S’

AS
S

r’
r

AD1
AD2

D

Loanable Funds
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RGDP

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Monetary Transmission
• The Monetary Transmission Mechanism is
the means by which changes in the interest
rate impact the overall economy through
changes in business investment and consumer
spending.
• The Fed can impact the interest rate with
monetary policy.
• The Fed cannot count on interest rates
changing business investment and consumer
spending.
• When the Monetary Transmission Mechanism
fails, you have a liquidity trap.
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New Tools of Monetary Policy
• Purchases of Commercial Paper, short term
debt of corporations.
• Purchases of longer term Federal Treasuries
• Purchases of mortgage backed securities.

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Central Bank Independence
• Countries with Central Banks (the
general name for institutions like
the US Federal Reserve) that are
more independent of political
control have higher rates of
economic growth.
• This is because political influences
tend to create inflationary
tendencies which raises interest
rates and lowers long-term
investment.

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Fed History 1975-1983
• In the late 1970s, the Fed battled
the slow growth caused by high oil
prices by increasing loanable funds
so as to lower interest rates.
• The result was high inflation and
even higher interest rates.
• The Fed induced the 1982
recession with contractionary
policy. Once inflation fell below 6%
in 1983 it engaged in
expansionary policy.
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Fed History 1984-1990
• The Fed battled high deficits

(expansionary fiscal policy) by keeping
real interest rates fairly high.
• The Fed chose not to react to the 1990
recession hoping to persuade Congress
and the first President Bush to
compromise on deficit reduction.

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Fed History 1990-2003
• The Fed steered a stabilization
course through the 1990’s.
• A fear of inflation led to a rapid
increase in interest rates in 2000.
• A fear of recession led to a rapid
decrease in interest rates in 2001.
• The Fed tried to dampen the
economic impact of the Sept 11,
2001 terrorist attacks with quick and
deep rate cuts.
• Rate cutes left the Federal Funds rate
at 1% though 2003
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Fed History 2004-2007
• Began raising interest rates in 2004
• Raised interest rates 17 times until the Fed
Funds rate was at 5.25%
• Maintained that rate for several months.

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Fed History 2008-2011
• In 2008, it began cutting interest rates in
response to the economic slowdown.
• Brought the federal funds rate to zero (to
0.25) percent in late 2008.
• Purchased AIG in September 2008
• QE2 in 2010-2011

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Key Interest Rates

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The Inflation/Deflation Debate
• The Fed is often criticized by economists but
primarily by politicians for being more
concerned about inflation than preventing
recession or getting the most out of the US
economy.
• There was little the Fed could have done to
stimulate the economy after the final cut to
1%. There was an active concern on 2003 that
deflation was possible.

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Aggressive Fed Action on the
Federal Funds Rate (1999-2011)

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