Stabilizing the Economy: The Role of the Fed and Monetary Policy

Chapter 26

Stabilizing the Economy: The Role of the Fed

@ 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw Hill.Learning Objectives

1. Show how the demand for money and the supply of money interact to determine the equilibrium nominal interest rate.
2. Explain how the Fed uses its ability to affect the money supply to influence nominal and real interest rates.
3. Discuss how the Fed uses its ability to affect bank reserves and the reserve-deposit ratio to affect the money supply.
4. Describe the additional monetary policy tools that the Fed can use when interest rates hit the zero lower bound.
5. Explain how changes in real interest rates affect aggregate expenditure and how the Fed uses changes in the real interest rate to fight a recession or inflation.
6. Discuss the extent to which monetary policymaking is an art or science.

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Fed Watch

• Analysts attempt to forecast Fed decisions about monetary policy
• Greenspan briefcase indicator
• Fed decisions have significant effects on financial markets and the macro economy

• Monetary policy is a major stabilization tool
• Quickly decided and implemented
• More flexible and responsive than fiscal policy

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The Fed and Interest Rates

• Controlling the money supply is the primary task of the FOMC
• Money supply and demand determine the interest rate
• Fed manipulates supply to achieve its desired interest rate

• Portfolio allocation decisions allocate a person's wealth among alternative forms
• Diversification is owning a variety of different assets to manage risk

• The demand for money is the amount of wealth held in the form of money

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Demand for Money

• Demand for money is sometimes called an individual's liquidity preference
• The Cost-Benefit Principle indicates people will balance the marginal cost of holding money versus the marginal benefit

• Money's benefit is the ability to make transactions
• Quantity of money demanded increases with income
• Technologies such as online banking and ATMs have reduced the demand for money

• M1 has decreased from 26% of GDP in 1960 to 18% in 2017

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Demand for Money: Interest Foregone

• The marginal cost of holding money is the interest foregone
• Most forms of money pay little or no interest

• Assume the nominal interest rate on money is 0
• Alternative assets such as stocks or bonds have a positive nominal interest rate
• The higher the nominal interest rate, the smaller the quantity of money demanded
• Business demand for money is similar to individuals'
• Businesses hold more than half of the money stock

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Demand for Money Factors

• Demand for money depends on:
• Nominal interest rate (i)
• The higher the interest rate, the lower the quantity of money demanded
• Real income or output (Y)
• The higher the level of income, the greater the quantity of money demanded
• The price level (P)

• The higher the price level, the greater the quantity of money demanded

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The Money Demand Curve

• Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate
• The money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal interest rate
• An increase in the nominal interest rate increases the opportunity cost of holding money
• Negative slope Nominal interest rate (i) MD Money (M)

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Shifts in the Money Demand Curve

• Changes in factors other than the nominal interest rate cause a shift in the money demand curve
• A change in demand for money can result from anything that affects the cost or benefit of holding money
• An increase in output
• Higher price levels
• Technological advances
• Financial advances
• Foreign demand for dollars Nominal interest rate (i) - I MD' MD Money (M)

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Demand for Dollars in Argentina

• The average Argentine holds more U.S. dollars than the average U.S. citizen
• In the 1970s and 1980s, Argentina had high rates of inflation
• Real returns on assets in pesos declined
• Argentines switched to dollars as a store of value
• In 1990, the U.S. dollar and Argentine peso traded 1:1
• Both were accepted for transactions
• By 2001, inflation in Argentina caused the system to break down
• Peso was worth less than the dollar

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Supply of Money

• The Fed primarily controls the supply of money with open- market operations
• An open-market purchase of bonds by the Fed increases the money supply
• An open-market sale of bonds by the Fed decreases the money supply
• Supply of money is vertical
• Equilibrium is at E Nominal interest rate (i) MS E i MD M Money (M)

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Equilibrium in the Money Market

• Bond prices are inversely related to the interest rate
• Suppose the interest rate is at i,, below equilibrium
• Quantity of money demanded is M, more than the money available
• To get more money, people sell bonds
• Bond prices go down, interest rates rise
• Quantity of money demanded decreases from My to M Nominal interest rate (i) MS E i I I i 1 MD M M, Money (M)

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Fed Controls the Nominal Interest Rate

• Fed policy is stated in terms of target interest rates
• The tool they use is the supply of money
• Initial equilibrium at E
• Fed increases the money supply to MS'
• New equilibrium at F
• Interest rated decrease to i' to convince the market to hold the new, larger amount of money Nominal interest rate (i) MS MS' E i F MD M M' Money (M)

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Fed Controls the Nominal Interest Rate: Actions

To Decrease the Money Supply

Fed sells bonds to the public Supply of bonds increases Price of bonds decrease Interest rate increases

To Increase the Money Supply

Fed buys bonds from the public Demand for bonds increases Price of bonds increase Interest rate decreases

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The Fed Targets the Interest Rate

• The Fed cannot set the interest rate and the money supply independently
• Fed policy is announced in terms of interest rates because
• Public is not familiar with the size of the money supply
• Main effects of monetary policy on the economy work through interest rates
• Interest rates are easier to monitor than the money supply

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Role of the Federal Funds Rate (FFR)

• The federal funds rate is the rate commercial banks charge each other on short- term (usually overnight) loans.
• Banks borrow from each other if they have insufficient funds.
• Market determined rate - supply and demand.
• Targeted by the Fed.
• To decrease the federal funds rate the Fed conducts open market purchases.
• For example, when the Federal Reserve buys Treasury securities on the open market, it injects reserves into the banking system and lowers the federal funds rate.
• Reserves increase; excess reserves can be loaned to other banks in the federal funds market.
• Banks holding excess reserves are incentivized to lend to other banks to avoid holding idle reserves, leading to a downward pressure on interest rates as they compete to offer lower rates.
• Interest rates tend to move together; consumer, mortgage, prime rates fall.
• Federal Reserve uses its monetary policy tools to influence the FFR as needed to achieve its policy objectives.

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The Federal Funds Rate, 1955-2022

FRED - Federal Funds Effective Rate 20.0 17.5 15.0 1 12.5 Percent 10.0 7.5 5.0 2.5 0.0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Shaded areas indicate U.S. recessions. Source: Board of Governors of the Federal Reserve System (US) fred.stlouisfed.org

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Can The Fed Control The Real Interest Rate?

• Fed controls the money supply to control the nominal interest rate, i
• Investment and saving decisions are based on the real interest rate, r
• Fed has some control over the real interest rate r= i-x where It is the rate of inflation
• The Fed has good control over i
• Inflation changes relatively slowly
• Changes in nominal rates become changes in real rates

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Additional Controls over the Money Supply

• Open-market operations are the main tool of money supply
• Fed offers lending facility to banks, called discount window lending
• If a bank needs reserves, it can borrow from the Fed at the discount rate
• The discount rate is the rate the Fed charges banks to borrow reserves
• Typically higher than the federal funds rate
• Penalty rate that encourages bank to lend and borrow from one another instead
• Commercial banks can only borrow from the discount window of they meet certain eligibility criteria and pay the penalty rate
• Lending increases reserves and ultimately increases the money supply
• Source of liquidity in times of distress or financial stability
• Changes in the discount rate signal tightening or loosening of the money supply

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Additional Controls over the Money Supply: Bank Reserves

• Money supply is determined by three things: Bank Reserves Money Supply = Public Currency + Reserve-Deposit Ratio
• The Fed can affect the money supply by affecting any of these three things:
• Currency held by the public
• Bank reserves
• The desired reserve-deposit ratio
• Open-market operations can affect banking reserves.
• For example, if the central bank wants to increase the amount of bank reserves, it can purchase government bonds from commercial banks.
• The central bank pays for these securities by crediting reserve accounts of the bank, which increase reserve balances.

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Additional Controls over the Money Supply: Reserve Requirement

• The Fed can also change the reserve requirement for banks
• The reserve requirement is the minimum values of the ratio of bank deposits that must be held in reserves
• The reserve requirement is rarely changed
• Bank reserves can also be affected by discount window lending
• Banks short on reserves can borrow from the discount window
• The discount rate on these loans is set by the fed

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