chapter 17 domestic and international dimensions of monetary policy

Chapter 17

Domestic and International Dimensions of Monetary Policy

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 17-2

Introduction

Why does the Federal Reserve use a federal funds rate target as its primary tool of monetary policy, and what are the implications of its choice?

When you have completed this chapter you will be able to answer this question.


Learning Objectives

• Identify the key factors that influence the quantity of money that people desire to hold

• Describe how the Federal Reserve’s tools of monetary policy influence market interest rates

• Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run


Learning Objectives (cont'd)

• 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

• Explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously


Chapter Outline

• What’s So Special About Money?

• The Tools of Monetary Policy

• Effects of an Increase in the Money Supply

• Open Economy Transmission of Monetary Policy


Chapter Outline (cont'd)

• Monetary Policy and Inflation

• Monetary Policy in Action: The Transmission Mechanism

• Fed Target Choice: Interest Rates or Money Supply?

• The Way the Fed Policy is Currently Implemented


Did You Know That…

• Bond prices change noticeably during televised congressional hearings featuring testimony by Ben Bernanke, chair of the Fed’s Board of Governors?

• Fed policymaking, which involves varying the supply of money or the rate at which it grows, has something to do with market interest rates on bonds?


What’s So Special About Money?

• Money is the product of a “social contract” in which we all agree to

1. Express all prices in terms of a common unit of account, which in the United States we call the dollar

2. Use a specific medium of exchange for market transactions


What’s So Special About Money? (cont'd)

• Something that changes the amount of money in circulation will have some affect on many transactions and thus on elements of GDP.

Something that affects the amount of money in existence is going to affect all markets.



• Holding money

To use money, one must hold money.

If people desire to hold money, there is a demand for money.



• The demand for money, what people wish to hold People have certain motivation that causes

them to want to hold money balances.

There is a demand for money by the public, motivated by several factors.Transactions demandPrecautionary demandAsset demand



• Money Balances

Synonymous with money, money stock, and money holdings



• Transactions Demand

Holding money as a medium of exchange to make payments

The level varies directly with nominal GDP.



• Precautionary Demand

Holding money to meet unplanned expenditures and emergencies



• Asset Demand

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).


Figure 17-1 The Demand for Money Curve


The Demand for Money Curve

Quantity of Money

Inte

rest

Rat

e

Md

• When the interest rate rises the opportunity cost of holding money increases and the quantity of money demanded falls

• The location of Md is determined by the level of income

Q1

Br2

Ar1

Q2


The Tools of Monetary Policy

• The Fed seeks to alter consumption, investment, and aggregate demand as a whole by altering the rate of growth of the money supply.


The Tools of Monetary Policy (cont'd)

• The Fed has three tools at its disposal as part of its policymaking action.

Open market operations

Discount rate changes

Reserve requirement changes



• Open market operations

Fed purchases and sells government bonds issued by the U.S. TreasuryAt first, there is some equilibrium level of

interest rate (and bond prices).

An open market operation must cause a change in the price of bonds.


Contractionary Policy• Fed sells bonds• Supply of bonds increases• Bond prices fall

Figure 17-2 Determining the Price of Bonds, Panel (a)


Expansionary Policy• Fed buys bonds• Supply of bonds falls• Bond prices rise

Figure 17-2 Determining the Price of Bonds, Panel (b)



• Relationship between the price of existing bonds and the rate of interest There is an inverse relationship between

the price of existing bonds and the rate of interest.

• Question So what happens to the yield on a

bond when the price of a bond increases (decreases)?


Bond yield =$50

$1,000= 5%


• Example

You pay $1,000 for a bond that pays $50/year in interest.


Bond yield =$50

$500= 10%


• Example

Now suppose you pay $500 for the same bond.



• The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.



• Changes in the difference between the discount rate and the federal funds rate

The discount rate is kept at 1 percentage point above the market-determined federal funds rate.

Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves.



• Changes in the reserve requirements

An increase (decrease) in the required reserve ratioMakes it more (less) expensive for banks to

meet reserve requirements

Reduces (expands) bank lending


Effects of an Increase in The Money Supply

• What if hundreds of millions 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?


Effects of an Increase in The Money Supply (cont'd)

• 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

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).



• Indirect effect Banks lower rates to induce borrowing.

Businesses engage in investment. Individuals consume durable goods (like

housing and autos).

Increased loans generate an increase in aggregate demand.More people are involved in more spending

(even those who didn’t get money from the helicopter!).


Graphing the Effects of an Expansionary Monetary Policy

• 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.


Figure 17-3 Expansionary Monetary Policy with Underutilized Resources

• The recessionary gap isdue to insufficient AD

• To increase AD, use expansionary monetary policy

• AD increases and real GDP increases to full employment


Graphing the Effects of Contractionary Monetary Policy

• 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.


•The inflationary gap is shown

•To decrease AD, use contractionary monetary policy

•AD decreases and real GDP decreases

Figure 17-4 Contractionary Monetary Policy with Overutilized Resources


International Policy Example: The People’s Bank of China Learns About the Real Interest Rate

• In 2003 and 2005 the People’s Bank of China engaged in monetary policy actions that pushed up market interest rates for the first time in nine years.

• The objective of the interest rate increase was to try to reduce the growth of aggregate demand and thereby prevent higher inflation levels from occurring.

• The problem was that higher inflation expectations already existed, and so the expected inflation rate rose faster than nominal interest rates.


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.


Open Economy Transmission of Monetary Policy (cont'd)

• The net export effect

Impact 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



• The net export effect Impact of expansionary monetary

Lower interest ratesFinancial capital flows out of the United StatesDemand for dollars will decrease International price of dollar goes downForeign goods look more expensive in

United StatesNet exports increase (imports fall)



• Globalization of international money markets

How will global money markets impact the Fed's ability to control the rate of growth in the money supply?


Monetary Policy and Inflation

• Most theories of inflation relate to the short run and the price index in the short run can fluctuate due to Oil price shocks, labor union strikes

• In the long run, there is a more stable relationship between growth in the money supply and inflation.


Monetary Policy and Inflation (cont'd)

• Simple supply and demand analysis can be used to explain Why the price level rises when the money

supply is increased

• If the supply of money expands relative to the demand for money It takes more units of money to purchase

given quantities of goods and services (i.e., the price level has risen)


MsV = PY


• The Equation of Exchange

The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP



• The equation of exchange and the quantity theory: MSV = PY

MS = actual money balances held by nonbanking public

V = income velocity of money; the number of times, on average per year, each monetary unit is spent on final goods and services



• Income Velocity of Money

The number of times per year the dollar is spent on final goods and services; equal to the nominal GDP divided by the money supply.



• The equation of exchange and the quantity theory: MSV = PY

P = price level or price index

Y = real GDP per year



• The equation of exchange as an identity

Total funds spent on final output MsV equals total funds received PY

The value of goods purchased is equal to the value of goods sold

MsV = PY = nominal GDP



• Quantity Theory of Money and Prices

The hypothesis that changes in the money supply lead to equiproportional changes in the price level


MsV = PY


• The quantity theory of money and prices

Assume: V is constantY is stable


MsV = PY


• The quantity theory of money and prices

Increases in Ms must be matched by equal increases in the price level


Figure 17-5 The Relationship Between Money Supply Growth Rates and Rates of Inflation


Monetary Policy in Action: The Transmission Mechanism

• Recall we talked about the direct and indirect effects of monetary policy.

Direct effect: implies increase in money supply causes people to have excess money balances.

Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.


Figure 17-6 The Interest-Rate-Based Money Transmission Mechanism


Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a)

At lower rates, a larger quantity of money will be demanded


Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (b)

The decrease in the interest rate stimulates investment


Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c)

The increase in investment shifts the AD curve to the right


Fed Target Choice: Interest Rates or Money Supply?

• It is not possible to stabilize the money supply and interest rates simultaneously.

• The Fed has often sought to achieve an interest rate target.

• There is a fundamental tension between targeting interest rates and controlling the money supply.


Figure 17-8 Choosing a Monetary Policy Target

If the Fed selects re, it

must accept Ms

If the Fed selects M’s,

it must allow the interest rate to fall


Fed Target Choice: Interest Rates or Money Supply? (cont'd)

• The Fed, in the short run, can select an interest rate or a money supply target but not both.


Fed Target Choice: Interest Rates or Money Supply? (cont'd)

• Choosing a policy target

Money supplyWhen variations in private spending occur

Interest ratesWhen the demand for (or supply of) money

is unstable

Interest rate targets are preferred


The Way Fed Policy is Currently Implemented

• At present the Fed announces an interest rate target.

• The rate referred to is the federal funds rate of interest.

• Or, the rate at which banks can borrow excess reserves from each other.


The Way Fed Policy is Currently Implemented (cont'd)

• If the Fed wants to raise “the” interest rate, it engages in contractionary open market operations.

Fed sells more Treasury securities than it buys, thereby reducing the money supply.This tends to boost “the” rate of interest.



• Conversely, if the Fed wants to decrease “the” rate of interest, it engages in expansionary open market operations.

Fed buys more Treasury securities, increasing the money supply.This tends to lower “the” rate of interest.



• FOMC Directive

A document that summarizes the Federal Open Market Committee’s general policy strategy

Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth



• Trading Desk

An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC



• Taylor Rule

A suggested guideline for monetary policy

An equation determining the Fed’s interest rate target based on Estimated long-run real interest rateDeviation of the actual inflation rate from the

Fed’s objectiveGap between actual real GDP and a measure

of potential GDP


Figure 17-9 Actual Federal Funds Rates and Values Predicted by a Taylor Rule


Issues and Applications: How the Fed Pursues Monetary Policymaking

• The Fed conducts open market operations to keep the federal funds rate at a target level called the neutral federal funds rate.

• At this neutral interest level the growth rate of real GDP tends not to speed up or slow down in relation to its potential, where all the economy’s resources are being fully utilized.


Summary Discussion of Learning Objectives

• Key factors that influence the quantity of money that people desire to hold

To make transactions

To hold for precautionary reasons

To hold as an asset (store of value)


Summary Discussion of Learning Objectives (cont'd)

• How the Federal Reserve’s monetary policy tools influence market interest rates

Open market purchases, reducing the discount rate, or reducing the required reserve ratio increases the money supply and lowers the interest rate.

Open market sales, raising the discount rate, or increasing the required reserve ratio decreases the money supply and raises the interest rate.



• How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run

Expansionary monetary policy Pushing up money supply, inducing a fall in

interest rates Total planned expenditures rise, AD shifts rightward

Contractionary monetary policy Reduces the money supply increasing interest rates Total planned expenditures fall, AD shifts leftward



• The equation of exchange and the quantity theory of money and prices

Equation of exchangeMV = PY

Quantity theory of money and pricesV is constant and Y is stable Increases in M lead to equiproportional

increases in P



• The interest-rate-based transmission mechanism of monetary policy

Operates through effects of monetary policy actions on market interest rates

Bring about changes in desired investment and thereby affect equilibrium GDP via the multiplier effect



• Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously

To target the money supply the Fed must permit the interest rate to vary when the demand for money changes.

To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes.

End of Chapter 17

Domestic and International Dimensions of Monetary Policy

chapter 17 domestic and international dimensions of monetary policy

Documents

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