AP Macroeconomics – Chapter 33 Outline

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I. Learning Objectives—In this chapter students will learn: A. How the equilibrium interest rate is determined in the market for money. B. The goals and tools of monetary policy. C. About the Federal funds rate and how the Fed directly influences it. D. The mechanisms by which monetary policy affects GDP and the price level. E. The effectiveness of monetary policy and its shortcomings.

II. Interest Rates A. The Fed’s primary influence on the economy in normal economic times is through its ability to

change the money supply and therefore affect interest rates. B. Interest is the price paid for the use of money. C. The Demand for Money

1. Transactions demand, Dt, is money kept for purchases as a medium of exchange. a. The level of nominal GDP is the main determinant of the amount of money demanded

for transactions. b. The transactions demand for money varies directly with GDP; the higher the nominal

GDP, the more money is needed to finance those transactions. c. Figure 33.1a shows transactions demand as a vertical demand curve at the level of

nominal GDP.

2. Asset demand, Da, is money kept as a store of value for later use.

a. The interest rate is the main determinant of the amount of money demanded for assets. b. Asset demand varies inversely with the interest rate, because that is the price

(opportunity cost) of holding idle money; the higher the interest rate, the less money people want to hold in cash.

AP Macroeconomics – Chapter 33 Outline

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c. Figure 33.1b shows asset demand as a downsloping demand curve.

3. Total demand equals the quantity of money demanded for assets plus that for transactions,

added horizontally (Figure 33.1c). An increase in nominal GDP shifts money demand to the right; a decrease shifts money demand to the left.

D. The Equilibrium Interest Rate

1. Figure 33.1c illustrates the money market. The money supply is a vertical line, representing the money supply that has been set by the Federal Reserve.

2. The intersection of supply and demand for money determines the interest rate. 3. An increase in the money supply reduces interest rates; a decrease in the money supply

increases interest rates. E. Interest Rates and Bond Prices

1. Interest rates and bond prices are inversely related. When the interest rate increases, bond prices fall; when interest rates decrease, bond prices rise.

2. If other interest rates in the economy rise, bonds with lower interest rates are not as attractive. So bond owners must lower the bond price in order to sell it, so that the bond’s yield reaches the same yield the new investor could earn on other competitive investments.

3. If other interest rates in the economy fall, bonds with higher interest rates will look more attractive to investors, who will bid up the price of the bond.

III. The Consolidated Balance Sheet of the Federal Reserve Banks

AP Macroeconomics – Chapter 33 Outline

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A. Assets (Table 33.1)

1. Securities, which are federal government bonds purchased by Fed 2. Loans to commercial banks (including other thrift institutions)

B. Liabilities 1. Reserves of commercial banks held as deposits at Federal Reserve Banks 2. Treasury deposits of tax receipts and borrowed funds 3. Federal Reserve Notes outstanding, our paper currency

C. Global Perspective 33.1 lists the central banks of several nations. IV. Tools of Monetary Policy

A. Open-Market Operations 1. Open-market operations refer to the Fed’s buying and selling of government bonds. This is

the Fed’s most important day-to-day instrument for influencing the money supply. 2. Buying Securities

a. The Fed’s purchase of securities will increase bank reserves and the money supply (Figure 33.2).

b. If the Fed buys directly from banks, then bank reserves go up by the value of the

securities sold to the Fed. Banks can use the full amount of those excess reserves to loan, increasing the money supply.

c. If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Some of the new reserves are required reserves for the new checkable deposits, and the bank can then loan out the excess reserves, increasing the money supply.

d. When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves.

3. Selling Securities a. When the Fed sells securities, bank reserves will go down. b. Eventually the money supply will go down by a multiple of the banks’ decrease in

reserves. 4. How the Fed attracts buyers or sellers:

a. When Fed buys, it raises the demand and price of bonds, which in turn lowers effective interest rate on bonds. The higher price and lower interest rate make selling bonds to the Fed attractive.

AP Macroeconomics – Chapter 33 Outline

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b. When Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rate make buying bonds from Fed attractive.

B. The Reserve Ratio 1. The reserve ratio is the fraction of customer deposits banks are required to hold in reserve,

either in vault cash or on deposit with the Federal Reserve (Table 33.2).

a. Raising the reserve ratio increases required reserves and shrinks excess reserves. The loss

of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.

b. Lowering the reserve ratio decreases the required reserves and expands excess reserves. The gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.

2. Changing the reserve ratio affects the money-creating ability of the banking system in two ways. a. It changes the amount of excess reserves. b. It changes the size of the monetary multiplier. For example, if reserve ratio is raised from

10 percent to 20 percent, the multiplier falls from 10 to 5. 3. Changing the reserve ratio is very powerful because it immediately affects banks’ lending

ability. It could create instability, so Fed rarely changes it. C. The Discount Rate

1. The discount rate is the interest rate that the Fed charges to commercial banks that borrow from the Fed.

2. An increase in the discount rate discourages banks from borrowing from the Fed, which reduces excess reserves.

3. A decrease in the discount rate reduces the cost for banks to borrow from the Fed, so they are more willing to borrow to expand excess reserves, increasing the money supply when they loan out those reserves.

D. The Term Auction Facility 1. This tool was introduced in December 2007 in response to the financial crisis. 2. Under the term auction facility, the Fed holds two auctions each month, and banks secretly

bid for the right to borrow reserves for 28 or 84 days. The bids are ranked from highest to lowest interest rate offered, and the bank offering to pay the lowest interest rate among the bids accepted sets the interest rate for all of the banks.

3. The tool helps the Fed to ensure that all the money it wants to pump into the money supply is borrowed by banks (which cannot be assured by changes in discount rates). It also helps banks that want or need to borrow from the Fed but do not want that information made public for fear of causing concerns that the bank may be insolvent.

E. Open-market operations are the most important of the four tools over the business cycle. 1. This tool is flexible because securities can be bought or sold quickly and in great quantities,

and reserves change quickly in response. 2. The reserve ratio is rarely changed since this could destabilize banks’ lending and profit

positions. The reserve requirement was last changed in 1992.

AP Macroeconomics – Chapter 33 Outline

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3. Until recently, the discount rate was mainly a passive tool of monetary policy. During the financial crisis, the Fed significantly reduced the discount rate to ensure plenty of money was available for banks to meet their reserve requirements and still be able to extend loans.

4. As the financial crisis deepened and banks began to collapse, many banks became reluctant to borrow from the Fed, fearing lenders and stockholders would see such borrowing as a signal that the bank was in serious financial trouble. The secret bidding of the term auction facility allows banks to borrow without concern about the public response. While the Fed has adopted this as a fourth permanent tool, most economists believe the Fed will primarily use it during times of financial crisis.

V. Targeting the Federal Funds Rate A. The Federal funds rate is the interest rate that banks charge each other for overnight loans. B. Banks lend to each other from their excess reserves, but because the Fed is the only supplier of

Federal funds (the currency used as reserves), it can set a target for the Federal funds rate and use open-market operations to achieve that rate (Figure 33.3).

1. The Fed will increase the availability of reserves if it wants the Federal funds rate to fall (or

keep it from rising). 2. The Fed will withdraw reserves if it wants to raise the Federal funds rate (or keep it from

falling). C. Expansionary Monetary Policy

1. If the economy is experiencing a recession and rising unemployment, the Fed may use expansionary monetary policy (“easy money policy”) to increase the money supply.

2. The Fed will initially announce a lower target for the Federal funds rate, and then use open-market operations (buying bonds). The Fed may also lower the reserve requirement or the discount rate or auction off more reserves, but open-market operations are the most frequently used tool of the Fed.

3. Increasing reserves will generate two results: a. The supply of Federal funds increases, lowering the Federal funds rate. b. A greater expansion of the money supply will occur through the money multiplier.

AP Macroeconomics – Chapter 33 Outline

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4. Expansionary monetary policy will put downward pressure on interest rates, including the prime interest rate—the benchmark interest rate banks use to set many other interest rates. The Federal funds rate and the prime rate closely track each other (Figure 33.4).

D. Restrictive Monetary Policy

1. To combat rising inflation, the Fed uses contractionary monetary policy (“tight money policy”).

2. The initial step is for the Fed to announce a higher target for the Federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve requirement, raising the discount rate, and auctioning off fewer reserves are also options.

3. Reducing reserves will produce results opposite of those for expansionary monetary policy. a. The reduced supply of Federal funds raises the Federal funds rate to the new target. b. Multiple contraction of the money supply occurs through the money multiplier.

4. Restrictive monetary policy results in higher interest rates, including the prime rate. E. Consider This … The Fed as a Sponge

1. If reserves in the banking system are like a bowl of water, the Fed can use open-market operations as a sponge that can change the amount of water (reserves) in the bowl.

2. If there are too many reserves, the Fed “soaks up” the excess by selling bonds. 3. If the Fed wants more reserves in the system, it “squeezes the sponge,” putting more money

into the banking system by buying bonds. F. The Taylor Rule

1. This rule of thumb for targeting the Federal funds rate closely models Fed policy. 2. The rule assumes a target inflation rate of 2 percent and says the FOMC follows three rules:

a. When real GDP is at its potential and inflation is at its 2 percent target, the Federal funds rate should be at 4 percent (implying a real interest rate of 2 percent).

b. For each 1 percent increase of real GDP above potential, the Federal funds rate should be raised by 1/2 percentage point.

c. For each 1 percent increase in the inflation rate above the 2 percent target, the Fed should raise the real Federal funds rate by 1/2 percentage point (meaning a 1 1/2 percent increase in the nominal rate, because 1 percent is for the inflation increase).

3. The rule works in reverse, as well, if real GDP is below its potential and inflation is below the 2% target.

AP Macroeconomics – Chapter 33 Outline

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4. While the Fed has roughly followed the Taylor rule in recent years, it has also deviated under certain circumstances.

VI. Monetary Policy, Real GDP, and the Price Level A. Cause-Effect Chain (Key Graph 33.5)

1. The demand for money is made up of asset and transactions demand, while the supply of

money is determined by the Fed. The equilibrium real interest rate is where supply and demand are equal (Figure 33.5a).

2. The interest rate determines amount of investment businesses are willing to make. Investment demand is inversely related to interest rates (Figure 33.5b).

3. Interest rate changes have a great effect on the level of investment because the interest cost of large, long-term investment is a sizable part of investment cost.

4. As investment rises or falls, equilibrium GDP rises or falls by a multiple of that initial investment (Figures 33.5c and 33.5d).

AP Macroeconomics – Chapter 33 Outline

Sarver

B. Effects of an Expansionary Monetary Policy: If unemployment and recession are the problem, the Fed increases excess reserves, which lowers the interest rate and increases investment, which, in turn, increases aggregate demand and real GDP (Table 33.3, Column 1).

C. Effects of a Restrictive Monetary Policy: If inflation is the problem, the Fed reduces excess

reserves, which raises the interest rate and decreases investment, which, in turn, reduces aggregate demand and inflation (Table 33.3, Column 2).

VII. Monetary Policy: Evaluation and Issues A. Strengths of Monetary Policy

1. It is speedier and more flexible because the Fed can buy and sell securities daily. 2. Fed Board members are isolated from political pressure, so it is easier for them to make

appropriate, but unpopular decisions. Fed Board members are appointed and serve 14-year terms, and monetary policy changes are more subtle and less noticed than fiscal policy changes.

B. Recent United States Monetary Policy 1. To counter the recession that began in March 2001, the Fed pursued an easy money policy

that saw the prime interest rate fall from 9.5 percent at the end of 2000 to 4.25 percent in December 2002. Most economists credit the Fed for keeping the 2001 recession relatively mild and for its swift and strong responses to the September 11, 2001, terrorist attacks.

2. In response to strong economic growth in 2004, the Fed began a series of quarterpercentage-point increases in the Federal funds rate until the prime rate reached 8.25 percent in the summer of 2006.

3. As the mortgage default crisis began in August 2007, the Fed lowered the discount rate, then the target Federal funds rate, and then initiated the auction term facility in December 2007. By December 2008, the targeted Federal funds rate was 0 to 0.25 percent, where it remained through the end of 2009. While most economists credit the Fed with preventing a

AP Macroeconomics – Chapter 33 Outline

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financial system collapse, some economists criticize the Fed for keeping interest rates too low for too long during the recovery from the 2001 recession.

C. Problems and Complications 1. Recognition and operational lags impair the Fed’s ability to quickly recognize the need for

policy change and increase the time required for policies to affect the economy. Although policy changes can be implemented rapidly, there is a lag of at least 3 to 6 months before the changes will have their full impact.

2. Cyclical asymmetry may exist. a. A restrictive monetary policy works effectively to slow inflation, but an expansionary

monetary policy is not always as effective in stimulating the economy from recession. While monetary policy can effectively “pull the string” to decrease aggregate demand, it is less effective in “pushing the string” to increase aggregate demand.

b. The Fed can increase reserves, but if consumers and firms choose not to borrow, or banks choose not to lend, aggregate demand will not increase.

c. As a result, the economy can enter a liquidity trap, where lowering interest rates (making more reserves available) has no effect on increasing aggregate demand.

d. The liquidity trap rendered monetary policy ineffective in increasing investment during the Great Recession of 2007-2009, so policymakers turned to fiscal policy for a more effective solution to the crisis.

3. Consider This … Up, Up, and Away a. During the 2007-2009 recession, total Fed assets increased from $885 billion to $2317

billion. Using its lender-of-last-resort function, the Fed bought an enormous number of government and mortgage-backed securities to increase liquidity in the financial system. The Fed also significantly increased loans to banks through the term auction facility.

b. The Fed’s liabilities increased from $43 billion to $1148 billion as commercial banks put the proceeds from their securities sales into their reserve accounts at the Fed.

c. The Fed will have to use monetary policy to absorb the large amount of excess reserves as the economy recovers, in order to prevent significant inflation.

VIII. LAST WORD: The “Big Picture” A. Key Graph 33.6 illustrates that the levels of output, employment, income, and prices all result

from the interaction of aggregate supply and aggregate demand. In particular, note the items shown in red that constitute, or are strongly influenced by, public policy.

AP Macroeconomics – Chapter 33 Outline

Sarver

B. Fiscal and monetary policies are interrelated. The impact of an increase in government spending will depend on whether it is accommodated by monetary policy. For example, if government spending comes from money borrowed from the general public, it may be offset by a decline in private spending, but if the government borrows from the Fed or if the Fed increases the money supply, then the initial increase in government spending may not be counteracted by a decline in private spending.