Monetary Policy - Lecture Notes | ECO 230, Study notes of Introduction to Macroeconomics

Download Monetary Policy - Lecture Notes | ECO 230 and more Study notes Introduction to Macroeconomics in PDF only on Docsity! CHAPTER 15: MONETARY POLICY Chapter Outline: History & Structure of the Federal Reserve System Functions of the Federal Reserve Tools of Monetary Policy Open Market Operations Change in the Discount Rate Change in the Required Reserve Ratio Summary of Monetary Policy Tools Impacts of Monetary Policy on the Economy The Loanable Funds Market Monetary Policy and Interest Rates The Impact of Monetary Policy on the Economy The Federal Reserve is the United States Central Bank. It is probably the most powerful, yet least understood, organization in our economy. Its actions may affect everyday consumers whenever we purchase things on credit, take out a loan, or feel the effects of inflation or unemployment. We will examine the history, structure, and operations of the Federal Reserve. Functions of the Federal Reserve include: 1. check collection and clearing; 2. holding bank reserves; 3. acting as a fiscal agent of the federal government; 4. supervising financial intermediaries; 5. providing and controlling the money supply; 6. being the lender of last resort. * The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks to stabilize the banking system. History & Structure of the Federal Reserve The Federal Reserve ("the Fed") was founded in 1913-1914 after four severe banking panics. Two other central banks were set up in the 1800s but each lasted only a short time. The Federal Reserve is chartered by the federal government, but is largely independent of the authority of the Congress and President. The Fed must only report to the Congress periodically and operate within broad mandates. The role of the Fed is to conduct stabilization policy and to act as a lender of the last resort to banks to stabilize the banking system. The lender of last resort is probably the Fed's biggest responsibility. Many economists believe that the Great Depression was due mainly to the collapse of our banking system. The Fed did not do enough to prevent its collapse. When a business needs money, it can often go to the bank for help. Before the Federal Reserve was created, banks had nowhere to turn to when they were in trouble. The Fed is now there to back them up. The unique structure of the Federal Reserve is a consequence of history and politics. Figure 1 gives a breakdown of the main divisions within the Fed. Figure 1 The Board of Governors consists of 7 members and is the highest governing body of the Federal Reserve. The Board of Governors is the highest governing body of the Federal Reserve. It consists of 7 members including the chairperson, currently Alan Greenspan. The chair is appointed to a 4-year term by the President of the U.S. The appointment is usually staggered with the election of President of U.S., i.e. every two years either the President or chair comes up for election/appointment. However, this staggered cycle was disrupted when Paul Volcker resigned early from the Federal Reserve in 1987. The other six members of the Board of Governors are appointed to 14-year terms by the President of the United States and they must be confirmed by the Senate. The long terms try to assure stability and continuity in the Fed's policy decisions. However, many of the board members do not serve their full terms and leave early to work in the private sector. The Twelve District Banks were initially designed to decentralize the Federal Reserve. The United States has a long history of being fearful of centralization, and this was a way to diffuse the power. However, although the District Banks have some autonomy, they ultimately fall under the leadership of the Board of Governors when it comes to monetary policy. The District Banks perform numerous functions in their respective areas. They regulate and supervise banks and bank holding companies, run a check-clearing service, do research and monitor economic activity, circulate the currency, sell savings bonds, and so on. Moreover, the New York Federal Reserve Bank conducts open market operations and foreign exchange stabilization which will be explained below. Boar of Governors 12 District Banks Federal Open market Committee Monetary Policy is the federal funds market. Other banks who have excess reserves can lend their reserves to those banks who are short of their reserves. The interest rate that is charged when one bank lends reserves to another is called the federal funds rate. A bank needing reserves could also turn to the Federal Reserve's discount window. If the Fed decides to lend to the bank, the Fed charges interest also. This interest rate charged is called the discount rate. The discount rate is the interest rate at which the Federal Reserve lends funds to banks. It is the only interest rate that the Fed sets directly. The Federal Reserve controls the discount rate in order to influence the supply of money in the economy. If the Federal Reserve lowers the discount rate, it is signaling that it is loosening the money supply and consequently, banks will be more willing to make loans to customers and make up any shortage in reserves by borrowing from the Fed. Conversely, if the Fed raises the discount rate, it is signaling that monetary policy is tightening and banks had better make sure they have enough reserves on hand. Lowering the discount rate increases the money supply; raising the discount rate contracts the money supply. Let's look at an example. Suppose the Fed decreases the discount rate by one percentage point. This induces banks to borrow $5 million more in reserves from the Fed. The $5 million is an asset that goes in the bank's reserves, but it is simultaneously a liability that is a loan from the Fed. However, the loan from the Fed carries no reserve requirements. The bank is free to lend out the entire $5 million provided that it has enough reserves to meet its required ratio. This scenario is charted if Figure 3 below. Example of a Decrease in the discount Rate (in millions) Assets Liabilities Reserves + $5 Deposits $0 Loans from Fed $5 Loans Reserve Analysis Change in reserves $5 Required Reserves $0 Excess Reserves $5 Figure 3 Tool #3: Change in the Required Reserve Ratio The last tool of monetary policy is to change the required reserve ratio. Currently, the required reserve ratio is 10 percent. If the Federal Reserve lowers the required reserve ratio, then a bank has to hold fewer reserves on a given amount of deposits. For example, if a bank has deposits of $100,000 and a required reserve ratio of 12.5 percent, then it has to hold $12,500 as reserves. If the Fed lowers this to 10 percent, then the bank only has to hold $10,000 as reserves. Therefore, $2,500 in excess reserves are created. RRR=12.5% RRR=10% Total Deposits 100,000 100,000 Reserves on hand: $12,500 $12,500 Reserves $12,500 $10,000 Excess Reserves $0 $2,500 Figure 4 The Federal Reserve does not use this tool often because banks must constantly estimate their reserves to make sure they meet the required level, and if the rules of the game keep changing for banks, then it makes it much more difficult for banks to manage their assets. The Fed prefers to use Open Market Operations. Summary of Monetary Policy Tools Tool Expansionar y Contractionar y OMO Purchase Sale Discount Rate Lower Raise RRR Lower Raise Figure 5 Impacts of Monetary Policy on the Economy1 1 Note that, even though monetary policy may stimulate a struggling economy, a quick rebound may not happen for a number of reasons. Businesses may not jump back with both feet and start investing in new equipment until they see definite signs that things are turning around again. Long-struggling Japan, for example, slashed interest rates to near zero in 2000 and 2001. Despite the desperate measure that effectively amounts to throwing money out of airplanes to get the Japanese to spend and stimulate the economy, there is no proof that the policy is working. Second, It takes up to a year for the Fed's policy shift to filter through the economy. And business expansion is also a long and costly process. It includes opening plants, buying inventories of raw materials and hiring and training people. It can take up to a year for new investments to benefit the economy. This section establishes the link between monetary policy and the behavior of the economy. We explain how Federal Reserve actions impact the behavior of output, inflation, and unemployment. Monetary Policy works by changing the level of demand for goods and services in the economy. When the Fed expands the money supply, banks have more reserves to lend out. They will usually "sell" these reserves to the public by lowering the interest rate and prompting more borrowers to come forward. The lower interest rate will induce higher levels of investment and will lead to more demand for goods and services, boosting the economy's level of output. The Loanable Funds Market We best illustrate the impacts of monetary policy by examining the loanable funds market. Demand for loanable funds comes from anyone wishing to borrow money, whether it be to buy a home or go to college. As the interest rate falls, the cost of borrowing funds falls, so more potential borrowers want funds. Therefore, the demand curve is downward sloping. Draw the Figure here. The supply of loanable funds comes from anyone wishing to lend money, whether it be a bank or an individual. As the interest rate rises, the profit opportunity for lending funds rises, so more people wish to lend their funds. Therefore, the supply curve is upward sloping. Equilibrium occurs where demand and supply for loanable funds are equal, as illustrated in Figure 4. This determines the equilibrium interest rate and the quantity of loanable funds in the economy. Monetary Policy and Interest Rates When the Fed conducts expansionary (contractionary) monetary policy, it is giving