Chapter 15: Monetary Policy

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Chapter 15 Monetary Policy

• The purpose of this chapter includes the
  following
• Objectives of monetary policy
• Consolidated balance sheet of the Federal Reserve
  System
• Techniques of monetary controls
• Cause and effect chain of monetary policy
• Evaluate the effectiveness of monetary policy

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• The Goal of Monetary Policy The fundamental
  objective of monetary policy is to assist the
  economy in achieving a full-employment,
  noninflationary level of output.

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• Consolidated Balance of the Federal Reserve Banks
  (See Table 15-1)
• Assets (Two are important to monetary theory.)
• Securities
• Federal debt obligations (Treasury bills and
  Treasury bonds)
• These securities are bought and sold primarily to
  influence CB reserves and the money supply (not
  the income they generate).
• The earnings do make for a unique situation
  regarding budgeting for the Fed.
• Loans to CBs
• CBs occasionally borrow from the Fed.
• When CBs borrow from the Fed CB reserves are
  increased in exchange for an IOU.
• Liabilities (Three items are of note.)
• Reserves of Commercial Banks
• Treasury Deposits The US Treasury uses the Fed
  for checking account.

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• TOOLS OF MONETARY POLICY
• Open Market Operations
• Reserve Ratio
• Discount Rate

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• Open Market Operations involves the buying and
  selling of government bonds (securities) by the
  Federal Reserve Banks in the open market.
• When the Fed buys securities CB reserves are
  increased.
• a. Buys from CBs (See transaction page 270.)
• b. Buys from the public (See transaction page
  271.)
• 2. When the Fed sells securities CB reserves
  decrease.
• a. Sells to CBs (See transaction page 272.)
• b. Sells to public (See transaction page 273.)

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• Reserve Ratio
• Raising the reserve ratio reduces the ability of
  banks to create money.
• Lowering the reserve ratio increases the ability
  of banks to create money.
• Note The effect of changing the reserve ratio
  is two-fold
• It changes the amount of excess reserves.
• It changes the size of the monetary multiplier.

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• Discount Rate Rate of interest charged when CBs
  borrow from the Fed.
• Increasing the discount rate discourages
  borrowing by CBs and reduces the ability to
  create money by lending.
• Decreasing the discount rate encourages borrowing
  by CBs and increases the ability to create money
  by lending. (Show the transaction, page 274.)

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• Easy Money Policy
• Buy securities
• Reduce the reserve ratio
• Lower the discount rate

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• Tight Money Policy
• Sell securities
• Increase the reserve ratio
• Raise the discount rate

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• Relative Importance of Monetary Tools
• Open market operations is the most important tool
  available to the Fed for changing the money
  supply. This is an efficient tool, for
  securities can be bought or sold easily and the
  impact on CB reserves is prompt.
• The discount rate is less important than OMO
  because CBs do not borrow much from the Fed.
  There is an announcement effect of changing the
  discount rate that signals the type of Fed
  policy.
• The reserve ratio is used sparingly by the Fed to
  accomplish monetary objectives. Changing the
  reserve ratio affects the ability of CBs to earn
  profit and is rarely used by the Fed. (Last
  used in 1992)

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• Monetary Policy, Real GDP and the Price Level
• Explain the cause-effect chain of monetary policy
  using Figure 15-2.
• Effects of an Easy Money Policy (Recession)
• Effects of a Tight Money Policy (Demand
  Inflation)
• A policy summary is provided in Table 15-3.

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• Effectiveness of Monetary Policy
• Speed and flexibility The Open Market Committee
  can buy and sell securities daily to influence
  the money supply and interest rates.
• The Fed is isolated from political pressure due
  to 14-year terms of appointees to the Feds Board
  of Governors.
• Hard decisions can be more easily made than with
  fiscal policy.
• Policy impacts are more politically palatable
  than the changes in G and T of fiscal policy.

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• Focus on the Federal Funds Rate
• The Fed focuses monetary policy on the Federal
  funds rate as needed to stabilize the economy.
• The Federal funds rate is the rate of interest
  that banks charge one another for overnight
  lending of reserves.
• The Federal funds rate and the Prime interest
  rate normally parallel each other (Figure 15-3).
  When the Fed uses monetary policy to affect the
  Federal funds rate they are affecting interest
  rates as well.

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• Shortcomings and Problems
• Monetary policy is hindered by recognition and
  operational lags, but not administrative lab.
• It takes the Fed awhile to recognize a problem
  with the economy.
• Once the Fed acts, it may take 3 to 6 months for
  interest rate changes to impact on investment,
  aggregate demand, real GDP and the price level.
• Changes in velocity of money may go contrary to
  monetary policy.
• a. Tight money policy to fight inflation may be
  somewhat frustrated by increased velocity of
  money.
• b. Easy money policy to fight unemployment may
  be somewhat frustrated by decreased velocity of
  money.
• Cyclical Asymmetry of Monetary Policy
• a. Reduction of the money supply can be forced.
• b. Expansion of the money supply can be
  encouraged.
• Note Even regarding some problems, monetary
  policy remains an effective tool for achieving
  economic stability.
• For an explanation of Monetary Policy in an
  International Setting see Table 15-4.

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• Suggestions
• Work problems pps. 288-289 2., 3., 6., 8.
• Work through M-C questions in study guide.
• Take two quizzes for chapter from the McConnell
  website.