This facility was temporarily extended to non-banks during the mortgage meltdown of 2007 – 2008.Access to the discount window is quid pro quo for the Fed regulating banks.
1. MONETARY POLICYGT01003Macroeconomics
2. Learning Objectives1. Analyze how changes in real interest rates affectplanned aggregate expenditures (PAE) and short-runequilibrium output2. Show how the demand for money and the supply ofmoney determine equilibrium nominal interest rate3. Discuss how central bank uses control of the moneysupply to influence nominal and real interest rates
3. Introduction: Monetary Policy• Monetary policy is a major stabilization tool• Quickly decided and implemented• More flexible and responsive
4. Introduction: Central Banks• Responsibilities of Central Banks are• Conduct monetary policy• Oversight and regulation of financial markets• Central to solving financial crises
5. Introduction: Central Bank and theEconomyEliminate output gaps by changing themoney supplyChanges in money supply causechanges in nominal interest rateInterest rates affect plannedaggregate expenditures, PAE
6. HOW DOES INTEREST RATEAFFECT PAE & SHORT-RUNEQUILIBRIUM OUTPUT??
7. PAE and Real Interest Rate• Planned Aggregate Expenditures have components thatare affected by r• Savings decisions of households• More saving at higher real interest rates• Higher saving means less consumption• Investment by firms• Higher interest rates mean less investment• Investments are made if the cost of borrowing is less than the return on theinvestment• Both consumption and planned investment decreasewhen the interest rate increases
8. Interest in the Keynesian Model – AnExample• Components of aggregate spending areC = 640 + 0.8 (Y – T) – 400rIP = 250 – 600 rG = 300NX = 20T = 250• If r increases from 0.04 to 0.05 (that is, from 4% to 5%)• Consumption decreases by 400 (0.01) = 4• Planned investment decreases by 600 (0.01) = 6• A one percentage point increase in r reduces plannedspending by 10 – before the multiplier is considered
9. Planned Aggregate ExpendituresPAE = C + IP + G + NXPAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r + 300+ 20PAE = 1,010 – 1,000 r + 0.8 Y• In this example, planned aggregate expenditure dependson both the real interest rate and the level of output• Equilibrium output can only be found once we know the value of r
10. Planned Aggregate ExpendituresPAE = 1,010 – 1,000 r + 0.8 Y• Suppose the real interest rate is 5%, or 0.05• Planned aggregate expenditures becomesPAE = 1,010 – 1,000 (0.05) + 0.8 YPAE = 960 + 0.8 Y• Short-run equilibrium output is PAE = YY = 960 + 0.8 Y0.2 Y = 960Y = $4,800• The graphical solution is the same as before
11. Can Central Bank Control the RealInterest Rates?• Central Bank controls the money supply to controlnominal interest rates, i• Investment and saving decisions are based on the realinterest rate, r• Central bank has some control over the real interest rater = i -where is the rate of inflation• Central Bank has good control over i• Inflation changes relatively slowly• Changes in nominal rates become changes in real rates
12. Monetary Policy and EconomicFluctuationsr C, IP PAEY via themultiplierr C, IP PAE Y via themultiplierRecessionary GapExpansionary Gap
13. Central Bank Fights a RecessionOutput (Y)Plannedaggregateexpenditure(PAE)Y = PAEEExpenditure line (r = 5%)4,800A reduction in r shifts theexpenditure line upward andcloses the recessionary gap5,000Y*Expenditure line (r = 1%)F
14. Central Bank Fights Inflation• Expansionary gap can lead to inflation• Planned spending is greater than normal output levels at theestablished prices• Short-run unplanned decreases in inventories• If gap persists, prices will increase• Central bank attempts to close expansionary gaps• Raise interest rates• Decrease consumption and planned investment• Decrease planned aggregate expenditures• Decrease equilibrium output
15. Monetary Policy for an Expansionary GapPAE = 1,010 – 1,000 r + 0.8 Y• The real interest rate, r, is 5%• Short-run equilibrium output is $4,800• Potential output is $4,600• Expansionary gap is $200• Monetary policy can be used to decrease PAE• The Central Bank should decrease the real interest rate to9%
16. Central Bank Fights InflationOutput (Y)Plannedaggregateexpenditure(PAE)Y = PAEEExpenditure line (r = 5%)4,800An increase in r shifts theexpenditure line down andcloses the expansionary gap4,600Y*Expenditure line (r = 9%)G
17. Central Bank Fights InflationrPlanned C and IPAEYrPlanned C and IPAEYExpansionary Gap Recessionary Gap
18. HOW DO CENTRAL BANKSCONTROL INTEREST RATES?
19. Central Bank and Interest Rates• Controlling the money supply is the primary task of acentral bank:• Money supply and demand determine the interest rate• Central bank manipulates supply to achieve its desired interest rate• To better understand how the central bank determinesinterest rates, we will look first at the market for money –the demand for money and the supply of money.
20. Demand for Money• Demand for money is sometimes calledan individuals liquidity preference• The Cost – Benefit Principle indicates peoplewill balance the marginal cost of holdingmoney versus the marginal benefit• Moneys benefit is the ability to maketransactions• Quantity of money demanded increases withincome• Technologies such as online banking andATMs have reduced the demand for money• M1 has decreased from 28% of GDP in 1960 to12% in 2004
21. Demand for Money• 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 moneydemanded• The price level (P)• The higher the price level, the greater the quantity of money demanded
22. Demand for Money• The marginal cost of holding money is the interestforegone• 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 nominalinterest rate• The higher the nominal interest rate, the smaller thequantity of money demanded• Business demand for money is similar to individuals• Businesses hold more than half of the money stock
23. The Money Demand Curve• Interaction of the aggregate demand for money and thesupply of money determines the nominal interest rate• The money demand curve shows the relationshipbetween the aggregate quantity of money demanded, M,and the nominalinterest rate• An increase in thenominal interest rateincreases theopportunity cost ofholding money• Negative slopeMoney (M)Nominalinterestrate(i)MD
24. The Money Demand Curve• Changes in factors other than the nominal interest ratecause a shift in the money demand curve• An increase in demand for money can result from• An increase in output• Higher price levels• Technological advances• Financial advances• Foreign demand fordollarsMoney (M)Nominalinterestrate(i)MDMD
25. Supply of Money• Central bank primarily controls the supply of money withopen-market operations• An open-market purchase of bonds by central bank increases themoney supply (expansionary monetary policy)• An open-market sale ofbonds by central bankdecreases the moneysupply (contractionary monetary policy)• Supply of money is vertical• Equilibrium is at EMoney(M)MDEMSMiNominalinterestrate(i)
26. Central Bank Controls the NominalInterest Rate• Initial equilibrium at E• Central Bank increases the moneysupply to MS• New equilibrium at F• Interest rated decrease to ito convince the marketto hold the new, largeramount of moneyMoney (M)MDMSMEiNominalinterestrate(i)FiMMS
27. Central Bank (CB) Controls the NominalInterest RateCB sellsbonds tothe publicSupply ofbondsincreasesPrice ofbondsdecreaseInterestrateincreasesTo Decrease the Money SupplyCB buysbondsfrom thepublicDemandfor bondsincreasesPrice ofbondsincreaseInterestratedecreasesTo Increase the Money Supply
30. Additional Controls over the MoneySupply• Open market operations are the main tool ofmoney supply• Central bank offers lending facility to banks• If a bank needs reserves, it can borrow from theCentral Bank at the discount rate• The discount rate is the rate the Central Bankcharges banks to borrow reserves• Lending increases reserves and ultimatelyincreases the money supply• Changes in the discount rate signaltightening or loosening of the money supply
31. Additional Controls over the MoneySupply• Central Bank can also change the reserve requirementfor banks• The reserve requirement is the minimum percentage of bankdeposits that must be held in reserves• The reserve requirement is rarely changed• The Central Bank could increase the money supply bydecreasing the reserve requirement• Banks would have excess reserves to loan• The Central Bank could decrease the money supply byincreasing the reserve requirement