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Econ201-Chapter35-2023Fall.pptx
- 1. CHAPTER 35 Monetary Policy, GDP, and the Price Level
- 2. The Dual Mandate Tools of Monetary Policy Monetary Policy, Real GDP, and the Price Level Monetary Policy: Evaluation and Issues The “Big Picture” Appendix: The Taylor Rule Chapter Contents
- 3. Monetary Policy Monetary policy is the central bank’s attempt to control the quantity of money and interest rates to achieve its goals. Goals of the federal Reserve in the U.S. include • Price stability • Full employment • Economic growth A central bank can control money supply through banking system and interest rates in money market.
- 4. The Dual Mandate Congress ordered the Fed to pursue two objectives: 1. Full employment rate of unemployment the Fed sets a target rate of unemployment as an estimate of the full employment rate. Set around 3.5 percent. 2. Target rate of inflation Set at 2 percent per year since 2012. The Dual Mandate Bullseye Chart
- 5. How to Control Money Supply The money supply is sum of currencies and checkable deposits. • The Federal Reserve can issue new currencies or withdraw old currencies from circulation. • The Federal Reserve can change the quantity of reserves in the banking system (sum of vault cash and deposits at the Fed by banks), which affects banks’ ability to provide loans, and in turn, affects the quantity of checkable deposits in the economy.
- 6. Four Tools of Monetary Policy The Federal Reserve’s monetary policy tools: Tools to affect the quantity of reserves in the banking system 1. Open-market operations • Buying and selling of government securities 2. Discount windows operations • Discount loan: Fed’s loans to banks 3. Administered rates • Direct control of interest rates on loans between the Fed and banks 4. Forward Guidance • Persuasion through communication
- 7. Open-Market Operations Open-market operations: Buying from and selling of government securities (or bonds) to commercial banks and the general public. • Fed buys securities from bank (Bank receives reserves from the Fed) bank reserves Bank loans and deposits Money supply • Fed sells securities to bank (Bank loses reserves to the Fed) bank reserves Bank loans and deposits Money supply • Most frequently used to influence the money supply
- 8. Discount Windows Operations The discount loans • Short term loans to banks • The Fed changes the discount rate (interest rate on discount loan) to encourage or discourage banks to borrow from the Fed • Passive monetary policy tool – it depends on bank’s decision on borrowing from the Fed • Lender of last resort: if no other banks want to make a loan, the Fed stands to make the loan.
- 9. Administered Rates • Interest rate on reserve balances (IORB): The Fed pays interests on deposits made by banks at the Fed Higher interest rate encourages banks to hold more reserves and discourage loaning out, ultimately reduce the money supply. • Overnight reverse repo (ON RRP): The Fed sells securities with promise to buy back. The Fed can change the quantity of reserves and money supply temporally. A difference between sales price and buy-back price is the interest. • These interest rates fully controlled by the Fed influence interest rates that banks charge to their customers.
- 10. Forward Guidance Forward guidance—communicates to public how the Federal Reserve 1) sees the state of the economy and 2) intends to conduct monetary policy going forward. • Individuals and businesses use the information to shape financial decisions. • Can affect the economy’s money supply and interest rates.
- 11. Federal Funds Rate Federal funds: overnight interbank loans Federal funds rate—Federal Reserve’s policy rate. • Helps to communicate monetary policy stance. • The Fed sets a federal funds target range. • Determined in the federal funds market where banks demand and supply funds to each others. The federal funds rate affects all other bank interest rates • Instead of trying to affect all interest rates in economy, the Federal Reserve targets the federal funds rate which in turn sets other interest rates.
- 12. Prime Interest Rate and Federal Funds Rate Changes in Federal funds rate lead changes in other market interest rates.
- 13. Evolution of the Fed’s Tools and Strategies Prior to recession of 2007-2008, the Fed used a smaller number of monetary policy tools—open market operations. The Fed appeared to be out of options as the effective funds rate fell toward zero—the zero lower bounds problem. Quantitative easing (QE)—trying to lower longer-term interest rates through open market bond purchases. Quantitative tightening (QT)—selling bonds to raise interest rates.
- 14. Monetary Policy to Real GDP & Price Level Changes in money supply has effects on real GDP and price level. • Money Market: Changes in money supply affect interest rates. • Investment demand: Changes in the interest rate affect investment spending. • Aggregate expenditure and aggregate demand: Changes in investment affect the aggerate expenditure and aggregate demand. • Real GDP and price level: Changes in the aggregate demand affect real GDP and price level.
- 15. Monetary Policy •Two types of Monetary Policy • Expansionary monetary policy: Used to “Expand” the economy during a recession by “Expanding” money supply • Contractionary (Restrictive) monetary policy: Used to “Contract” the economy during high inflation by “contracting” money supply
- 16. Expansionary Monetary Policy When Economy is at below-full-employment equilibrium • Unemployment rate is higher than natural rate • Recessionary (negative GDP) gap: Real GDP is below potential GDP • Recessionary expenditure gap: Not enough spending (Aggregate expenditure) To restore the full-employment equilibrium • AE and AD should increase • Real GDP increases • Unemployment rate decreases
- 17. Expansionary Monetary Policy Process To restore the full-employment equilibrium Fed lowers target for Federal funds rate Fed buys securities in Open market operation and lowesr administered rates/discount rate Money supply increases Interest rate decreases Investment and consumption increase AE increases AD increases Real GDP increases
- 18. Expansionary Monetary Policy Effects Real rate of interest, i (percent) Amount of money demanded and supplied (billions of dollars) Amount of investment, I (billions of dollars) 10 8 6 0 $15 $20 $25 Sm1 Smf Dm ID The market for money Investment demand 0 $125 $150 10 8 6 Real rate of interest, i and expected rate of return (percent) Investment demand Price level Real domestic product, GDP (billions of dollars) Q1 = $880 0 Pf P1 ADf (I = $20) Aggregate Demand – Aggregate Supply AS Qf = $900 AD1 (I = $15) a b c d e f
- 19. Contractionary (Restrictive) Monetary Policy When Economy is at above-full-employment equilibrium • Unemployment rate is lower than natural rate • Inflationary gap: Real GDP is above potential GDP • Price level is high & inflation is imminent To restore the full-employment equilibrium • Either AD or AS should decrease • Real GDP decreases • Price level decreases
- 20. Contractionary (Restrictive) Monetary PolicyProcess To restore the full-employment equilibrium Fed raises target for Federal funds rate Fed sells securities in Open market operation and raises administered rates/discount rate Money supply decreases Interest rate increases Investment and consumption decrease AE decreases AD decreases Real GDP decreases
- 21. Contractionary Monetary Policy Effects Real rate of interest, i (percent) Amount of money demanded and supplied (billions of dollars) Amount of investment, I (billions of dollars) 10 8 6 0 $15 $20 $25 Smf Sm3 Dm ID The market for money Investment demand 0 $125 $150 $175 10 8 6 Real rate of interest, i and expected rate of return (percent) Investment demand Price level Real domestic product, GDP (billions of dollars) Q1 = $880 0 $910 P2 P3 ADf (I = $20) AD3 (I = $25) Aggregate Demand – Aggregate Supply AS Qf = $900 f c e b d a
- 22. Evaluation and Issues Advantages of monetary policy over fiscal policy • Speed and flexibility Change the target federal funds rate immediately Change the money supply by any amount Reverse the policy course easily if necessary • Isolation from political pressure Federal Reserve officers are appointed and serve for a long term
- 23. Problems and Complications • Lags: May not show effects in timely manner Even though it can affect interest rate quickly, it takes time to affect money supply and investment spending. • Passive: Fed cannot directly affect aggregate demand, but rely on banks’ and firms’ actions • Cyclical asymmetry: Not effective during depression When expected return on projects are low and risk is high, low interest rate will not affect investment decision. • Liquidity trap: When interest rate is already low near zero, it cannot further lower the interest rate to stimulate investment.
- 24. Recent U.S. Monetary Policy The Mortgage Default Crisis. • Responded with quick and innovative actions during the 2007-2008 financial crisis and severe recession. • Kept short-term interest rates low under a zero-interest rate policy (ZIRP). • Purchased debt securities at pre-crisis prices so financial firms wouldn’t have to sell at current “panic prices.”
- 25. The 2010s Recovery By 2009, slow recovery was under way. Zero lower bound problem meant short-term interest rates were as low as possible. Quantitative easing. Quantitative tightening.
- 26. The 2020 COVID Recession COVID-related mandatory lockdowns a grave economic threat. The Fed addressed the issue with: • Forward guidance • Lowered the federal funds target range • Used administered rates • Reinitiated quantitative easing The recession was the shortest on record.
- 27. Monetary Policy and Fiscal Policy Monetary policy and Fiscal policy must be coordinated to achieve the macroeconomic goals. • Coordinated an expansionary policy to tackle a deep recession • Coordinated a contractionary policy to tackle a high inflation • Two policies are complementary. An expansionary fiscal policy accompanies a deficit spending which leads to a higher interest rate and causes the crowding-out of private investment, offsetting its effect on aggregate demand. Coordinated Fed’s open market purchase can keep the market rate low to avoid the crowding out and help the fiscal policy to have its full effect on aggregate demand.
- 28. Appendix: The Taylor Rule Due to lags, discretionary monetary policy may cause instability of economy Set a simple rule for monetary policy proposed by economist John Taylor • Suggests how the Fed will adjust the nominal interest rate as it pursues the Dual Mandate. • Raise the federal funds rate by ½% for every 1% increase in real GDP over potential GDP • Raise the federal funds rate by ½% for every 1% increase in inflation rate
- 29. Appendix: Taylor Rule Definitions To express the Taylor Rule mathematically, we must define: • Inflation Gap = the current actual rate of inflation minus the Fed’s 2.0 percent target rate for inflation • Unemployment Gap = the current actual unemployment rate minus the Fed’s 4.3 percent target rate for the unemployment rate • Real risk-free interest rate = 2 percent Fed target interest rate = real risk-free interest rate + current actual inflation rate + 0.5*(Inflation Gap) – 1.0*(Unemployment Gap)
- 30. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University It includes copy-righted materials from
Editor's Notes
- This chapter starts by introducing the transactions and asset demand for money and explaining how the interaction of the demand and supply of money determine the interest rates in the market. Banks’ balance sheets are used to explain how open-market operations are effective in changing the money supply. We will learn about tools other than open-market operations that the Fed might use to manipulate the money supply and the reasons that these tools are chosen or not chosen. We will then evaluate expansionary and restrictive monetary policy, conditions under which these policies should be used, and how they impact interest rates, investment, and aggregate demand. We close with a discussion of issues related to monetary policy and current monetary policy.
- Learning Objectives LO35.1 Explain the tools of monetary policy, including open-market operations, forward guidance, and the administered rates. LO35.2 Relate how the Fed's tools and strategies have evolved over the past several decades. LO35.3 Define the Fed's dual mandate and explain how conflicts can arise between meeting the inflation target and the unemployment target. LO35.4 Explain how monetary policy affects real GDP and the price level.. LO35.5 Explain the advantages and shortcomings of monetary policy. LO35.6 Describe how the various components of macroeconomic theory and stabilization policy fit together. LO35.7 (Appendix) State the Taylor Rule and explain how it balances the two parts of the Fed's dual mandate.
- The Fed’s overall goal is to comply with the dual mandate given to it by Congress in 1977. That dual mandate states that the Fed’s main objectives should be to help the economy achieve full employment and stable prices. To do that, it targets the goals of achieving full-employment (an unemployment rate between 3 percent and 4 percent) while at the same time maintaining a target rate of inflation, currently set at around 2 percent per year. These targets are determined by the Fed based upon the current economic conditions. Other things equal, the Fed will be more inclined toward a restrictive monetary policy if the actual inflation rate as measured by the CPI is above the target rate or the actual unemployment rate falls below the target rate, and it will be more inclined toward an expansionary monetary policy if actual inflation is below the target rate or if the unemployment rate is above the target. The target unemployment rate factors in frictional and cyclical unemployment, while the target inflation rates balances the desire to allow for growth while keeping prices stable and interest rates above 0 to prevent people from pulling deposits from banks.
- The Fed has a number of monetary policy tools at its disposal to mange the U.S. money supply. These tools help the agency manage interest rates and general economic activity.
- Open-market operations are used by the Fed to increase or decrease the commercial bank reserves available, which, in turn, will affect the amount of money available in the economy. When a bond’s price rises, its interest rate falls and vice versa. By purchasing Treasury bonds in quantity, for example, the Fed can both decrease their equilibrium interest rate and increase the money supply by creating new money to pay for them.
- As the “lender of last resort,” the Fed makes short-term loans to banks to cover unexpected and immediate needs for additional funds. The rate that the Fed charges the banks is called the discount rate. In providing the loan, the Fed increases the reserves of the borrowing bank. Since there are no required reserves against loans from the Fed, all new reserves are considered excess reserves, and as such, they enhance the ability of the bank to lend. If the Fed raises the discount rate, it discourages banks from borrowing, and if it lowers the rate, it encourages banks to borrow.
- Of the three types of administered rates deployed by the Federal Reserve, the Interest rate on reserve balances and the overnight reserve repo rate are used to influence the money market by changing the rates at which financial institutions can lend money to the Fed. The discount rate, however, is the rate at which financial institutes can borrow money from the Fed.
- If the Fed feels a recession is imminent and announces a future lowering of interest rates, businesses may elect to engage in more investment spending. Positive forward guidance inspires more lending and borrowing and increases the money supply, while negative forward guidance tightens the demand and supply of credit and reduces the size of the money supply.
- The federal funds rate is an interest rate on a specific type of short-term, low-risk loan. While the federal funds market is a competitive market in which supply and demand determine an equilibrium price, it is also an aggressively managed market. The Fed sets a federal funds target range for the federal funds rate. The Fed adjusts the IORB rate and the ON RRP rate to ensure that the equilibrium interest rate in the federal funds market always lands within the federal funds target range.
- With conventional open market operations appearing inadequate to address the 2007-2008 recession, the Fed tried several unconventional strategies. These included lowering interest rates through quantitative easing and raising them through quantitative tightening. Later, the Fed learned to control short-term interest rates with IORB and ON RRP.
- This next section will discuss how monetary policy affects the economy’s levels of investment, aggregate demand, real GDP, and prices.
- During times of recession and unemployment, the Fed will initiate expansionary monetary policy. The idea is to increase the supply of money in the economy in order to increase borrowing and spending. One of the problems that hindered the recovery following the recession of 2007 to 2009 was that while spending increased somewhat, borrowing was down. It seems ironic that when people save instead of borrow, it can actually be detrimental to the economy
- This chain illustrates the causes and effects of expansionary monetary policy. When faced with the problems of unemployment and recession, the Fed takes actions to increase the money supply, which should eventually lead to real GDP rising. Unfortunately, it is not an immediate reaction, so the Fed may overshoot the mark, which can lead to inflation.
- An expansionary monetary policy that shifts the money supply curve rightward in (a) lowers the interest rate from 10 percent to 8 percent, which results in the investment spending in (b) to increase from $15 to $20 billion and causes aggregate demand to increase. The expansionary monetary policy shown in the graphs on the previous slide causes aggregate demand to increase and shifts the aggregate demand curve rightward from AD1 to AD2 in (c) so that real output rises to the full employment level, Qf, along the horizontal dashed line. Conversely, a restrictive monetary policy will cause the money supply curve to shift leftward, thereby increasing the interest rate, decreasing investment and aggregate demand. In (d), the economy at point a has an inflationary output gap because it is producing above potential output.
- During times of rising inflation, the Fed will switch to a more restrictive monetary policy. In order to keep prices down, the Fed will increase the interest rate in order to reduce borrowing and spending, which will hopefully slow the expansion of aggregate demand that is driving up the price levels.
- This chain illustrates the causes and effects of expansionary monetary policy. When faced with the problems of unemployment and recession, the Fed takes actions to increase the money supply, which should eventually lead to real GDP rising. Unfortunately, it is not an immediate reaction, so the Fed may overshoot the mark, which can lead to inflation.
- An expansionary monetary policy that shifts the money supply curve rightward in (a) lowers the interest rate from 10 percent to 8 percent, which results in the investment spending in (b) to increase from $15 to $20 billion and causes aggregate demand to increase. The expansionary monetary policy shown in the graphs on the previous slide causes aggregate demand to increase and shifts the aggregate demand curve rightward from AD1 to AD2 in (c) so that real output rises to the full employment level, Qf, along the horizontal dashed line. Conversely, a restrictive monetary policy will cause the money supply curve to shift leftward, thereby increasing the interest rate, decreasing investment and aggregate demand. In (d), the economy at point a has an inflationary output gap because it is producing above potential output.
- Compared to fiscal policy, which involves the government changing its taxing and spending policies, monetary policy has several advantages. It can quickly be changed to fit the current economic conditions, and because the members of the Fed’s Board of Governors serve fixed terms and are appointed, not elected, they are not subject to the political pressures that elected officials are subjected to.
- The lags complicate monetary policy because although its impact is faster than fiscal policy, there is still a three- to six-month delay that can cause problems and result in the Fed overshooting its targets. Economists also maintain that monetary policy is more effective in dealing with slowing expansions and controlling inflation than it is with helping the economy recover from a severe recession. Even though the Fed may create excess reserves during periods of recession, that does not mean the banks will loan the money out. This is why in the recent recessionary period, the United States focused more on the use of fiscal policy to attempt to spend its way out of the recession. We will probably never figure out which policies actually succeeded.
- Given the fact that the recession was declared to have officially ended in June of 2009, many economists will continue to debate whether the Fed’s actions helped or hindered the recovery. Over the past decade, the Fed has acted quickly to attempt to stimulate the economy, even lowering the federal funds rate to almost zero.
- To help stimulate the economy after the Great Recession, the Fed implemented the zero-interest-rate policy, quantitative easing, Operation Twist, and forward guidance. Under the zero-interest policy, the Fed aimed to keep short-term interest rates near zero to stimulate the economy. When growth remained weak, the Fed had to find a way to deal with the zero lower bound policy under which a central bank is constrained in its ability to stimulate the economy through lower interest rates since you cannot have a negative interest rate. Their next response was quantitative easing which is similar to open-market operations but is not intended to lower interest rates but rather stimulate increased lending. In the second round, the Fed engaged in forward commitment, preannouncing exactly how much it was going to buy. By the close of 2015, the Fed felt that various economic indicators were signaling that monetary stimulus could end. For example, the unemployment rate had fallen back to just 5 percent in 2015, which was well below its 2009 peak of 10 percent. On that basis, the FOMC decided that the Fed could abandon ZIRP and QE while raising interest rates back up toward normal levels using forward guidance, a higher federal funds target range, increases in IORB and ON RRP, and quantitative tightening. Over the next five years, interest rates gradually increased and the economy continued to improve. By early 2020, the U.S. economy was operating at full employment, with a 3.5-percent unemployment rate that exactly equaled the Fed’s unemployment target and a 2.3-percent inflation rate that was only slightly higher than the Fed’s inflation target. Given that the economy was operating almost exactly at the center of the Fed’s bullseye target, it seemed that the Fed might have very little to do for the next few years.
- The Fed responded to the recession brought on by the COVID-19 pandemic by providing forward guidance to the public, lowering the federal funds target range to 0-0.25 percent, used administered rates to lower the effective federal funds rate, along with other money market rates, and purchased $3 trillion of longer-term bonds to lower longer-term interest rates.
- The lags complicate monetary policy because although its impact is faster than fiscal policy, there is still a three- to six-month delay that can cause problems and result in the Fed overshooting its targets. Economists also maintain that monetary policy is more effective in dealing with slowing expansions and controlling inflation than it is with helping the economy recover from a severe recession. Even though the Fed may create excess reserves during periods of recession, that does not mean the banks will loan the money out. This is why in recent recessionary periods, the United States focused more on the use of fiscal policy to attempt to spend its way out of the recession. We will probably never figure out which policies actually succeeded.
- The Taylor rule was developed by economist John Taylor and builds upon the theory that central banks are willing to tolerate a small positive inflation rate if doing so helps the economy achieve its potential output. The Taylor rule assumes that the Fed has a 2 percent target inflation rate and follows three basic rules when setting its target for the federal funds rate: (1) When real GDP = potential GDP and inflation is at the target rate of 2 percent, the federal funds rate should be 4 percent. (2) For each 1 percent increase of real GDP above potential GDP, the Fed should raise the real federal funds rate by ½ percent. (3) For each 1 percent increase in the inflation rate above the 2 percent target rate, the Fed should raise the real federal funds rate by ½ percent.
- The Taylor rule was developed by economist John Taylor and builds upon the theory that central banks are willing to tolerate a small positive inflation rate if doing so helps the economy achieve its potential output. The Taylor rule assumes that the Fed has a 2 percent target inflation rate and follows three basic rules when setting its target for the federal funds rate: (1) When real GDP = potential GDP and inflation is at the target rate of 2 percent, the federal funds rate should be 4 percent. (2) For each 1 percent increase of real GDP above potential GDP, the Fed should raise the real federal funds rate by ½ percent. (3) For each 1 percent increase in the inflation rate above the 2 percent target rate, the Fed should raise the real federal funds rate by ½ percent. The Taylor rule was developed by economist John Taylor and builds upon the theory that central banks are willing to tolerate a small positive inflation rate if doing so helps the economy achieve its potential output. The Taylor rule assumes that the Fed has a 2 percent target inflation rate and follows three basic rules when setting its target for the federal funds rate: (1) When real GDP = potential GDP and inflation is at the target rate of 2 percent, the federal funds rate should be 4 percent. (2) For each 1 percent increase of real GDP above potential GDP, the Fed should raise the real federal funds rate by ½ percent. (3) For each 1 percent increase in the inflation rate above the 2 percent target rate, the Fed should raise the real federal funds rate by ½ percent.