C H A P T E R 14 The Federal Reserve and Monetary Policy Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 14-1 CHAPTER The Federal Reserve and Monetary Policy 14 Little did Ben S Bernanke know when he took over the reins as chairman of the Federal Reserve on February 1, 2006, that he would face a novel and complex crisis brought on by the fall in housing prices and its reverberations throughout the entire financial system in 2007 and 2008 PREPARED BY Copyright © 2012 Pearson Prentice Hall All rights reserved Brock Williams C H A P T E R 14 The Federal Reserve and Monetary Policy APPLYING THE CONCEPTS How has the Fed recently expanded its role in financial markets? Beyond Purchasing Treasury Securities What happens to interest rates when the economy recovers from a recession? Rising Interest Rates during an Economic Recovery Is it better for decisions about monetary policy to be made by a single individual or by a committee? The Effectiveness of Committees Copyright © 2012 Pearson Prentice Hall All rights reserved 14-3 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.1 THE MONEY MARKET • money market The market for money in which the amount supplied and the amount demanded meet to determine the nominal interest rate The Demand for Money INTEREST RATES AFFECT MONEY DEMAND • transaction demand for money The demand for money based on the desire to facilitate transactions Copyright © 2012 Pearson Prentice Hall All rights reserved 14-4 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.1 THE MONEY MARKET (cont’d) The Demand for Money PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it FIGURE 14.1 Demand for Money As interest rates increase from r0 to r1, the quantity of money demanded falls from M0 to M1 Copyright © 2012 Pearson Prentice Hall All rights reserved 14-5 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.1 THE MONEY MARKET (cont’d) The Demand for Money THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income— its purchasing power—not the face value of money or income FIGURE 14.2 Shifting the Demand for Money Changes in prices and real GDP shift the demand for money Copyright © 2012 Pearson Prentice Hall All rights reserved 14-6 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.1 THE MONEY MARKET (cont’d) The Demand for Money OTHER COMPONENTS OF MONEY DEMAND • illiquid Not easily transferable to money • liquidity demand for money The demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs • speculative demand for money The demand for money that arises because holding money over short periods is less risky than holding stocks or bonds Copyright © 2012 Pearson Prentice Hall All rights reserved 14-7 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.2 HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY Open Market Operations • open market operations The purchase or sale of U.S government securities by the Fed • open market purchases The Fed’s purchase of government bonds from the private sector • open market sales The Fed’s sale of government bonds to the private sector Copyright © 2012 Pearson Prentice Hall All rights reserved 14-8 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.2 HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY (cont’d) Other Tools of the Fed CHANGING RESERVE REQUIREMENTS If the Fed wishes to increase the supply of money, it can reduce banks’ reserve requirements so they have more money to loan out CHANGING THE DISCOUNT RATE • discount rate The interest rate at which banks can borrow from the Fed • federal funds market The market in which banks borrow and lend reserves to and from one another • federal funds rate The interest rate on reserves that banks lend each other Copyright © 2012 Pearson Prentice Hall All rights reserved 14-9 C H A P T E R 14 The Federal Reserve and Monetary Policy APPLICATION BEYOND PURCHASING TREASURY SECURITIES APPLYING THE CONCEPTS #1: How has the Fed recently expanded its role in financial markets?? •Traditionally, to expand the money supply, the Fed purchased treasury securities It credited the reserve accounts in banks and, in part, determined the money and credit in the economy The Fed did not intervene in security or credit markets •After the crisis of 2008, the Fed changed policy and expanded its involvement •The Fed increased its assets from less than $1 trillion to over $2 trillion •In 2010 the Fed held over $1 trillion in mortgage-backed securities •Critics suggest the Fed has crossed a political threshold that may pose risks to its long-term independence •The Fed has reduced its investments in many markets, but increased its holdings of mortgage-backed securities and is still playing a direct role in the housing market Copyright © 2012 Pearson Prentice Hall All rights reserved 14-10 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.3 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY FIGURE 14.3 Equilibrium in the Money Market Equilibrium in the money market occurs at an interest rate of r*, at which the quantity of money demanded equals the quantity of money supplied Copyright © 2012 Pearson Prentice Hall All rights reserved 14-11 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.3 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY (cont’d) FIGURE 14.4 Federal Reserve and Interest Rates Changes in the supply of money will change interest rates Copyright © 2012 Pearson Prentice Hall All rights reserved 14-12 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.3 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY (cont’d) Interest Rates and Bond Prices HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES Bond prices rise as interest rates fall GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES Increased money demand will increase interest rates Copyright © 2012 Pearson Prentice Hall All rights reserved 14-13 C H A P T E R 14 The Federal Reserve and Monetary Policy APPLICATION RISING INTEREST RATES DURING AN ECONOMIC RECOVERY APPLYING THE CONCEPTS #2: What happens to interest rates when the economy recovers from a recession? •Economists have often noticed that as an economy recovers from a recession, interest rates start to rise •Some observers think this is puzzling because they associate higher interest rates with lower output Why should a recovery be associated with higher interest rates? •The simple model of the money market helps explain why interest rates can rise during an economic recovery One key to understanding this phenomenon is that the extra income being generated by firms and individuals during the recovery will increase the demand for money Because the demand for money increases while the supply of money remains fixed, interest rates rise •Another factor is that the Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy In this case, the Fed cuts back on the supply of money to raise interest rates In both cases, however, the public should expect rising interest rates during a period of economic recovery and rapid GDP growth Copyright © 2012 Pearson Prentice Hall All rights reserved 14-14 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) FIGURE 14.5 The Money Market and Investment Spending The equilibrium interest rate r* is determined in the money market At that interest rate, investment spending is given by I* Copyright © 2012 Pearson Prentice Hall All rights reserved 14-15 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) FIGURE 14.6 Monetary Policy and Interest Rates As the money supply increases, interest rates fall from r0 to r1 Investment spending increases from I0 to I1 Copyright © 2012 Pearson Prentice Hall All rights reserved 14-16 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) FIGURE 14.7 Money Supply and Aggregate Demand When the money supply is increased, investment spending increases, shifting the AD curve to the right Output increases and prices increase in the short run Copyright © 2012 Pearson Prentice Hall All rights reserved 14-17 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.4 Copyright © 2012 Pearson Prentice Hall All rights reserved INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14-18 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) Monetary Policy and International Trade • exchange rate The rate at which currencies trade for one another in the market • depreciation of a currency A decrease in the value of a currency Copyright © 2012 Pearson Prentice Hall All rights reserved 14-19 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) Monetary Policy and International Trade • appreciation of a currency An increase in the value of a currency Copyright © 2012 Pearson Prentice Hall All rights reserved 14-20 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.5 MONETARY POLICY CHALLENGES FOR THE FED Lags in Monetary Policy Inside lags are the time it takes for policymakers to recognize and implement policy changes Outside lags are the time it takes for policy to actually work Influencing Market Expectations: From the Federal Funds Rate to Interest Rates on Long-Term Bonds It is important to recognize that the Fed directly controls only very short-term interest rates in the economy, not long-term interest rates For the Fed to control investment spending, it must also somehow influence long-term rates It can this indirectly by influencing shortterm rates The Fed also tries to influence long-term rates by influencing market expectations about future short-term interest rates and inflation Copyright © 2012 Pearson Prentice Hall All rights reserved 14-21 C H A P T E R 14 The Federal Reserve and Monetary Policy APPLICATION THE EFFECTIVENESS OF COMMITTEES APPLYING THE CONCEPTS #3: Is it better for decisions about monetary policy to be made by a single individual or by a committee? •When Professor Alan Blinder returned to teaching after serving as vice-chairman of the Federal Reserve from 1994 to 1996, he was convinced that committees were not effective for making decisions about monetary policy With another researcher, Blinder developed an experiment to determine whether in fact individuals or groups make better decisions •The results of the experiment showed that committees make decisions as quickly as, and more accurately than, individuals making decisions by themselves Moreover, it was not the performance of the individual committee members that contributed to the superiority of committee decisions—the actual process of having meetings and discussions appears to have improved the group’s overall performance •In later research, Blinder also found that it did not really matter whether the committee had a strong leader His findings suggest it is the wisdom of the group, not its leader, that really matters And to the extent the leader has too much power—and the committee functions more like an individual than a group—monetary policy will actually be worse! Copyright © 2012 Pearson Prentice Hall All rights reserved 14-22 C H A P T E R 14 The Federal Reserve and Monetary Policy 14.5 MONETARY POLICY CHALLENGES FOR THE FED (cont’d) Looking Ahead: From the Short Run to the Long Run •Monetary policy can affect output in the short run when prices are largely fixed, but in the long run changes in the money supply affect only the price level and inflation •In the long run, the Federal Reserve can only indirectly control nominal interest rates, and it can’t control real interest rates— the rate after inflation is figured in •In the next part of the book, we will explain how output and prices change over time, and how the economy makes the transition by itself from the short to the long run regardless of what the Fed does Copyright © 2012 Pearson Prentice Hall All rights reserved 14-23 C H A P T E R 14 The Federal Reserve and Monetary Policy KEY TERMS appreciation of a currency liquidity demand for money depreciation of a currency money market discount rate open market operations exchange rate open market purchases federal funds market open market sales federal funds rate speculative demand for money illiquid transaction demand for money Copyright © 2012 Pearson Prentice Hall All rights reserved 14-24 ... reserved 14- 16 C H A P T E R 14 The Federal Reserve and Monetary Policy 14. 4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) FIGURE 14. 7 Money Supply and Aggregate Demand... reserved 14- 11 C H A P T E R 14 The Federal Reserve and Monetary Policy 14. 3 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY (cont’d) FIGURE 14. 4 Federal Reserve and. .. INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14- 18 C H A P T E R 14 The Federal Reserve and Monetary Policy 14. 4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT