Chapter 23 - Monetary policy and the central bank. When you finish this chapter, you should be able to: Describe the structure and responsibilities of the federal reserve system, analyze how changes in real interest rates affect planned aggregate expenditure and short-run equilibrium output, show how the demand for money and the supply of money interact to determine the equilibrium nominal interest rate, discuss how the fed uses its ability to control the money supply to influence nominal and real interest rates.
Monetary Policy and the Central Bank Chapter 23 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved 231 Learning Objectives Describe the structure and responsibilities of the Central Banking System Analyze how changes in the federal funds rate and real interest rate affect planned aggregate expenditure and short-run equilibrium output Show how the demand for money and the supply of money interact to determine the equilibrium nominal interest rate Discuss how the central bank uses its ability to control the money supply to influence nominal and real interest rates 232 Fed Watch • Analysts attempt to forecast Fed (the U.S central bank) decisions about monetary policy – – • Greenspan briefcase indicator Central bank decisions have significant effects on financial markets and the macro economy Monetary policy is a major stabilization tool – – Quickly decided and implemented More flexible and responsive than fiscal policy 233 Central Banks of Selected Economies Country/Economy Central Bank Australia Canada China Hong Kong Indonesia Japan Malaysia Singapore South Korea United Kingdom United States Reserve Bank of Australia Bank of Canada People’s Bank of China Hong Kong Monetary Authority Bank Indonesia Bank of Japan Bank Negara Malaysia Monetary Authority of Singapore Bank of Korea Bank of England Federal Reserve System (Fed) 234 The Central Banking System and the Federal Reserve • Responsibilities of the central bank: – – Conduct monetary policy Oversee and regulate financial markets • • Central to solving financial crises The Federal Reserve System began operations in 1914 – – Does not attempt to maximize profit Promotes public goals such as economic growth, low inflation, and smoothly functioning financial markets • www.federalreserve.gov/ 235 The Federal Reserve Organization • • • 12 Federal Reserve Bank districts – Assess economic conditions in their region – Provide services to commercial banks in their region Leadership is provided by the Board of Governors – Seven governors are appointed by the President to 14-year terms – President selects one of the seven as chairman for a four-year term The Federal Open Market Committee (FOMC) reviews economic conditions and sets monetary policy – 12 members who meet eight times a year 236 Stabilizing Financial Markets • • • • Motivation for creating the central bank was to stabilize the financial markets and the economy Banking panics occurred when customers believe one or more banks might be bankrupt – Depositors rush to withdraw funds – Banks have inadequate reserves to meet demand • Banks close The central bank prevents bank panics by – Supervising and regulating banks – Loaning banks funds if needed Fed did not prevent the bank panics of 1930 – 1933 237 Bank Panics, 1930 - 1933 • One-third of the banks closed – – – • Increased the severity of the Great Depression Difficult for small businesses and consumers to get credit Money supply decreased With no federal deposit insurance, people held cash – – Feared banks would close and they would lose their deposits Holding cash reduced banks’ reserves • Lower reserves decreased the money supply by a multiple of the change in reserves 238 Bank Panics, 1930 - 1933 • Banks increased their reserve – deposit ratio – Further decreased the money supply Date Currency Reserve – Bank Held by Deposit Reserves Public ($B) Ratio ($B) Money Supply ($B) 12 / 1929 3.85 0.075 3.15 45.9 12 / 1930 3.79 0.082 3.31 44.1 12 / 1931 4.59 0.092 3.11 37.3 12 / 1932 4.82 0.109 3.18 34.0 12 / 1933 4.85 0.133 3.45 30.8 239 Deposit Insurance • U.S Congress created deposit insurance in 1934 – Deposits of less than $100,000 will be repaid even if the bank is bankrupt • • • Decreases incentive to withdraw funds on rumors No significant bank panics since 1934 With less risk, depositors pay less attention to whether banks are making prudent investments – In the 1980s, many savings and loan associations went bankrupt • Cost the taxpayers hundreds of billions of dollars 2310 Demand for Money • The marginal cost of holding money is the interest foregone – Most forms of money pay little or no interest • • • • Assume the nominal interest rate on money is Alternative assets such as stocks or bonds have a positive nominal interest rate The higher the nominal interest rate, the smaller the quantity of money demanded Business demand for money is similar to individuals' – Businesses hold more than half of the money stock 2333 Demand for Money • Demand for money depends on: – Nominal interest rate (i) • – Real income or output (Y) • – The higher the interest rate, the lower the quantity of money demanded The higher the level of income, the greater the quantity of money demanded The price level (P) • The higher the price level, the greater the quantity of money demanded 2334 The Money Demand Curve • Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate The money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal interest rate – An increase in the nominal interest rate increases the opportunity cost of M D holding money • Negative slope Money (M) Nominal interest rate (i) • 2335 The Money Demand Curve • Changes in factors other than the nominal interest rate cause 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 for MD' dollars Nominal interest rate (i) • MD Money (M) 2336 Demand for Dollars in Argentina • • • • The average Argentine holds more dollars than the average U.S citizen In the 1970s and 1980s, Argentina had high rates of inflation – Real returns on assets in pesos declined – Argentines switched to dollars as a store of value In 1990, the U.S dollar and Argentine peso traded 1:1 – Both were accepted for transactions By 2001, inflation in Argentina caused the system to break down – Peso was worth less than the dollar 2337 International Demand for U.S Dollars • Political instability in some countries also increases the demand for dollars – • Avoids confiscation and taxes Largest U.S bill is $100, popular with drug dealers – The Euro is available in €500 bills, worth more than $500 • – More compact way of storing a given amount of wealth If drug dealers switch to holding their cash in Euros, the demand for the U.S dollar will decrease 2338 Supply of Money • • The central bank primarily controls the supply of money with open-market operations – An open-market purchase of bonds by the central bank increases the money supply – An open-market sale of bonds by the central bank M decreases the money S supply E Supply of money is vertical i M Equilibrium is at E Nominal interest rate (i) • D M Money (M) 2339 Equilibrium in the Money Market • Bond prices are inversely related to the interest rate Suppose the interest rate is at i1, below equilibrium – Quantity of money demanded is M1, more than the money available – To get more money, people MS sell bonds • Bond prices go down, E interest rates rise i i1 – Quantity of money MD demanded decreases from M1 to M Nominal interest rate (i) • M M1 Money (M) 2340 The Central Bank Controls the Nominal Interest Rate • • Central bank policy is stated in terms of interest rates – The tool they use is the supply of money Initial equilibrium at E The central bank increases MS MS' the money supply to MS' – New equilibrium at F E i – Interest rated decrease to i' F i' to convince the market MD to hold the new, larger amount of money M M' Nominal interest rate (i) • Money (M) 2341 The Central Bank (CB) Controls the Nominal Interest Rate To Decrease the Money Supply To Increase the Money Supply 2342 The Central Bank Targets the Interest Rate • • The central bank cannot set the interest rate and the money supply independently Central bank policy is announced in terms of interest rates because – – – Public is not familiar with the size of the money supply Interest rate changes affect planned spending and the level of economic activity Interest rates are easier to monitor than the money supply 2343 Federal Funds Rate The federal funds rate is the interest rate that banks in the United States charge each other for very short-term loans • – Closely watched in financial markets The Fed targets this interest rate because it is closely tied to the level of bank reserves • • • Changes in the federal funds rate indicate the Fed's plans for monetary policy Other interest rates could be used to indicate the Fed's intentions 2344 • • • • Additional Controls over the Money Supply Open market operations are the main tool of money supply The central bank offers lending facility to banks, called discount window lending – If a bank needs reserves, it can borrow from the central bank at the discount rate • The discount rate is the rate the central bank charges banks to borrow reserves Lending increases reserves and ultimately increases the money supply Changes in the discount rate signal tightening or loosening of the money supply 2345 Additional Controls over the Money Supply • The central bank can also change the reserve requirement for banks – – • The central bank could increase the money supply by decreasing the reserve requirement – • The reserve requirement is the minimum percentage of bank deposits that must be held in reserves The reserve requirement is rarely changed Banks would have excess reserves to loan The central bank could decrease the money supply by increasing the reserve requirement 2346 Stabilizing the Economy: The Role of theCentral Central Bank Stock Market Bank Keynesian Model Interest Rates: Supply of Money Money Market Demand for Money Real, Nominal, Fed Funds Stabilization Policy Monetary Policy Open Market Operations Discount Rate Reserve Requirement 2347 ... Bank of Australia Bank of Canada People’s Bank of China Hong Kong Monetary Authority Bank Indonesia Bank of Japan Bank Negara Malaysia Monetary Authority of Singapore Bank of Korea Bank of England... needed Fed did not prevent the bank panics of 1930 – 1933 23 7 Bank Panics, 1930 - 1933 • One-third of the banks closed – – – • Increased the severity of the Great Depression Difficult for small... Leadership is provided by the Board of Governors – Seven governors are appointed by the President to 14-year terms – President selects one of the seven as chairman for a four-year term The Federal Open