The big picture marcoeconomics 12e parkin chapter 14

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M O N E T A RY P O L I C Y C h a p t e r 14 MONETARY POLICY** The Big Picture Where we have been: Chapter 14 heavily uses material from Chapter 8, which was the first chapter dealing with money, and Chapter 10, which introduced the aggregate supplyaggregate demand model The expenditure multiplier, covered in Chapter 11, plays a small role in this chapter Playing a larger role is the loanable funds market, developed in Chapter Where we are going: Chapter 14 is the last dealing with macroeconomics The next chapter, on international trade, will not use the material from this chapter N e w i n t h e Tw e l f t h E d i t i o n This chapter is largely the same as the eleventh edition with a nice update to the At Issue section along with data updates throughout The At Issue section now presents opposing opinions from Janet Yellen and other members of the Federal Reserve System The Economics In The News feature has a 2014 story and analysis about the Fed’s continued promises to keep interest rates low in the near future The Worked Problem discusses federal funds rate movement and its effect on other macroeconomic variables It challenges the student to explain how and when a Fed policy to stimulate the economy works To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are still in the MyEconLab and are called Extra Problems 129 Lecture Notes Monetary Policy    The Fed can influence the federal funds interest rate and thereby affect economic activity What are the transmission channels of monetary policy? What are alternative monetary policy strategies? The Fed (and other government agencies) has responded to the financial crisis of 2007-2008 with a variety of innovative policies designed to fight the crisis I Monetary Policy Objectives and Framework Monetary Policy Objectives The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  Goals: The goals in the mandate are “maximum employment, stable prices, and moderate long-term interest rates.” Achieving stable prices, keeping the inflation rate low, is the key It is the source of maximum employment and moderate longterm interest rates Low inflation rates mean that people make decisions without the confusion created by inflation And, because the nominal interest rate equals the real interest plus the inflation rate, a low inflation rate means low long-term interest rates  Operational “Stable Prices” Goal: The Fed pays close attention to the core PCE deflator, the PCE deflator excluding food and fuel The core inflation rate is the rate of increase of the core PCE deflator Price stability can mean either a core inflation rate “low and stable enough so that it does not enter materially into the decisions of households and firms” (Alan Greenspan) or a core inflation rate of “1 or percent” (Ben Bernanke)  Operational “Maximum Employment” Goal: The Fed tracks the output gap, the percentage deviation of real GDP from potential GDP The Fed tries to minimize the output gap Responsibility for Monetary Policy    The Role of the Fed The Federal Reserve Act makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy The Fed has ultimate responsibility for monetary policy The FOMC makes monetary policy decisions at eight scheduled meetings a year The Role of Congress Congress plays no role in making monetary policy decisions but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress The Role of the President The formal role of the president of the United States is limited to appointing the members and the chairman of the Board of Governors II The Conduct of Monetary Policy The Monetary Policy Instrument A monetary policy instrument is a variable that the Fed can directly control or closely target  The Fed could fix the exchange rate as its policy instrument But then it could not pursue an independent monetary policy, so for that reason the Fed does not fix the exchange rate      The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument The interest rate the Fed targets is the federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other Although the Fed can change the federal funds rate by any reasonable amount, it normally changes the federal funds rate one quarter of a percentage point at a time The federal funds rate is determined in the market for reserves The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them So the higher the federal funds rate, the smaller the quantity of reserves demanded As shown in the figure, the demand curve for reserves is downward sloping The Fed’s open market operations determine the supply of reserves Because the Fed determines the quantity of reserves, the figure shows that the supply curve of reserves is vertical at this quantity  An Open Market Purchase: The Fed buys government securities from a bank and pays for the purchase by increasing the bank’s reserves The supply of reserves increases  An Open Market Sale: The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves The supply of reserves decreases The figure shows the market for reserves In the figure the equilibrium federal funds rate is percent  If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities The quantity of reserves increases and the federal funds rate falls  If the Fed wants to raise the federal funds rate, the Fed undertakes an open market sale of government securities The quantity of reserves decreases and the federal funds rate rises Interest Rate Determination: The reason that an increase in the reserves lowers the interest rate can be easily developed by focusing on banks Using an open market operation, the Fed increases excess reserves Banks want to loan these new excess reserves, and thus the supply of loans and loanable funds increases As a result, the interest rate on loans falls as they struggle to make more loans This type of intuitive explanation often can be quite helpful in supplementing the formal analysis FOMC Decision Making and the Market for Reserves After assessing the current state of the economy using the Beige book (which is now online), the Fed turns to forecasting three key variables: the inflation rate, the unemployment rate, and the output gap Based on those forecasts, The FOMC formulates its monetary policy and decides upon its target federal funds rate The FOMC instructs the New York Fed to use open market operations—the purchase or sale of government securities in the open market —to hit its federal funds target rate 140 CHAPTER 14 Interest on Reserves: You may want to mention that because of the 2008 financial crisis, the Fed accelerated its plan to implement paying interest on reserves This change effectively created a lower bound for the federal funds rate and added another tool to the Fed’s toolbox A relevant article on the subject can be found on the San Francisco Fed website entitled “Why did the Federal Reserve start paying interest on reserve balances held on deposit at the Fed? Does the Fed pay interest on required reserves, excess reserves, or both? What interest rate does the Fed pay?” III Monetary Policy Transmission Ripple Effects of Changing the Interest Rate Suppose the Fed lowers the federal funds rate using an open market sale As a result:       Other interest rates: Other short-term interest rate falls Long-term bond interest rates also fall, but by a lesser amount Exchange rate: The fall in the U.S interest rate lowers the U.S interest rate differential The demand for U.S dollars decreases and the supply of U.S dollars increases The exchange rate falls (the dollar depreciates) Money and bank loans: Banks’ reserves have increased so they have excess reserves Banks loan the excess reserves, so loans and the quantity of money increases Long-term real interest rate: The real interest rate is determined in the loanable funds market In the short run, the increase in loans increases the supply of loanable funds and lowers the real interest rate Expenditure plans: Consumption expenditure and investment increase as a result of the lower real interest rate Net exports increase as a result of the fall in the exchange rate Aggregate demand: Aggregate demand increases with a multiplier effect so that the price level rises and real GDP increases Effects of Money on Real GDP and the Price Level: We bring in here the expenditure multiplier; it is important to ensure that students not get confused between the multiplier impact of open market operations on the quantity of money, and the multiplier process that magnifies autonomous expenditure changes Additionally, when using the ASAD model to explain the impact of deflationary monetary policy, it is important to stress the text’s point that the model is a stationary simplification, whereas in reality output and the price level both tend to grow, so that rather than reducing real GDP and the price level, the Fed’s anti-inflation policy would slow their growth The Fed Fights Recession If the Fed believes that real GDP is less than potential GDP (a negative output gap), the Fed will undertake expansionary monetary policy: it lowers the federal funds rate using an open market sale The monetary policy is transmitted as outlined above and real GDP increases The Fed Fights Inflation If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem (a positive output gap), the Fed will undertake contractionary monetary policy: it raises the federal funds rate using an open market sale The effect of the monetary policy is transmitted as described, only the directions of the changes are reversed Real GDP decreases Tying it All Together: Students often think that macroeconomics is difficult because there are so many different concepts introduced Among others, students must learn about aggregate demand curve and the short-run and long-run aggregate supply curves; the aggregate production function; ; the demand for labor, the supply of labor, and the labor market; the demand for reserves, the supply of reserves, how Fed policy affects the supply of reserves, and the market for reserves; the demand for money, the supply of money, the money multiplier, and the market for money; and, the demand for loanable funds, the supply of loanable funds, the market for loanable funds, and government impacts on this market This chapter offers a great chance for you to use the book’s very clear presentation and very straightforward presentation of monetary policy transmission to help the student see how all the parts interact Use the book’s “four quadrant diagrams” (Figures 14.6a, 14.6b, 14.6c, and 14.6d as well as 14.7a, 14.7b, 14.7c, and 14.7d) to show the students how everything they learned ties together to give a complete and coherent view of the otherwise exceedingly complex macroeconomy Don’t hesitate to refer back to earlier chapters to remind the students what they learned in those chapters and how that is now being used to explain how our economy functions Loose Links and Long and Variable Lags  In reality, the ripple effects of monetary policy are not as precise as outlined above  The long-term real interest rate that influences expenditure plans is linked only loosely to the federal funds rate And the response of expenditure plans to the real interest rate also is not tight   The transmission channels described above take time to operate and the time can vary from one episode to the next In the United States, when the federal funds rate rises relative to the long-term bond rate, a year later real GDP growth generally slows The Economics in the News section details how aggressive Fed policy since 2008 did not have an equally strong effect on GDP The section notes that the Fed’s policy had a weak effect on long-term interest rates which, in turn, had a weak effect on aggregate expenditure Effects of Money on Real GDP and the Price Level Revisited: You might want to remind the students that the effects of monetary policy on real GDP and the price level so clearly discussed in this chapter are short run effect In the long run, the quantity theory covered in Chapter rules the roost You can point out to your students that in the long run, the impact on real GDP dissipates and the only long run effect is on the price level (or the inflation rate) In the late 1970s and early 1980s, several central banks targeted the quantity of money to successfully lower their inflation rates However, central banks eventually abandoned this procedure as financial innovations made the demand for money (and velocity) mush less stable than in the past IV Extraordinary Monetary Stimulus The Key Elements of the Crisis The financial crisis of 2007-2008 started in the United States in August 2007 Banks were at the center of the crisis which eventually led to the largest recession since the great depression  Banks were put under stress from three sources:  A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value Banks suffered losses which reduced their equity  A Significant Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds This process created concern among banks that similar withdrawals would occur and that bank runs might start 142 CHAPTER 14    A Run on the Bank: One bank in the United Kingdom, Northern Rock, experienced a bank run In the United States, massive withdrawals of deposits from money market mutual funds occurred Banks’ desired reserves increased so banks increased their reserves by calling in loans  The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and commercial paper, so these markets essentially closed Because the loanable funds market is worldwide, these problems immediately spread throughout the world The drastic decrease in the supply of loanable funds started to affect the real economy The Policy Actions  Policy actions responding to the crisis were slowly implemented until by November 2008 eight groups of policies were in place:  Open Market Operations: The Fed undertook massive open market operations to give banks more liquidity The federal funds rate was lowered, in December to between 0.00 and 0.25 percent  Extension of Deposit Insurance: Deposit insurance was extended to other institutions, such as money market funds This policy was aimed at preventing runs  Term Auction Credit; Primary Dealer and Other Broker Credit; and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility: These are three separate policies but all have similar effects: The Fed accepted significantly riskier assets from a wider range of depository institutions than before in exchange for assets or reserves These policies allowed depository institutions to swap risky assets for safer assets or reserves  Troubled Asset Relief Program (TARP 1): The TARP is conducted by the U.S Treasury not the Fed The TARP was funded with $700 billion of government debt As first envisioned, the plan was for the U.S government to buy troubled assets from depository institutions and replace them with U.S government securities But this process was more difficult than thought and its overall value was questioned  Troubled Asset Relief Program (TARP 2): Because of the difficulties of the TARP and concern about its effectiveness, the TARP was modified to the TARP 2, in which the U.S government took direct equity stakes in major depository institutions This action directly increased these firms’ equity and reserves In December of 2008 some of the TARP funds were used to assist major automakers  Fair Value Accounting: The accounting standard that required depository institutions to value their assets at their current market value was relaxed and they were permitted, in rare occasions, to use a model to value the assets The effect of this policy was to try to keep depository institutions’ (accounting measure of their) equity higher Persistently Slow Recovery   Despite extraordinary efforts by monetary and fiscal policy, the U.S economy at the end of 2010 still had slow growth and high unemployment, with the unemployment rate near 10 percent Critics argue that the Fed did more harm than good by creating uncertainty with its policies They argued that the Fed should create greater clarity about its monetary policy strategy The At Issue detail presents arguments within the Fed for and against keeping interest rates low for a “considerable time.” Janet Yellen, chair of the Fed presents arguments in favor of this policy and Richard Fisher, President of the Dallas Fed, argues against it Policy Strategies and Clarity Two alternative decision-making strategies have been proposed Both strive to create greater openness and certainty about the Fed’s monetary policy Inflation Rate Targeting  Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and to explain how its policy actions will achieve that target Other countries (England, New Zealand, Canada, Sweden, and the EU) have successfully used inflation targeting rules to keep their inflation rate low Taylor Rule  The Taylor rule uses a formula to set the target federal funds rate The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate, assumed to be percent, plus amounts based on the inflation rate (INF) and the output gap (GAP) according to: FFR = + INF + 0.5(INF  2) + 0.5GAP John Taylor says that the Fed has come close to following this rule but if it had followed it precisely the economy would have performed better Why Rules?  Rules are important because rules enable households and firms to form more accurate inflation expectations Markets work best when inflation expectations are most accurate and rules allow accuracy in inflationary expectations 144 CHAPTER 14 Additional Problems In Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP is $300 billion, and the short-run aggregate supply curve is SASB a What are the price level and real GDP? b Does Freezone have an unemployment problem or an inflation problem? Why? c What will happen in Freezone if the central bank takes no monetary policy actions? d What monetary policy action would you advise the central bank to take and what you predict will be the effect of that action? Suppose that in Freezone, shown in problem 1, the short-run aggregate supply curve is SASA and a drought decreases potential GDP to $250 billion a What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c Do you recommend that the central bank lower or raise the federal funds rate? Why? Figure 14.2 shows the economy of Freezone The aggregate demand curve is AD, and the short-run aggregate supply curve is SASA Potential GDP is $300 billion a What are the price level and real GDP? b Does Freezone have an unemployment problem or an inflation problem? Why? c What you predict will happen in Freezone if the central bank takes no monetary policy actions? d What monetary policy action would you advise the central bank to take and what you predict will be the effect of that action? Suppose that in Freezone, shown in problem 3, the short-run aggregate supply curve is SASB and potential GDP increases to $350 billion a What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c Do you recommend that the central bank lower or raise the federal funds rate? Why? China Raises Reserve Requirements The People’s Bank of China, the country’s central bank, raised the reserve requirements of its top commercial banks to put a squeeze on the credit market following a spell of robust economic growth Source: International Business Times, October 11, 2010 a If the United States had the economic performance of China, what monetary policy actions would the Fed’s most likely take b How would you expect China’s monetary policy of squeezing the credit market to influence aggregate demand in China Would you expect it to have a multiplier effect? Why or why not? c What actions might the People’s Bank of China take to slow the economy? Solutions to Additional Problems a The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve The price level is 110 and real GDP is $400 billion b Freezone has an inflation problem because its real GDP, $400 billion, is greater than its potential GDP, $300 billion In this case if no action is taken Freezone will suffer from inflation c If the central bank takes no monetary policy action, the nominal wage rate and other resource costs will eventually rise so that short-run aggregate supply decreases Ultimately in the long run the economy will reach equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will rise to 120 d The central bank can take a contractionary monetary policy by raising the interest rate This policy decreases aggregate demand, which decreases real GDP, lowers the price level, and decreases inflation Decreasing real GDP, however, will increase the unemployment rate a Freezone’s price level is 130 and its real GDP is $200 billion Freezone has an unemployment problem because its real GDP is less than its potential GDP If the central bank lowers the federal funds rate and buys securities, aggregate demand will increase The increase in aggregate demand will raise the price level and increase real GDP, helping solve Freezone’s unemployment problem b If the central bank raises the federal funds rate and sells securities, aggregate demand decreases As a result, the price level falls and real GDP decreases, which worsens Freezone’s unemployment problem c Freezone should lower the interest rate and buy securities because this policy will help solve Freezone’s unemployment problem a The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve The price level is 130 and real GDP is $200 billion b Freezone has an unemployment problem because its real GDP, $200 billion, is less than its potential GDP, $300 billion c If the central bank takes no action, the nominal wage rate and other resource costs eventually fall so that the short-run aggregate supply increases Ultimately in the long run the economy will reach an equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will fall to 120 146 CHAPTER 14 d The central bank can take an expansionary monetary policy by lowering the interest rate This policy increases aggregate demand, which raises the price level and increases real GDP Unemployment decreases Raising the price level, however, increases the inflation rate a Freezone’s price level is 110 and its real GDP is $400 billion Freezone has an inflation problem because its real GDP is greater than its potential GDP If the central bank lowers the federal funds rate and buys securities, aggregate demand increases The increase in aggregate demand increases real GDP and further raises the price level, worsening Freezone’s inflation problem b If the central bank raises the federal funds rate and sells securities, aggregate demand decreases As a result, real GDP decreases and the price level falls, which will decrease inflation and help solve Freezone’s inflation problem c Freezone should raise the federal funds rate and sell securities because this policy will help solve Freezone’s inflation problem a The Fed most likely would undertake contractionary monetary policy, as did the People’s Bank of China The Fed, however, would probably raise the federal funds rate rather than raise reserve requirements b China’s policy is designed to decrease the supply of loanable funds in China, thereby raising the real interest rate in China and decreasing investment and consumption expenditure Aggregate demand decreases because both consumption expenditure and investment decrease The overall impact of this policy might be smaller than expected because foreign loanable funds will flow into China to take advantage of the higher Chinese real interest rate This increase in the supply of loanable funds will moderate the rise the interest rate Even so, it is likely there will be a small multiplier effect if aggregate demand decreases because there will be some induced decrease in consumption expenditure c The People’s Bank of China could raise the Chinese interest rate or, as it has done, increase reserve requirements Additional Discussion Questions Suppose events in the rest of the world cause the exchange rate to fall when the U.S economy is at full employment How should the Fed react in order to maintain macroeconomic stability? Why? The fall in the foreign exchange rate increases U.S aggregate demand and will, if left alone, create an inflationary gap The Fed should conduct a contractionary monetary policy by raising the federal funds rate The contractionary monetary policy decreases U.S aggregate demand and offsets the incipient inflationary gap What limits the Fed’s ability to steer the economy to avoid both recession and inflation? The Fed can offset fluctuations in aggregate demand because its monetary policy affects aggregate demand So, for instance, if aggregate demand decreases the Fed can undertake expansionary monetary policy to increase aggregate demand, thereby offsetting the original decrease However the Fed cannot offset fluctuations in aggregate supply without either creating more inflation or more unemployment For instance, if aggregate supply decreases, the price level rises and real GDP decreases If the Fed combats the higher price level (and rise in inflation) by using contractionary monetary policy, real GDP decreases even more And if the Fed combats the decrease in real GDP (and rise in unemployment) by using expansionary monetary policy, the price level rises still higher 3 Why is there a difference between the short-run and long-run effects from an increase in the quantity of money? In the short run the price level rises and the money wage rate does not change, so the economy moves along its short-run aggregate supply curve and real GDP increases Real GDP can be different from potential GDP But in the long run the money wage rate rises to adjust to the rise in price level Once this adjustment takes place, real GDP returns to potential GDP When that occurs in the long run, the effect of the increase in the quantity of money has worn off What are the benefits of using rules to conduct monetary policy? Rules have one major benefit: People can understand them The point is that members of the economy need to make decisions about what to supply and what to demand On average these decisions will be better the less uncertainty faced One source of uncertainty is monetary policy If monetary policy is erratic and takes people by surprise they will often find that they have made sub-optimal decisions that they regret If monetary policy follows rules— especially easily followed and easily understood rules—then this source of uncertainty is removed from people’s calculations As a result, following rules will help members of the public make better economic decisions which means the economy will function better ... to help the student see how all the parts interact Use the book’s “four quadrant diagrams” (Figures 14. 6a, 14. 6b, 14. 6c, and 14. 6d as well as 14. 7a, 14. 7b, 14. 7c, and 14. 7d) to show the students... reserves rather than loaning them So the higher the federal funds rate, the smaller the quantity of reserves demanded As shown in the figure, the demand curve for reserves is downward sloping The Fed’s... Goal: The Fed tracks the output gap, the percentage deviation of real GDP from potential GDP The Fed tries to minimize the output gap Responsibility for Monetary Policy    The Role of the Fed The
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