Bài giảng Macroeconomics - Chapter 19: Monetary Policy and the Federal Reserve

Chapter 19: Monetary Policy and the Federal ReserveDescribe the structure and responsibilities of the Federal Reserve SystemAnalyze how changes in real interest rates affect planned aggregate expenditure and short-run equilibrium outputShow how the demand for money and the supply of money interact to determine the equilibrium nominal interest rateDiscuss how the Fed uses its ability to control the money supply to influence nominal and real interest ratesThe Federal ReserveResponsibilities of the Federal Reserve:Conduct monetary policyOversee and regulate financial marketsCentral to solving financial crisesThe Federal Reserve System began operations in 1914The Federal Reserve Organization12 Federal Reserve Bank districtsLeadership is provided by the Board of GovernorsThe Federal Open Market Committee (FOMC) reviews economic conditions and sets monetary policyStabilizing Financial MarketsMotivation for creating the Fed was to stabilize the financial markets and the economyBanking panics occurred when customers believe one or more banks might be bankruptFed prevents bank panics bySupervising and regulating banksLoaning banks funds if neededTargeting Interest Rates: Real or NominalFed controls the money supply to control the nominal interest rate, iInvestment and saving decisions are based on the real interest rate, rFed has some control over the real interest rater = i - where  is the rate of inflationRole of the Federal Funds RateThe federal funds rate is the rate commercial banks charge each other on short-term (usually overnight) loansBanks borrow from each other if they have insufficient fundsMarket determined rateTargeted by the FedTo decrease the federal funds rate the Fed conducts open market purchasesReserves increaseInterest rates tend to move togetherPlanned Spending and Real Interest RatePlanned aggregate expenditure has components that are affected by rSaving decisions of householdsMore saving at higher real interest ratesHigher saving means less consumptionInvestment by firmsHigher interest rates mean less investmentInvestments are made if the cost of borrowing is less than the return on the investmentBoth consumption and planned investment decrease when the interest rate increasesFed Fights InflationExpansionary gap can lead to inflationPlanned spending is greater than normal output levels at the established pricesShort-run unplanned decreases in inventoriesIf gap persists, prices will increaseThe Fed attempts to close expansionary gapsRaise interest ratesDecrease consumption and planned investmentDecrease planned aggregate expenditureDecrease equilibrium outputInflation and the Stock MarketBad news about inflation causes stock prices to decreaseInvestors anticipate the Fed will increase interest ratesSlows down economic activity, lowering firms' sales and perhaps profitsLower profits mean lower dividends which mean lower stock pricesHigher interest rates make non-stock financial instruments more attractiveReduces the demand for stocks and the stock pricesMonetary Policy and the Stock MarketThe Fed has limited ability to manage the stock marketFed does not know the "right" pricesInformation available to the Fed is publicly availableMonetary policy is not well suited to addressing an asset bubble (a speculative increase in asset prices over their underlying market value)Fed can raise interest rates and slow the economyCould result in a recession and rising unemployment The debate over the Fed's role in asset prices got new attention after the mortgage meltdown on 2007 - 2008The Fed and Interest RatesControlling the money supply is the primary task of the FOMCMoney supply and demand determine the interest rateFed manipulates supply to achieve its desired interest ratePortfolio allocation decisions allocate a person's wealth among alternative formsDiversification is owning a variety of different assets to manage riskThe demand for money is the amount of wealth held in the form of moneyDemand for MoneyDemand for money is sometimes called an individual's liquidity preferenceThe Cost – Benefit Principle indicates people will balance the marginal cost of holding money versus the marginal benefitMoney's benefit is the ability to make transactionsQuantity of money demanded increases with incomeTechnologies such as online banking and ATMs have reduced the demand for moneyM1 has decreased from 28% of GDP in 1960 to 12% in 2004Demand for MoneyThe marginal cost of holding money is the interest foregoneMost forms of money pay little or no interestAssume the nominal interest rate on money is 0Alternative assets such as stocks or bonds have a positive nominal interest rateThe higher the nominal interest rate, the smaller the quantity of money demandedBusiness demand for money is similar to individuals'Businesses hold more than half of the money stockDemand for MoneyDemand for money depends on: Nominal interest rate (i)The higher the interest rate, the lower the quantity of money demandedReal income or output (Y)The higher the level of income, the greater the quantity of money demandedThe price level (P)The higher the price level, the greater the quantity of money demandedThe Money Demand CurveInteraction of the aggregate demand for money and the supply of money determines the nominal interest rateThe money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal interest rateAn increase in the nominal interest rate increases the opportunity cost of holding moneyNegative slopeMoney (M)Nominal interest rate (i)MDThe Money Demand CurveChanges in factors other than the nominal interest rate cause a shift in the money demand curveAn increase in demand for money can result fromAn increase in outputHigher price levelsTechnological advancesFinancial advancesForeign demand for dollarsMoney (M)Nominal interest rate (i)MDMD'Supply of MoneyThe Fed primarily controls the supply of money with open-market operationsAn open-market purchase of bonds by the Fed increases the money supplyAn open-market sale of bonds by the Fed decreases the money supplySupply of money is verticalEquilibrium is at EMoney (M)MDEMSMiNominal interest rate (i) Equilibrium in the Money MarketBond prices are inversely related to the interest rateSuppose the interest rate is at i1, below equilibriumQuantity of money demanded is M1, more than the money availableTo get more money, peoplesell bondsBond prices go down,interest rates riseQuantity of money demanded decreases from M1 to MMoney (M)MDEMSMNominal interest rate (i) M1i1iFed Controls the Nominal Interest RateFed policy is stated in terms of interest ratesThe tool they use is the supply of moneyInitial equilibrium at EFed increases the money supply to MS'New equilibrium at FInterest rated decrease to i'to convince the marketto hold the new, largeramount of moneyMoney (M)MDMSMEiNominal interest rate (i) Fi'M'MS'Additional Controls over the Money SupplyOpen market operations are the main tool of money supplyFed offers lending facility to banks, called discount window lendingIf a bank needs reserves, it can borrow from the Fed at the discount rateThe discount rate is the rate the Fed charges banks to borrow reservesLending increases reserves and ultimately increases the money supplyChanges in the discount rate signal tightening or loosening of the money supplyAdditional Controls over the Money SupplyThe Fed can also change the reserve requirement for banksThe reserve requirement is the minimum percentage of bank deposits that must be held in reservesThe reserve requirement is rarely changedThe Fed could increase the money supply by decreasing the reserve requirementBanks would have excess reserves to loanThe Fed could decrease the money supply by increasing the reserve requirement