Lecture Notes Ch. 13

Monetary Policies

Monetary Policies
 A. The government exercises power over money supplies.
 B. Equation of exchange

C. Monetarists are conservatives. Believe that the market system has a potential for a high degree of stability. Fiscal policies are bad because the government is ill advised and inflexible; the government is the greatest creator of instability in the system. The economy is on equilibrium in the long run but not the short run.

D. Monetary policies are part of the government but are handled by an autonomous agency of the executive branch. This agency is the Federal Reserve System.

E. The Federal Reserve System (FRS)

F. Money A. In the real sector of the economy, real goods and services are exchanged.

B. For every real transaction, there is a financial transaction that mirrors it.
1. The financial sector is central to almost all macroeconomic debates because behind every real transaction, there is a financial transaction that mirrors it.
2. All trade's in the goods market involves both the real sector and the financial sector.

C. Why is the financial sector so important to macro?
1. The financial sector is important to macroeconomics because of it role in channeling flows out of the circular flows, such as savings - back into the circular flow in the form of:
a. Consumer loans.
b. Business loans.
c. Loans to government.
2. Flow from the spending stream is channeled into the financial sector as savings when individuals buy financial assets such as stocks or bonds and back into the spending stream as investment.
a. These obligations by the issuer of the financial asset are called financial liabilities.
b. For every financial asset there is a corresponding financial liability.

D. The role of interest rates in the financial sector.
1. While price is the mechanism that balances supply and demand in the real sector, interest rates do the same in the financial sector.
2. The interest rate is the price paid for use of a financial asset.
3. When financial assets make fixed interest payments, as do bonds - promises to pay a certain amount plus interest in the future - the price of the financial asset is determined by the market interest rate.
a. As the market interest rates go up, price of the bond goes down.
b. As the market interest rates go down, the price of the bond goes up.

E. Savings that escape the circular flow.
1. Some economists do not believe that the interest rate balances demand and supply for savings.
2. In order to make sense of the problem, macroeconomics divides the flows into two types of financial assets.
a. The first type works its way into the system. Examples include bonds and loans.
b. The second type, money held by individuals, is not necessarily assumed to work its way back into the flow.

II.  The Definition and Functions of Money

A. Money is a highly liquid financial asset that is generally accepted in exchange for other goods, is used as a reference in valuing other goods, and can be stored as wealth.
1. To be liquid means to be easily changeable into another asset or good.

2. Social customs and standard practices are central to the liquidity of money.

B. The U.S. Central Bank: the Fed.
1. American currency is printed with the caption 'Federal Reserve Note,' meaning that it is a liability of the Federal Reserve Bank (the Fed)- the U.S. central bank whose liabilities (Federal Reserve Notes) serve as cash in the U.S. [Internet address of the Fed: http://www.bos.frb.fed.us.
a. A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms.
b. Individuals' deposits in savings and checking accounts serve the same purpose as does currency and are also considered money.
2. The Fed, being the nation's central bank has the right to issue these notes and by convention the notes are acceptable for payment to all the people of the country.

B. Functions of money.
1. Money as a medium of exchange.
a. Without money, we would have to barter -a direct exchange of goods and services.
b. Money facilitates exchange by reducing the cost of trading.
c. All that is necessary for money to work is that everyone believes that other people will exchange it for their goods.
(1) If there is too much money, compared to the goods and services at existing prices, the goods and services will sell out, or the prices will rise.
(2) If there is too little money, compared to the goods and services at existing prices, there will be a shortage of money and people will have to resort to barter, or prices will fall.
d. Thus, the Fed's job is to not issue too much or too little money.
2. Money as a unit of account.
a. Money prices are actually relative prices.
b. A single unit of account saves our limited memories and helps us make reasonable decisions based on relative costs.
c. Money is a useful unit of account only as long as its value relative to other prices does not change too quickly.
d. In a hyperinflation, all prices rise so much that our frame of reference is lost and money loses its usefulness as a unit of account.
3. Money as a store of value.
a. Money is a financial asset. It is simply a government bond that pays no interest.
b. As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth.
c. Money's usefulness as a store of wealth also depends upon how well it maintains its value. Hyperinflations destroy money's usefulness as a store of value.
d. Why do people keep currency under the mattress if they do not receive interest on it? It is because our ability to spend money for goods makes money worthwhile to hold even if it does not pay interest.
4. Unit of deferred payments. past, present and future value
C. Alternative definitions of money.
1. Since it is difficult to define money unambiguously, economists have defined different concepts of money and have called them M1, M2, and L.
a. M1.
(1) M1 consists of currency in the hands of the public, checking account balances, and travelers' checks.
(2) Checking account deposits are included in all definitions of money.
b. M2.
(1) M2 is made up of M1 plus savings deposits, small denomination time deposits (certificates of deposit or CDs), and money market mutual fund shares, along with some other esoteric financial instruments.
(2) The money in savings accounts is counted as money because it is readily available.
(3) All M2 components are highly liquid and play an important role in providing reserves and lending capacity for commercial banks.
(4) The M2 definition is important because economic research has shown that the M2 definition most closely correlates with the price level and economic activity.
c. Beyond M2:
(1) The broadest definition of the money supply is L (which stands for liquidity - the ability to change an asset into an immediately spendable asset). It consists of almost all short term financial assets.
(2) Because of the difficulty of defining money in an ever changing world, measures of money have lost some their appeal, and broader concepts of asset liquidity have taken their place.
2. Distinguishing between money and credit.
a. Credit card balances cannot be money since they are assets of a bank. In a sense, they are the opposite of money.
b. Credit cards are prearranged loans.
c. Credit cards affect the amount of money people hold - generally, credit card holders carry less cash.

III. Banks and the Creation of Money

A. The functions of banks.
1. Banks take in deposits and use the money they borrow to make loans to others.
2. Banks make a profit by charging a higher interest on the money they lend out than they pay for the money they borrow.
3. Banks can be analyzed from the perspective of asset management - how a bank handles its loans and other assets and liability management - how a bank attracts deposits and how it pays for them.
4. Thus, banks are both borrowers and lenders.
5. Banks operate in a regulated environment, the primary regulator being the Fed.

B. How banks create money.
1. Banks create money because a bank's liabilities are defined as money. So when a bank incurs liabilities it creates money.
2. When a bank places the proceeds of a loan it makes to you in your checking account, it is creating money.
3. The first step in the creation of money.
a. The Fed creates money by simply printing currency and exchanging it for bonds.
b. Currency is a financial asset to the bearer and a liability to the Fed.

4. The second step in the creation of money.
a. The bearer deposits the currency in a checking account at the bank.
b. The bank holds your money and keeps track of it until you write a check.
5. Banking and goldsmiths.
a. In the past, gold was used as payment for goods and services.
b. But gold is heavy and the likelihood of being robbed as great.
6. From gold to gold receipts.
a. It was safer to leave gold with a goldsmith who gave you a receipt.
b. The receipt could be exchanged for gold whenever you needed gold.
c. People soon began using the receipts as money since they knew the receipts were backed 100 percent by gold.
d. At this point, there were two forms of money: gold and gold receipts.
7. The third step in the creation of money. Gold receipts become money.
a. Since so little gold was redeemed, the goldsmith began issuing more receipts than he had in gold, and charged interest on the newly created gold receipts. He created money.
b. The goldsmith realized he could make more money in interest than he could earn in goldsmithing.
c. The gold receipts were backed partly by gold and partly by people's trust that the goldsmith would pay off in gold on demand. The goldsmith had become a banker.
8. Banking is profitable.
a. As the goldsmiths became wealthy, others jumped in offering to hold gold for free, or even offering to pay for the privilege of holding the public's gold.
b. That is why most banks today are willing to hold the public's money at not charge - they can lend it out and in the process, make profits.

C. The Money multiplier.
1. Reserves and reserve ratios.
a. Reserves are cash and deposits a bank keeps on hand or at the Fed or central bank, enough to manage the normal cash inflows and outflows.
b. The reserve ratio is the ratio of cash (or deposits at the central bank) to deposits a bank keeps as a reserve against cash withdrawals. The reserve ratio consists of required and excess ratios.
(1) When banks are required by the Fed to hold a percentage of deposits, that percentage is called the required reserve ratio.
(2) If banks choose to hold an additional amount, this is called the excess reserve ratio.
c. Banks 'hold' currency for people and in return allow individuals to write checks for the amount they have on deposit at the bank.
2. Determining how many demand deposits will be created.
a. It is possible to determine the total amount of money that will eventually be created by multiplying the original amount, say a $100 loan, that was deposited and redeposited by 1/r, where r is the reserve ratio.
b. For a reserve ratio of 10 percent, the formula would be: 1/r = 1/.10 = 10. (10 X $100 (the original loan) = $1,000.
c. This means that $900 of new money was created ($1,000 - $100).
3. Calculating the money multiplier.
a. The ratio 1/r is called the simple money multiplier -the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no cash.
b. The higher the reserve ratio, the smaller the money multiplier, and the less money will be created.
4. An example of the creation of money.
a. The process through 10 rounds assuming a deposit of $10,000 and a reserve ratio of 20 percent.
b. If banks keep excess reserves for safety reasons, the money multiplier decreases
5. Calculating the approximate real world money multiplier.
a. The approximate real world money multiplier in the economy is 1/(r +c) where r = the percentage of deposits banks hold in reserve and c is the ratio of money people hold in cash to the money they hold as deposits .
b. An example: assume banks keep 8 percent in reserve and the ratio of individuals' cash holdings to their deposits is 20 percent. The approximate real world money multiplier is: 1/(.08 +.20) = 1/.28 = 3.57.

D. Faith as the backing of our money supply.
1. Promises to pay underlie any financial system.
2. All that backs the modern money supply are bank loan customers' promises to pay and the guarantee of the government to see that banks' liabilities to individuals will be met.

IV. Regulation of Banks and the Financial Sector

A. Financial panics.
1. The financial history of the world is filled with stories of financial upheavals and monetary problems.
2. In the U.S. in the 1800s, local banks were allowed to issue their own notes, which were often worthless.

B. Anatomy of a financial panic.
1. Financial systems are based on trust that expectations will be fulfilled. Banks borrow short and lend long, which means that if people lose faith in banks, the banks cannot keep their promises .
2. If all the people, all at once, decided to ask for their money ('a run on a bank'), there would not be nearly enough to satisfy everyone.

C. Government policy to prevent panic.
1. To prevent financial panics, the U.S. government has guaranteed the obligations of various government institutions.
2. The most important guaranteeing program is the Federal Deposit Insurance Corporation (FDIC).
a. The financial institutions, say a bank, pay a small premium for each dollar of deposit to the FDIC.
b. The FDIC puts the money into a fund used to bail out banks experiencing a run on deposits.
3. These guarantees have two effects:
a. They prevent the unwarranted fear that causes financial crises.
b. They prevent warranted fears.

D. The benefits and problems of guarantees.
1. The fact that deposits are guaranteed does not serve to inspire banks to make certain deposits are covered by loans in the long run.
2. Since deposits are covered up to $100,000 by the FDIC, some financial institutions make risky loans knowing that the guarantee is good.
3. The savings and loan fiasco of the late 1980s and early 1990s.
4. How could the savings and loan fiasco happen?
a. Part of the answer lay in out-and-out fraud.
b. The spread is the difference between a bank's costs of funds and the interest it receives on lending out those funds.
(1) The Samp; Ls' cost of funds grew because of competition from other Samp; Ls.
(2) The Samp; Ls were forced to make riskier loans to maintain the spread.
c. Samp; Ls bet there would be no recession - they lost.

Outline Chapter 13: Money and Monetary Policies

I. Introduction.
A. In the real sector of the economy, real goods and services are exchanged.
B. For every real transaction, there is a financial transaction that mirrors it.
1. The financial sector is central to almost all macroeconomic debates because behind every
real transaction, there is a financial transaction that mirrors it.
2. All trade's in the goods market involves both the real sector and the financial sector.

II. Why Is the Financial Sector So Important to Macro?
A. The financial sector is important to macroeconomics because of its role in channeling
flows out of the circular flows -- such as savings -- back into the circular flow in the form of
consumer loans, business loans, and loans to government.
B. Flow from the spending stream is channeled into the financial sector as savings when
individuals buy financial assets such as stocks or bonds and back into the spending stream
as investment.
C. These obligations by the issuer of the financial asset are called financial liabilities. For
every financial asset there is a corresponding financial liability.
D. Interest rates equilibrate supply and demand in the financial sector.
1. The interest rate is the price paid for use of a financial asset.
2. When financial assets make fixed interest payments, as do bonds -- promises to pay a
certain amount plus interest in the future -- the price of the financial asset is determined by
the market interest rate.
a. As the market interest rates go up, price of the bond goes down.
b. As the market interest rates go down, the price of the bond goes up.
3. This relationship exists because when the interest rate rises, the value of the flow of
payments from fixed interest rate bonds goes down since one can earn more on new bonds
that pay the new, higher interest.
E. Saving escapes the circular flow in the form of money.
1. Some economists do not believe that the interest rate balances demand and supply for
savings.
2. In order to make sense of the problem, macroeconomics divides the flows into two types
of financial assets.
a. The first type works its way into the system. Examples include bonds and loans.
b. The second type, money held by individuals, is not necessarily assumed to work its way
back into the flow.

III. The Definition and Functions of Money.
A. Money is a highly liquid financial asset that is generally accepted in exchange for other
goods, is used as a reference in valuing other goods, and can be stored as wealth.
1. To be liquid means to be easily changeable into another asset or good.
2. Social customs and standard practices are central to the liquidity of money.
B. The U.S. central bank is the Fed.
1. American currency is printed with the caption "Federal Reserve Note," meaning that it is
a liability of the Federal Reserve Bank (the Fed) -- the U.S. central bank whose
liabilities (Federal Reserve Notes) serve as cash in the U.S. [Internet address of the Fed:
http://www.federalreserve.gov .
a. A bank is a financial institution whose primary function is holding money for, and lending
money to, individuals and firms.
b. Individuals' deposits in savings and checking accounts serve the same purpose as does
currency and are also considered money.
2. The Fed, being the nation's central bank has the right to issue these notes and by
convention the notes are acceptable for payment to all the people of the country.
B. Money serves three functions.
1. Money is a medium of exchange.
a. Without money, we would have to barter -- a direct exchange of goods and services.
b. Money facilitates exchange by reducing the cost of trading.
c. All that is necessary for money to work is that everyone believes that other people will
exchange it for their goods.
(1) If there is too much money, compared to the goods and services at existing prices, the
goods and services will sell out, or the prices will rise.
(2) If there is too little money, compared to the goods and services at existing prices, there
will be a shortage of money and people will have to resort to barter, or prices will fall.
2. Money is a unit of account.
a. Money prices are actually relative prices.
b. A single unit of account saves our limited memories and helps us make reasonable
decisions based on relative costs.
c. Money is a useful unit of account only as long as its value relative to other prices does not
change too quickly.
d. In a hyperinflation, all prices rise so much that our frame of reference is lost and money
loses its usefulness as a unit of account.
3. Money is a store of wealth.
a. Money is a financial asset. It is simply a government bond that pays no interest.
b. As long as money is serving as a medium of exchange, it automatically also serves as a
store of wealth.
c. Money's usefulness as a store of wealth also depends upon how well it maintains its
value. Hyperinflations destroy money's usefulness as a store of value.
d. Why do people keep currency under the mattress if they do not receive interest on it? It
is because our ability to spend money for goods makes money worthwhile to hold even if it
does not pay interest.

IV. Money is measured in different ways.
A. Since it is difficult to define money unambiguously, economists have defined different
concepts of money and have called them M1, M2, and L.
B. M1.
1. M1 consists of currency in the hands of the public, checking account balances, and
travelers' checks.
2. Checking account deposits are included in all definitions of money.
C. M2.
1. M2 is made up of M1 plus savings deposits, small denomination time deposits
(certificates of deposit or CDs), and money market mutual fund shares.
2. The money in savings accounts is counted as money because it is readily available.
3. All M2 components are highly liquid and play an important role in providing reserves and
lending capacity for commercial banks.
4. The M2 definition is important because economic research has shown that the M2
definition most closely correlates with the price level and economic activity.
D. Beyond M2: L.
1. The broadest definition of the money supply is L (which stands for liquidity -- the ability
to change an asset into an immediately spendable asset). It consists of almost all short term
financial assets.
2. Because of the difficulty of defining money in an ever changing world, measures of money
have lost some their appeal, and broader concepts of asset liquidity have taken their place.
E. Money is not credit; credit is not money.
1. Credit card balances cannot be money since they are assets of a bank. In a sense, they
are the opposite of money.
2. Credit cards are prearranged loans.
3. Credit cards affect the amount of money people hold -- generally, credit card holders
carry less cash.

V. Banks and the Creation of Money.
A. What do banks do?
1. Banks take in deposits and use the money they borrow to make loans to others.
2. Banks make a profit by charging a higher interest on the money they lend out than they
pay for the money they borrow.
3. Banks can be analyzed from the perspective of asset management -- how a bank
handles its loans and other assets -- and liability management -- how a bank attracts
deposits and how it pays for them.
4. Thus, banks are both borrowers and lenders.
B. Banks create money.
1. Banks create money because a bank's liabilities are defined as money. So when a bank
incurs liabilities (lends) it creates money (Chapter Objective 5).
2. When a bank places the proceeds of a loan it makes to you in your checking account, it
is creating money.
3. The first step in the creation of money is the Fed issues currency.
4. The second step in the creation of money is the holder of currency deposits it.
5. Banking and goldsmiths.
a. In the past, gold was used as payment for goods and services.
b. But gold is heavy and the likelihood of being robbed as great.
6. From gold to gold receipts.
a. It was safer to leave gold with a goldsmith who gave you a receipt.
b. The receipt could be exchanged for gold whenever you needed gold.
c. People soon began using the receipts as money since they knew the receipts were
backed 100 percent by gold.
d. At this point, there were two forms of money: gold and gold receipts.
7. The third step in the creation of money. Gold receipts become money.
a. Since so little gold was redeemed, the goldsmith began issuing more receipts than he had
in gold, and charged interest on the newly created gold receipts. He created money.
b. The goldsmith realized he could make more money in interest than he could earn in
goldsmithing.
c. The gold receipts were backed partly by gold and partly by people's trust that the
goldsmith would pay off in gold on demand. The goldsmith had become a banker.
8. Banking is profitable.
a. As the goldsmiths became wealthy, others jumped in offering to hold gold for free, or
even offering to pay for the privilege of holding the public's gold.
b. That is why most banks today are willing to hold the public's money at not charge -- they
can lend it out and in the process, make profits.
C. The money multiplier.
1. Reserves and reserve ratios.
a. Reserves are cash and deposits a bank keeps on hand or at the Fed or central bank,
enough to manage the normal cash inflows and outflows.
b. The reserve ratio is the ratio of cash (or deposits at the central bank) to deposits a
bank keeps as a reserve against cash withdrawals. The reserve ratio consists of required
and excess ratios.
(1) When banks are required by the Fed to hold a percentage of deposits, that percentage
is called the required reserve ratio.
(2) If banks choose to hold an additional amount, this is called the excess reserve ratio.
c. Banks "hold" currency for people and in return allow individuals to write checks for the
amount they have on deposit at the bank.
2. Determining how many demand deposits will be created.
a. It is possible to determine the total amount of money that will eventually be created by
multiplying the original amount, say a $100 loan, that was deposited and redeposited by 1/r,
where r is the reserve ratio.
b. For a reserve ratio of 10 percent, the formula would be: 1/r = 1/0.10 = 10. (10 X $100
(the original loan) = $1,000.
c. This means that $900 of new money was created ($1,000 - $100).
3. Calculating the money multiplier.
a. The ratio 1/r is called the simple money multiplier -- the measure of the amount of
money ultimately created per dollar deposited in the banking system, when people hold no
cash (Chapter Objective 6a).
b. The higher the reserve ratio, the smaller the money multiplier, and the less money will be
created.
4. An example of the creation of money.
a. Figure 29-3 shows the process through 10 rounds assuming a deposit of $10,000 and a
reserve ratio of 20 percent.
b. If banks keep excess reserves - reserves held by banks in excess of what banks are
required to hold -- for safety reasons, the money multiplier decreases
5. Calculating the approximate real world money multiplier.
a. The approximate real world money multiplier in the economy is 1/(r +c) where r =
the percentage of deposits banks hold in reserve and c is the ratio of money people hold in
cash to the money they hold as deposits.
b. An example: assume banks keep 8 percent in reserve and the ratio of individuals' cash
holdings to their deposits is 20 percent. The approximate real world money multiplier is:
1/(.08 +.20) = 1/.28 = 3.57.
D. Faith as the backing of our money supply.
1. Promises to pay underlie any financial system.
2. All that backs the modern money supply are bank loan customers' promises to pay and
the guarantee of the government to see that banks' liabilities to individuals will be met.

VI. Regulation of Banks and the Financial Sector.
A. Financial panics.
1. The financial history of the world is filled with stories of financial upheavals and monetary
problems.
2. In the U.S. in the 1800s, local banks were allowed to issue their own notes, which were
often worthless.
B. Anatomy of a financial panic.
1. Financial systems are based on trust that expectations will be fulfilled. Banks borrow
short and lend long, which means that if people lose faith in banks, the banks cannot keep
their promises.
2. If all the people, all at once, decided to ask for their money ("a run on a bank"), there
would not be nearly enough to satisfy everyone.
C. Government policy to prevent panic.
1. To prevent financial panics, the U.S. government has guaranteed the obligations of
various government institutions.
2. The most important guaranteeing program is the Federal Deposit Insurance Corporation
(FDIC).
a. The financial institutions, say a bank, pay a small premium for each dollar of deposit to
the FDIC.
b. The FDIC puts the money into a fund used to bail out banks experiencing a run on
deposits.
3. These guarantees have two effects:
a. They prevent the unwarranted fear that causes financial crises.
b. They prevent warranted fears.
D. The benefits and problems of guarantees.
1. The fact that deposits are guaranteed does not serve to inspire banks to make certain
deposits are covered by loans in the long run.
2. Since deposits are covered up to $100,000 by the FDIC, some financial institutions
make risky loans knowing that the guarantee is good.
E. The savings and loan bailout.
1. The deregulated S&Ls made so many bad loans that they failed.
2. The S&Ls could not repay depositors their money, so the government had to step in and
do it for them.
3. Banks and bad loans. How can banks make so many bad loans?
a. Part of the answer lay in out-and-out fraud. Part of it lies in the spread.
b. The spread is the difference between a bank's costs of funds and the interest it receives
on lending out those funds.
c. The S&Ls' cost of funds grew because of competition from other S&Ls.
d. The S&Ls were forced to make riskier loans to maintain the spread.
e. S&Ls bet there would be no recession -- they lost.

NOTE: For an in depth view of financial institutions and financial markets, see Appendix A,
"A Closer Look at Financial Institutions and Financial Markets."

NOTE: For an alternative approach to explaining the creations of money, see Appendix B,
"Creation of Money Using T-Accounts."

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   Lecture Notes Ch. 14       Monetary Policy and Macro Policies

I. Introduction

A. Monetary policy is that influences the economy through changes in the money supply and available credit.
1. Monetary policy, one of the two main traditional macroeconomic tools by which government attempts to control the aggregate economy.
2. Government (the President and Congress) control fiscal policy.
3. The Federal Reserve (The Fed) controls monetary policy.
4. What is the effect of monetary policy on the macro policy model?
a. Expansionary monetary policy shifts the AED curve to the right.
b. Contractionary monetary policy shifts the AED curve to the left.
c. In Range A, where the AS path is flat, real income will rise with expansionary monetary policy and decline with contractionary monetary policy. The price level is unaffected.
d. In Range C, where the AS path is vertical, real income does not change; the effect is on the price level and inflation.
e. In Range B, the effects are divided between real income and the price level.

B. Thus, the AS path is central to the effect one believes monetary policy will have on the economy.

II. Duties and Structure of the Fed
A. A central bank is a bankers' bank.
1. It conducts monetary policy and acts as financial adviser to the government.
2. If banks need to borrow money, they go to the central bank.
3. If there is a run on a bank, the central bank lends money to the imperiled bank until the danger has passed.
4. Its IOUs are cash, so simply issuing an IOU it can create money.

B. Historical influences in the Federal Reserve Bank's structure.
1. In Great Britain, the Bank of England is part of the government.
2. In the U.S., the Fed is not part of the government.

C. Structure of the Fed.
1. The Fed is a semi autonomous organization composed of 12 regional banks. It is run by a Board of Governors appointed by the President with the advice and consent of the Senate .
2. The Fed, although an agency of the federal government, has much more independence than most agencies.
a. The considerable profits the Fed earns are turned over to the U.S. Treasury, not to the 'owners,' the member banks.
b. Once appointed for a term of 14 years, governors cannot be removed from office, which means they can pretty well do what they think is right.
3. The seven Fed governors are paid less than they could receive in the private sector. Generally, the governors do not serve out their full terms but are recruited by private businesses for substantially higher salaries.
4. The President appoints one of the seven members to chairman of the Board of Governors for a four year term, generally conceded to be the second most powerful official in government.
5. Geographically, the Fed's districts reflects its political history, with nine of the twelve banks situated in the East and Midwest.

D. Duties of the Fed
1. Conducting monetary policy (influencing the supply of money and credit in the economy). This the most important job the Fed has to do.
2. Supervising and regulating financial institutions.
3. Serving as a lender of last resort to financial institutions.
4. Providing banking services to the U.S. government.
5. Issuing coin and currency.
6. Providing financial services such as check clearing to commercial banks, savings and loan associations, savings banks, and credit unions.

III. The Importance of Monetary Policy

A. Monetary policy is the Fed's most important job, and the most used policy in macroeconomics.
1. The Fed conducts it and controls it.
2. Actual decisions about monetary policy are made by the Federal Open Market Committee (FOMC) - the Fed's chief policymaking body.
a. The membership is made up of the seven members of the Board of Governors, together with the president of the New York Fed and a rotating group of four of the presidents of the other regional banks.
b. The actions of this group are closely watched - indeed some observers have made a career out of guessing with the Fed is likely to do in the future.

B. The conduct of monetary policy.
1. Bank reserves are IOUs of the Fed - either vault cash or deposits are the Fed. These are called the monetary base.
2. By controlling the monetary base, the Fed can influence the amount of money in the economy and the activities of commercial banks.
3. Other things being equal, as reserves decline, the interest rate will rise; and as reserves increase, interest rates will fall. Thus, monetary policy is concerned with the cost of money interest rates.

IV. Tools of Monetary Policy.

A. Changing the reserve requirement.
1. By law, the Fed controls the minimum percentage of deposits banks keep in reserve by controlling the reserve requirement of all U.S. banks.
2. The minimum is called the reserve requirement - the percentage the Federal Reserve System sets as the minimum amount of reserves a bank must have.
3. Required reserves and excess reserves.
a. For most banks, the Fed's reserve requirement determines what they hold as reserves.
(1) Banks hold as little in reserves as possible since they earn no interest on them
(2) In the late 1990s, required reserves for demand deposits were about 10 percent, and zero for all other accounts, making the reserve requirement for all liabilities a little under 2 percent.
b. In some situations, as in the Spring of 1992, banks have excess reserves available, but do not lend them out.
4. The reserve requirement and the money supply.
a. By changing the reserve requirement, the Fed can increase or decrease the money supply.
(1) If the Fed increases the reserve requirement, it contracts the money supply.
(2) Since they have less money to lend out, the decreased money multiplier (the multiple contraction of deposits occurring in response to a change in reserves) further contracts the money supply.
(3) If the Fed decreases the money supply, it expands the money supply.
(4) The money multiplier further expands the money supply.
b. The approximate real world money multiplier in the economy is 1/(r +c) where r = the percentage of deposits banks hold in reserve and c is the ratio of money people hold in cash to the money they hold as deposits.
c. An example: assume banks keep 8 percent in reserve and the ratio of individuals' cash holdings to their deposits is 20 percent. The approximate real world money multiplier is: 1/(.08 +.20) = 1/.28 = 3.57. So $1,000,000 in vault cash will support a total $3,570,000 money supply.
d. In reality, the cash-to-deposit ratio (c) is about 0.4 percent. As mentioned above, the average reserve requirement for demand deposits (r) is about 0.1 . So the realistic approximate money multiplier for demand deposits (M1) is: 1/(0.1 + 0.4) = 1/.5 = 2
e. An example: A $1,000,000 increase of reserves will support a $2,000,000 increase in demand deposits. For other deposits, the reserve requirement is much lower, so the money multiplier is larger for those.
f. What to do if there is a shortage of reserves.
(1) Go to the Federal funds market where the bank can borrow reserves from another bank that has excess reserves.
(2) If the Federal funds market dries up, the bank may stop making new loans and keep as reserves the proceeds of loans that are paid off.
(3) Sell Treasury bonds in order to get reserves. The bonds themselves cannot be used as reserves (they are sometimes called secondary reserves) but the cash that comes from their sales does.

B. Changing the discount rate.
1. This second tool of the Fed concerns an alternative to those listed above-borrow reserves directly from the Fed, the bankers' bank.
2. The discount rate is the rate of interest the Fed charges for those loans it makes to banks.
a. An increase in the rate of interest makes it more expensive for banks to borrow from the Fed.
b. A decrease in the rate of interest makes it less expensive for banks to borrow from the Fed.
c. Therefore, by changing the discount rate, the Fed can expand or contract the money supply.
3. In practice, the discount rate is generally lower than other rates banks would have to pay to borrow reserves? So why not just go to the Fed and pay the discount rate?
a. The Fed discourages banks from using this option.
b. Therefore, most banks do this as a last resort.
c. Fed auditors may show up if this option is overused.
4. The Fed uses announced changes in the discount rate as a signal that the Fed wants the money supply to either expand or contract.

C. Open market operations.
1. Changes in the discount rate and reserve requirements are not used in day-to-day operations of the Fed. These tools are used for major changes.
2. For day-to-day operations the Fed uses a third tool, open market operations - the Fed's buying and selling of government securities (the only type of asset the Fed is allowed by law to hold in any appreciable quantity).
a. To expand money supply, the Fed buys bonds.
b. To contract money supply, the Fed sells bonds.
3. Open market operations are the Fed's most used tool in controlling money supply.
4. Periodically, the FOMC decides what its open market operations will be and whether it want to expand or contract the money supply.
5. Examples of open market operations.
a. An open market purchase.
(1) When the Fed buys bonds, it deposits the money in federal government accounts at a bank.
(2) When the Fed pays the government for its bonds, bank cash reserves rise, encouraging the banks to lend out the excess.
(3) Money supply rises.
(4) Thus, an open market purchase is an example of expansionary monetary policy - usually defined to be a monetary policy that tends to reduce interest rates and raise income.
b. An open market sale.
(1) Here, the Fed sells bonds.
(2) In return for the bond, the Fed receives a check drawn against a bank.
(3) The bank's reserve assets are reduced and money supply falls.
(4) Thus, an open market sale is an example of contractionary monetary policy - usually defined to be a monetary policy that tends to raise interest rates and lower income.
c. What happens to bond prices and interest rates during this process?
(1) An open market purchase.
(a) When the Fed buys bonds in an open market purchase, it raises the demand for bonds.
(b) Bond prices rise and interest rates fall.
(c) This happens in an expansionary monetary policy.
(2) An open market sale.
(a) When the Fed sells bonds in an open market sale, the supply of bonds moves to the right, thereby lowering the demand for bonds.
(b) Bond prices fall and interest rates rise.
(c) This happens in a contractionary monetary policy.

G. The Fed funds market.
1. How the Fed funds market works.
a. Banks with surplus reserves can lend money to banks with a reserve shortage.
b. It is lent overnight as Fed funds - loans of their reserves banks make to each other.
c. Banks with surplus reserves will call a Federal funds dealer to learn the Federal funds rate - the interest rate banks charge each other for Fed funds.
d. This is all done electronically.
e. The Federal funds market - the market in which banks lend and borrow reserves is highly efficient.
(1) When banks have shortages of reserves (tight money) the interest rates are high; when banks have a surplus of reserves (loose money) interest rates are low.
(2) Generally, large city banks are borrowers of Fed funds, while small country banks are lenders of Fed funds.
2. Offensive and defensive actions.
a. The Federal funds rate is an important intermediate target.
b. At times of national emergencies, such as floods or earthquakes, when it is impossible for businesses or individuals to get to the bank to make loan payments - the Fed will step in and buy or sell bonds to offset such changes. These actions are called defensive actions.
c. Defensive actions are meant to maintain the current monetary policy.
d. Offensive actions are those meant to make monetary policy have expansionary or contractionary effects on the economy.
3. The Fed funds rate as an intermediate target.
a. Monetary policy affects interest rates such as the Federal funds rate.
b. The Fed looks at the Federal funds rate to determine whether monetary policy is tight or loose.
c. If the Federal funds rate goes above the Fed's target range, it buys bonds, which increases reserves and lowers the Federal funds rate.
d. If the Federal funds rate goes below the Fed's target range, it sells bonds, which decreases reserves and raises the Federal funds rate.

H. International considerations in the conduct of monetary policy.
1. A rise in the domestic interest rate tends to increase the demand for a nation's currency, and push up that nation's exchange rate. That currency will cost more in terms of the currencies of other nations.
2. A fall in a nation's interest rate works in the opposite direction.
3. An example:
a. A nation has decided to run an expansionary monetary policy, pushing its interest rate down.
b. The fall in the interest rate leads investors to invest elsewhere, lowering the value of that nation's currency and causing an outflow of financial resources.
c. The outflow tends to push interest rates back up.
d. If the nation has international agreements to keep its exchange rate at a certain level, this outflow must be offset in some manner.
I. Contrasting views of the channels of monetary policy- Keynesians vs. Classicals.

V. Monetary Policy in the Keynesian Model
A. In Keynesian terms, monetary policy is seen working primarily through its effect on interest rates.
1. The Fed decreases money supply (uses contractionary monetary policy).
a. The interest rates go up.
b. As interest rates go up, the quantity of investment goes down.
c. As investment goes down, aggregate demand goes down.
d. Through repercussion effects, aggregate equilibrium demand and income go down by a multiple of decrease in investment.
e. The AED curve shifts to the left by a multiple of the shift in investment.
2. Expansionary monetary policy works in the opposite direction.

B. Keynesian monetary policy in the circular flow.
1. If monetary and fiscal policy are needed, it is because the financial sector is in some ways clogged and is not correctly translating savings into investment.
2. Monetary policy works to unclog the financial sector.
3. Fiscal policy provides an alternative route for savings around the financial sector.
4. A government budget deficit absorbs excess savings and translates it back into the spending stream.
5. A government budget surplus supplements the shortage of savings and reduces the flow back into the spending stream.

C. The Keynesian emphasis on the interest rate.
1. They interpret a rising interest rate as a tightening monetary policy.
2. They interpret a falling interest rate as a loosening of monetary policy.
3. The early Keynesians advocated keeping the interest rate low.
4. Keynesians today advocate keeping the interest rate low enough to foster growth, but high enough to keep inflation in check - a difficult task indeed.

VI. Monetary Policy in the Classical Model

A. The quantity theory of money the theory that the price level varies in response to changes in the quantity of money.
1. The Classical quantity theory of money centers around the equation of exchange - an equation of 'quantity of money times velocity of money equals price level times the quantity of real goods sold.' This equation is:  MV = PQ
2. Where:
M = money supply
V = velocity of money (is constant and determined by institutional forces).
P = price level
Q = real output (is relatively constant and determined by real, not monetary forces)
3. PQ is the economy's nominal output (nominal GDP- the quantity of goods valued at whatever price level exists at the time.
4. V, the velocity of money, is the number of times per year, on average, a dollar goes around to generate a dollar's worth of income.
5. The Classicals make certain assumptions about the variables in the equation of exchange.
a. Velocity is constant.
(1) Its rate is determined by the economy's institutional structure.
(2) If velocity is constant, the quantity theory can be used to predict how much nominal GDP will grow if we know how much the money supply grows.
b. The second assumption is that Q is independent of the money supply. That is, Classicals believe Q is autonomous, meaning real output is determined by forces outside the quantity theory.
(1) If Q grows, it is because of incentives in the real economy.
(a) Thus, their policy analysis is on the real economy - the supply side of the economy, not the demand side.
(b) This assumption is called the veil of money assumption, which holds that real output is not influenced by changes in the money supply.
 (c) The veil of money assumption allows Classical economists to separate two puzzles - how the real economy works, and how the financial sector works.
(2) With both V and Q unaffected by changes in M, the only thing that can change is P. Classicals say that M and P would change by equivalent percentages.
c. The third assumption is the direction of causation - changes in money supply cause changes in the price level. The arrow of causation goes from left to right:      MV =  PQ
6. In summary, the Classicals view expansionary monetary policy as increasing M, and in the long run they believe this will simply increase the price level, P. Contractionary monetary policy will do the opposite. In the long run, monetary policy has no effect on real economic variables such as income or employment.

B. The Classical emphasis on money supply.
1. A large increase in money supply indicates expansionary monetary policy.
2. A large decrease in money supply indicates contractionary monetary policy.
C. 'Steady-as-you-go' policy.
1. Classicals favor a monetary policy that increases the money supply just enough each year to allow for the normal real growth of the economy.
2. They oppose the Keynesian policy of an activist monetary policy.
3. They feel that in the short run no one knows exactly what the outcome will be for an activist monetary policy.
4. They feel the markets are doing a pretty good job of coordinating savings and investment.
D. Real and nominal interest rates.
1. Classical point out the difference between real and nominal interest rates.
a. Nominal interest rates are those you actually see and pay.
b. Real interest rates are those adjusted for expected inflation.
2. The real interest rate cannot be observed since it depends on expected inflation, which cannot be directly observed.     Nominal interest rate = Real interest rate + Expected inflation rate.
E. Real and nominal interest rates and monetary policy.
1. The linkage between real and nominal interest rates and monetary policy is that if the expansionary monetary policy (for example) leads to expectations of increased inflation, nominal interest rates will go up.
2. The distinction between nominal and real interest rates strengthens the Classical case that the best monetary policy is an unchanging policy, since in the short run, the monetary policy's effects are too uncertain, and in the long run, they limply lead to changes in the price level.
3. Monetary policy in the Fed model of the 1990s.
a. The Fed is eclectic; sometimes it uses the Keynesian model and sometimes the Classical model.
b. Thus, they use both interest rates and money supply measures in their planning.

VII. Problems in the Conduct of Monetary Policy.

A. Knowing what policy to use.
1. The potential level of income must be known.
2. Otherwise you don't know whether to use expansionary or contractionary monetary policy.

B. Understanding the policy you're using.
1. In order to use monetary policy effectively, you must know whether the monetary policy you are using is expansionary or contractionary.
2. The money multiplier is influenced by both the amount of cash people hold as well as the lending process at the bank. Neither of these are stable numbers.
3. Then there are interest rates. If interest rates rise, is it because of expected inflation or is it that the real interest rate is going up?

C. Lags in monetary policy.
1. Monetary policy takes time to work. Just because the Fed drops interest rates, that does not necessarily mean that people or businesses will go out and borrow money.
2. In the face of a contractionary monetary policy, banks have been creative in circumventing cuts in the money supply.

D. Political pressure.
1. The Fed is not totally insulated from political pressure.
2. Presidents place great pressure on the Fed to loosen the purse strings, especially during an election year.

E. Conflicting international goals.
1. Monetary policy is conducted in an international arena.
2. It must be coordinated with other nations.

 Lecture Outline:   Chapter 14 The federal Reserve System and  Its Macro Monetary Policy

I. Introduction.
A. Monetary policy is that which influences the economy through changes in the money supply and available credit.
1. Monetary policy is one of the two main traditional macroeconomic tools by which government attempts to control the
aggregate economy.
2. Government (the President and Congress) control fiscal policy.
3. The Federal Reserve (the Fed) controls monetary policy.
B. What is the effect of monetary policy on the AS/AD model?
1. Expansionary monetary policy shifts the AD curve to the right.
2. Contractionary monetary policy shifts the AD curve to the left.
3. What effect contractionary or expansionary monetary policy will have on equilibrium income and the price level depends on
whether or not inflationary pressures will be set in motion.
4. That in turn depends on how close the economy is to potential income.
5. The supply conditions of the economy are central to the effect one believes monetary policy will have on the economy.
6. The general rule states that expansionary monetary policy increases nominal income. Its effect on real income depends on
how the price level responds.
% Real Income = % Nominal Income - % Price Level

II. Duties and Structure of the Fed
A. A central bank is a bankers' bank.
1. It conducts monetary policy.
2. If banks need to borrow money, they go to the central bank.
3. If there is a run on a bank, the central bank lends money to the imperiled bank until the danger has passed.
4. Its IOUs are cash, so by simply issuing an IOU it can create money.
5. In Great Britain, the Bank of England is part of the government.
6. In the U.S., the Fed is not part of the government.
B. Structure of the Fed is as follows:
1. The Fed is a semiautonomous organization composed of 12 regional banks. It is run by a Board of Governors appointed by
the President with the advice and consent of the Senate.
2. The Fed, although an agency of the federal government, has much more independence than most agencies.
a. The considerable profits the Fed earns are turned over to the U.S. Treasury, not to the "owners," the member banks.
b. Once appointed for a term of 14 years, governors cannot be removed from office, which means they can pretty well do what
they think is right.
3. The seven Fed governors are paid less than they could receive in the private sector. Generally, the governors do not serve
out their full terms but are recruited by private businesses for substantially higher salaries.
4. The President appoints one of the seven members to chairman of the Board of Governors for a four year term, generally
conceded to be the second most powerful official in government.
5. Geographically, the Fed's districts reflect its political history, with nine of the twelve banks situated in the East and Midwest.
D. Duties of the Fed
1. Conducting monetary policy (influencing the supply of money and credit in the economy). This the most important job the
Fed has to do.
2. Supervising and regulating financial institutions.
3. Serving as a lender of last resort to financial institutions.
4. Providing banking services to the U.S. government.
5. Issuing coin and currency. The disastrous Susan B. Anthony minted dollar was initially distributed through the banking
system. It bombed. When the new Sacagawea minted dollar was initially distributed not only through the Fed but also through
Wal-Mart and Sam's Club, the banks and small retailers howled. It worked. The demand for the new coin reached 200 million
in the first month. It took the Susan B. Anthony four years to reach that level. See: Julia Angwin, "Bankers Assail Mint for Deal
With Wal-Mart," The Wall Street Journal, February 9, 2000, p. B1.
6. Providing financial services such as check clearing to commercial banks, savings and loan associations, savings banks, and
credit unions.
E. The Importance of Monetary Policy
1. Monetary policy is the Fed's most important job, and the most - used policy in macroeconomics.
2. The Fed conducts it and controls it.
3. Actual decisions about monetary policy are made by the Federal Open Market Committee (FOMC) -- the Fed's chief
policymaking body.
a. The membership is made up of the seven members of the Board of Governors, together with the president of the New York
Fed and a rotating group of four of the presidents of the other regional banks.
b. The actions of this group are closely watched -- indeed some observers have made a career out of guessing with the Fed is
likely to do in the future.
F. The conduct of monetary policy.
1. Bank reserves are IOUs of the Fed -- either vault cash or deposits are the Fed. The monetary base is vault cash, currency
in circulation, and deposits at the Fed.
2. By controlling the monetary base, the Fed can influence the amount of money in the economy and the activities of
commercial banks.
3. Other things being equal, as reserves decline, the interest rate will rise; and as reserves increase, interest rates will fall. Thus,
monetary policy is concerned with the cost of money -- interest rates.

III. Tools of Monetary Policy
A. Changing the reserve requirement.
1. By law, the Fed controls the minimum percentage of deposits banks keep in reserve by controlling the reserve requirement
of all U.S. banks.
2. The minimum is called the reserve requirement -- the percentage the Federal Reserve System sets as the minimum amount
of reserves a bank must have.
B. Required reserves and excess reserves.
1. For most banks, the Fed's reserve requirement determines what they hold as reserves.
a. Banks hold as little in reserves as possible since they earn no interest on them
b. In the late 1990s, required reserves for demand deposits were about 10 percent, and zero for all other accounts, making the
reserve requirement for all liabilities a little under 2 percent.
2. In the late 1990s, excess reserves were about $1 billion.
C. The reserve requirement affects the money supply.
1. By changing the reserve requirement, the Fed can increase or decrease the money supply.
a. If the Fed increases the reserve requirement, it contracts the money supply.
b. Since they have less money to lend out, the decreased money multiplier (the multiple contraction of deposits occurring in
response to a change in reserves) further contracts the money supply.
c. If the Fed decreases the money supply, it expands the money supply.
d. The money multiplier further expands the money supply.
2. The approximate real world money multiplier in the economy is 1/(r +c) where r = the percentage of deposits banks hold in
reserve and c is the ratio of money people hold in cash to the money they hold as deposits.
3. An example: assume banks keep 8 percent in reserve and the ratio of individuals' cash holdings to their deposits is 20
percent. The approximate real world money multiplier is: 1/(.08 +.20) = 1/.28 = 3.57. So $1,000,000 in vault cash plus
currency will support a total $3,570,000 money supply.
4. In reality, the cash-to-deposit ratio (c) is about 0.4 percent. As mentioned above, the average reserve requirement for
demand deposits (r) is about 0.1 . So the realistic approximate money multiplier for demand deposits (M1) is: 1/(0.1 + 0.4) =
1/.5 = 2
5. An example: A $1,000,000 increase of reserves plus currency will support a $2,000,000 increase in demand deposits. For
other deposits, the reserve requirement is much lower, so the money multiplier is larger for those.
6. What to do if there is a shortage of reserves?
a. Go to the Federal funds market where the bank can borrow reserves from another bank that has excess reserves. This is
called the Federal Funds market. The rate of interest charged is the Federal Funds rate.
b. If the Federal funds market dries up, the bank may stop making new loans and keep as reserves the proceeds of loans that
are paid off.
c. Sell Treasury bonds in order to get reserves. The bonds themselves cannot be used as reserves (they are sometimes called
secondary reserves) but the cash that comes from their sales does.
D. Changing the discount rate.
1. This second tool of the Fed concerns an alternative to those listed above -- borrow reserves directly from the Fed, the
bankers' bank.
2. The discount rate is the rate of interest the Fed charges for those loans it makes to banks.
a. An increase in the rate of interest makes it more expensive for banks to borrow from the Fed.
b. A decrease in the rate of interest makes it less expensive for banks to borrow from the Fed.
c. Therefore, by changing the discount rate, the Fed can expand or contract the money supply.
3. In practice, the discount rate is generally lower than other rates banks would have to pay to borrow reserves. So why not
just go to the Fed and pay the discount rate?
a. The Fed discourages banks from using this option.
b. Therefore, most banks do this as a last resort.
c. Fed auditors may show up if this option is overused.
4. The Fed uses announced changes in the discount rate as a signal that the Fed wants the money supply to either expand or
contract.
E. Executing open market operations.
1. Changes in the discount rate and reserve requirements are not used in day-to-day operations of the Fed. These tools are
used for major changes.
2. For day-to-day operations the Fed uses a third tool, open market operations -- the Fed's buying and selling of
government securities (the only type of asset the Fed is allowed by law to hold in any appreciable quantity).
a. To expand money supply, the Fed buys bonds.
b. To contract money supply, the Fed sells bonds.
3. Periodically, the FOMC decides what its open market operations will be and whether it want to expand or contract the
money supply.
F. Examples of open market operations.
1. An open market purchase.
a. When the Fed buys bonds, it deposits the money in federal government accounts at a bank.
b. When the Fed pays the government for its bonds, bank cash reserves rise, encouraging the banks to lend out the excess.
c. Money supply rises.
d. Thus, an open market purchase is an example of expansionary monetary policy -- usually defined to be a monetary policy
that tends to reduce interest rates and raise income.
2. An open market sale.
a. Here, the Fed sells bonds.
b. In return for the bond, the Fed receives a check drawn against a bank.
c. The bank's reserve assets are reduced and money supply falls.
d. Thus, an open market sale is an example of contractionary monetary policy -- usually defined to be a monetary policy
that tends to raise interest rates and lower income.
3. What happens to bond prices and interest rates during this process?
a. An open market purchase.
(1) When the Fed buys bonds in an open market purchase, it raises the demand for bonds.
(2) Bond prices rise and interest rates fall.
(3) This happens in an expansionary monetary policy.
b. An open market sale.
(1) When the Fed sells bonds in an open market sale, the supply of bonds moves to the right, thereby lowering the demand for
bonds.
(2) Bond prices fall and interest rates rise.
(3) This happens in a contractionary monetary policy.
G. The Fed funds market.
1. How the Fed funds market works.
a. Banks with surplus reserves can lend money to banks with a reserve shortage.
b. It is lent overnight as Fed funds -- loans of their reserves banks make to each other.
c. Banks with surplus reserves will call a Federal funds dealer to learn the Federal funds rate -- the interest rate banks charge
each other for Fed funds
d. This is all done electronically.
(1) A fall in bond prices means a rise in interest rates.
(2) When the price of bonds rises, the interest rate falls.
(3) Thus, the price of bonds and the interest rate are inversely related.
e. The Federal funds market -- the market in which banks lend and borrow reserves -- is highly efficient.
(1) When banks have shortages of reserves (tight money) the interest rates are high; when banks have a surplus of reserves
(loose money) interest rates are low.
(2) Generally, large city banks are borrowers of Fed funds, while small country banks are lenders of Fed funds.
2. Offensive and defensive actions.
a. The Federal funds rate is an important intermediate target.
b. At times of national emergencies, such as floods or earthquakes -- when it is impossible for businesses or individuals to get
to the bank to make loan payments -- the Fed will step in and buy or sell bonds to offset such changes. These actions are
called defensive actions.
c. Defensive actions are meant to maintain the current monetary policy.
d. Offensive actions are those meant to make monetary policy have expansionary or contractionary effects on the economy.
3. The Fed funds rate as an intermediate target.
a. Monetary policy affects interest rates such as the Federal funds rate.
b. The Fed looks at the Federal funds rate to determine whether monetary policy is tight or loose.
c. If the Federal funds rate goes above the Fed's target range, it buys bonds, which increases reserves and lowers the Federal
funds rate.
d. If the Federal funds rate goes below the Fed's target range, it sells bonds, which decreases reserves and raises the Federal
funds rate.
4. The Taylor rule. For every percentage point inflation is above (below) the Fed's inflation target, the Fed funds rates will rise
(fall) by 1.5 percentage points; for every percentage point the economy's total output is above (below) its potential output, the
Fed funds rate will rise (fall) by half a percentage point.

IV. Monetary Policy in the AS/AD Model
A. In the AS/AD model, monetary policy works primarily through its effect on interest rates..
1. The Fed decreases money supply (uses contractionary monetary policy).
a. Interest rates go up.
b. As interest rates go up, the quantity of investment goes down.
c. As investment goes down, aggregate demand goes down.
d. Through multiplier effects, aggregate equilibrium demand and income down up by a multiple of decrease in investment.
e. The AD curve shifts to the left by a multiple of the shift in investment.
f. Thus:
2. Expansionary monetary policy works in the opposite direction.
B. Monetary policy in the circular flow
1. If monetary and fiscal policies are needed, it is because the financial sector is in some ways clogged and is not correctly
translating savings into investment.
2. Monetary policy works to unclog the financial sector.
C. The emphasis on the interest rate.
1. A rising interest rate indicates a tightening monetary policy.
2. A falling interest rate indicates a loosening of monetary policy.
3. A natural conclusion is that the Fed should target interest rates in setting monetary policy.
D. Real and nominal interest rates.
1. There is a problem in using interest rates as a measure of the tightness or looseness of monetary policy. That problem is the
real/nominal interest rate problem.
a. Nominal interest rates are those you actually see and pay.
b. Real interest rates are those adjusted for expected inflation.
2. The real interest rate cannot be observed since it depends on expected inflation, which cannot be directly observed.
Nominal interest rate = Real interest rate + Expected inflation rate.
E. Real and nominal interest rates and monetary policy.
1. Making a distinction between nominal and real interest rates adds another uncertainty to the effect on monetary policy.
a. If expansionary monetary policy leads to expectations of increased inflation, expansionary expansionary monetary policy can
increase nominal interest rates and leave real interest rates unchanged.
b. Why? Because of expectations of increased inflation.
2. The possible effect of monetary policy on expectations of inflation has led most economists to conclude that a monetary
regime, not a monetary policy is the best approach to policy.
a. A monetary regime is a rule; it is a predetermined statement of the policy that will be followed in various situations.
b. On the other hand, a monetary policy is a policy response to events. It is chosen without a predetermined framework.
3. The monetary regime the Fed is currently following involves feedback rules that center on the federal funds rate.
a. If inflation is above its target, the Fed raises the federal funds rate by selling bonds thereby increasing the money supply, in an
attempt to slow inflation down.
b. If inflation is below its target, and if the economy is sliding into a recession, the Fed lowers the federal funds rate by buying
bonds thereby decreasing the money supply.

V. Problems in the Conduct of Monetary Policy
A. Knowing what policy to use.
1. The potential level of income must be known.
2. Otherwise you don't know whether to use expansionary or contractionary monetary policy.
B. Understanding the policy you're using.
1. In order to use monetary policy effectively, you must know whether the monetary policy you are using is expansionary or
contractionary.
2. The money multiplier is influenced by both the amount of cash people hold as well as the lending process at the bank.
Neither of these are stable numbers.
3. Then there are interest rates. If interest rates rise, is it because of expected inflation or is it that the real interest rate is going
up?
C. Lags in monetary policy.
1. Monetary policy takes time to work. Just because the Fed drops interest rates, that does not necessarily mean that people or
businesses will go out and borrow money.
2. In the face of a contractionary monetary policy, banks have been creative in circumventing cuts in the money supply.
D. Political pressure.
1. The Fed is not totally insulated from political pressure.
2. Presidents place great pressure on the Fed to loosen the purse strings, especially during an election year.
E. Conflicting international goals.
1. Monetary policy is conducted in an international arena.
2. It must be coordinated with other nations.

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