Monetary Policy (chapter 26)

1. TOPIK 9 : DASAR-DASAR MAKROEKONOMI Monetary Policy(chapter 26)

2. What Is Monetary Policy? • Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives. • The Goals of Monetary Policy • The Fed has set four monetary policy goals that are intended to promote a well-functioning economy: • PRICE STABILITY • HIGH EMPLOYMENT • ECONOMIC GROWTH • STABILITY OF FINANCIAL MARKETS AND INSTITUTIONS

3. PRICE STABILITY • During the inflation • HIGH EMPLOYMENT • Unemployed workers and underused factories, office buliding reduce GDP below its potential level. • ECONOMIC GROWTH • To raise living standard by providing incentives for saving to ensure large pool of investment funds as well as providing direct incentives for business investment. • STABILITY OF FINANCIAL MARKETS AND INSTITUTIONS • An efficient flow of funds from savers to borrowers.

4. 26 - 2 The Demand for Money The Money Market and the Fed’s Choice of Targets • Monetary Policy Targets • The Demand for Money • Monetary policy target: • money supply; • interest rate

5. 26 - 3 Shifts in the Money Demand Curve • Shifts in the Money Demand Curve

6. The Demand for Money • When interest rates low cause household and firms to switch from financial assets (treasury bill) to money, so the quantity of money demanded will increase. • The demand curve for money is downward sloping. • Shifts in the Money Demand Curve • Changes in real GDP and the price level cause money demand curve to shift. • An increase in real GDP (the amount of buying and selling in goods and services) or an increase in the price level will cause the money demand curve shift form MD1 to MD2.

7. 26 - 4 The Impact on the InterestRate When the Fed Increasesthe Money Supply • How the Fed Manages the Money Supply: A Quick Review • Equilibrium in the Money Market When Fed increase MS, h/h and firms will hold more money. H/h and firms buy bills & other financial assets with money (more). This increase in demand drives up the prices of these assets & drives down interest rate. Interest rate fall, h/h and firms hold money causes MS curves shift to the right.

8. 26 - 5 The Impact on Interest Rates When the Fed Decreasesthe Money Supply • Equilibrium in the Money Market When Fed decreases the money supply, h/h & firms will hold less money. H/h & firms will sell bill & other financial assets, reducing their prices & increasing interest rates. Reduction in money supply causes money supply curve shift to the left.

9. 26 - 1 What is the price of a Treasury bill that pays $1,000 in one year, if its interest rate is 4 percent? What is the price of the Treasury bill if its interest rate is 5 percent? The Relationship between Treasury Bill Prices and Their Interest Rates $1,000 1.04 $1,000 – P = 0.04P $1,000 = 1.04P P = = $962

10. Choosing a Monetary Policy Target • Feds chooses the MS or IR as its monetary policy. • Fed has generally focused more on IR than MS. • The Importance of the Federal Funds Rate • Federal funds rate The interest rate banks charge each other for overnight loans. • Banks that need additional reserves can borrow in the federal funds market from banks that have reserves available. • Feds does not set the federal funds rate, but its ability to increase or decrease bank reserves through open market operations keeps the actual federal funds rate close to Fed’s target rate.

11. Monetary Policy and Economic Activity • How Interest Rates Affect Aggregate Demand • Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: • Consumption • Lower IR caused increased in spending on durables because they lower the cost of these goods to consumersby lowering interest payments on loans – AD • Investment • Lower IR makes it less expensive for firms to borrow, so they will undertake more investment - AD • Net exports • If IR in US rise relative to other countries, causing foreign investors to increase their demand for dollars, which increase the vakue of dollars & NX will fall – AD

12. 26 - 7 An Expansionary Monetary Policy The Effects of Monetary Policy on Real GDP and the Price Level

13. The Effects of Monetary Policy on Real GDP and the Price Level • Expansionary monetary policyThe Federal Reserve’s increasing the money supply and decreasing interest rates in order to increase real GDP. (MS , IR ) • Figure 26.7 • The economy begins at equilibrium at point A, with real GDP of $12 t and price at $100. • Without monetary policy, AD shift from AD1 to AD2 which is not enough to keep the economy at full employment because LRAS has shifted from LRAS1 to LRAS2. • The economy will be in SR equilibrium at point B ($12.3 t, $102). • By lowering interest rates, the Fed increases I, C and NX which shift AD to AD2 (with policy-decrease interest rate). • The economy will be in equilibrium at point C ($12.4 t, $103), which is its full employment.

14. 26 - 8 A Contractionary MonetaryPolicy in 2000 Using Monetary Policy to Fight Inflation

15. Using Monetary Policy to Fight Inflation • Contractionary monetary policyThe Fed’s adjusting the money supply to increase interest rates to reduce inflation. • Figure 26.8 • The economy began at point A (equilibrium), with GDP $9.5 t and price level $97.9. • Potential real GDP increased from $9.3 t to $9.6 t (LRAS1999 to LRAS2000). • Without policy, AD shifted from AD1999 to AD2000(wop), and SR equilibrium at point B ($10 t, $102) • With policy (increase interest rate), AD increasing only to AD2000 (wp) and equilibrium at point C with real GDP $9.8 t and price level rising only to $100.

16. Example; If Fed want to keep real GDP at its potential level in 2011, should it use an expansionary policy or contractionary policy? Answer; The tables tells us that without monetary policy, the economy will be below its potential real GDP in 2011. To keep real GDP at its potential level, the Fed must undertake expansionary policy (effects on real GDP and price level). To implement an expansionary policy, Fed needs to buy Treasury bills. Buying Treasury bills will increase reserves in the banking system. Banks will increase their loans, which will increase the MS and lower the interest rate.

17. 26 - 2 • The Effects of Monetary Policy (cont’d.)

18. A Summary of How Monetary Policy Works

19. 26 - 10 The Fed Can’t Target Boththe Money Supply and theInterest Rate A Closer Look at the Fed’s Setting of Monetary Policy Targets • Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? (disequilibrium) The Fed is forced to choose between using interest rate or MS. It can’t have both because only combinations of the interest rate and the MS that represent equilibrium in the money market are possible.

20. The Taylor Rule • Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. • Begins with an estimate of the value of the equilibrium rate federal funds rate, which is the federal funs rate - adjusted for inflation - that would be consistent with real GDP being equal to potential GDP in the LR • Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap The difference btwn current inflation & a target rate The % difference btwn real GDP & potential GDP

21. Should the Fed Target Inflation? • Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. • By announcing an inflation target, the Fed make it easier for h/h & firms to form expectations of future inflation, improving their planning & the efficiency of the economy. • An announced inflation target would help good monetary policy. • An inflation target would promote accountability for the Fed by providing yardstick against which its performance could be measured.

22. Is the Independence of theFederal Reserve a Good Idea? The Case for Fed Independence • Independent - is to avoid inflation • Whenever a G spending more than its collecting, it must borrow the difference by selling bonds (sell to central bank). The more the bonds the central bank buys, the faster the MS grows & inflation will be higher. • G may use to that control to its political interest. Increase MS – decrease interest rates to increase production and employment before election. The Case against Fed Independence • Policy was decided by FOMC so they are not accountable for their actions to the ultimate authorities in a democracy. • Chairman & FOMC has full authority to make decisions based on its own experience, analysis and discussion among them.