Economics Chapter 14 The Interest Rate Paid Reserves Now Tool

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Chapter 14

Monetary Policy and the Federal Reserve System

◼ Learning Objectives

I. Goals of Chapter 14

A. Explain how the nation’s money supply is determined (Sec. 14.1)

II. Notes to Eighth Edition Users

A. We expand our discussion of central banks performing a function as the lender of last resort

Chapter 14 Monetary Policy and the Federal Reserve System 341

◼ Teaching Notes

I. Principles of Money Supply Determination (Sec. 14.1)

A. Three groups affect the money supply

1. The central bank is responsible for monetary policy

2. Depository institutions (banks) accept deposits and make loans

3. The public (people and firms) holds money as currency and coin or as bank deposits

2. Banks hold liquid assets called bank reserves

a. When bank reserves are equal to deposits, the system is called 100% reserve banking

b. But banks lend out some of their deposits, as only a fraction of reserves are needed to

Numerical Problem 1 gives students practice dealing with bank balance sheets.

C. Open-market operations

1. The most direct and frequently used way of changing the money supply is by raising or

Policy Application

Most of the use of open-market operations turns out not to be related to changes in monetary

D. The money multiplier

1. The relationship between the monetary base and the money supply can be shown

algebraically

342 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

M/BASE = (CU + DEP)/(CU + RES) (14.3)

6. This can be written as

M/BASE = [(CU/DEP) + 1]/[(CU/DEP) + (RES/DEP)] (14.4)

7. The currency–deposit ratio (CU/DEP, or cu) is determined by the public

Numerical Problems 2 and 3 deal with the money multiplier.

11. The monetary base is called high-powered money because each unit of the base that is issued

leads to the creation of more money

E. Bank runs

1. If people think a bank won’t be able to give them their money, they may panic and rush to

F. Application: The money multiplier during severe financial crises

1. The money multiplier during the Great Depression

a. The money multiplier is usually fairly stable, but it fell sharply in the Great Depression

Chapter 14 Monetary Policy and the Federal Reserve System 343

d. As a result, the price level fell sharply (nearly one-third) and there was a decline in output

(though attributing the drop in output to the decline in the money supply is controversial)

2. The money multiplier during the financial crisis of 2008

a. The worldwide financial panic in fall 2008 caused the money multiplier to decline

II. Monetary Control in the United States (Sec. 14.2)

A. The Federal Reserve System

1. The Fed began operation in 1914 for the purpose of eliminating severe financial crises

Policy Application

What do the twelve Federal Reserve Bank do? First, they clear checks between banks and supply

currency to banks. They also supervise and regulate banks. They collect the raw data that goes

3. The leadership of the Fed is provided by the Board of Governors of the Federal Reserve

System in Washington, D.C.

a. There are seven governors, who are appointed by the president of the United States,

Policy Application

There are a number of features of the setup of the Fed designed to prevent undue political

4. Monetary policy decisions are made by the Federal Open Market Committee (FOMC),

which consists of the seven governors plus five presidents of the Federal Reserve Banks

on a rotating basis (with the New York president always on the committee)

344 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

b. It may meet more frequently if economic developments warrant

Policy Application

The policymakers on the FOMC are briefed by economists before each meeting. A typical

B. The Federal Reserve’s balance sheet and open-market operations

1. Balance sheet of Fed (text Table 14.2)

a. Largest asset is holdings of Treasury securities

b. Also owns mortgage-backed securities, federal agency debt, and gold, makes loans to

Analytical Problem 1 looks at various effects on the money supply, some through changes in the

Fed’s balance sheet.

2. The monetary base equals banks’ reserves plus currency held by the nonbank public

(text Figure 14.6)

Policy Application

The FOMC generally votes on three options concerning immediate changes in policy: option A

C. Reserve requirements

1. The Fed forces banks to hold reserves of about 10% of the value of their transactions

deposits (less for small banks)

Chapter 14 Monetary Policy and the Federal Reserve System 345

Policy Application

Changes in reserve requirements are such a powerful tool that they aren’t used much. A small

change in reserve requirements can make a big difference in the reserves a bank holds. So

D. Discount window lending

1. Discount window lending is lending reserves to banks so they can meet depositors’

Policy Application

The formal mechanism by which the discount rate is changed is rather complicated. The board of

directors of each Federal Reserve Bank must vote every two weeks on the discount rate. They

3. The Fed was set up to halt financial panics by acting as a lender of last resort through the

discount window

4. A discount loan increases the monetary base

Policy Application

The Fed has three different categories for lending at the discount window: (1) adjustment credit,

which is a short-term loan to help banks meet temporary liquidity needs; (2) seasonal credit,

E. Application: The lender of last resort

1. Central bankers can reduce the damage to the economy from a financial crisis by acting as a

F. Interest rate on reserves

1. In the financial crisis that began in 2008, the Fed began paying interest to banks on their

reserves held on deposit at the Fed

346 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

2. The payment of interest on reserves gives banks the incentive not to spend resources

avoiding holding reserves

G. Summary 19: Factors affecting the monetary base, the money multiplier, and the money supply

1. An increase in res, cu, reserve requirements, or the interest rate on reserves has no effect

Policy Application

The Fed has two other instruments, though they are seldom used. The Fed can set margin

requirements on stock purchases. Currently, the margin requirements is 50%, which means an

III. Setting Monetary Policy Targets (Sec. 14.3)

A. Targeting the federal funds rate

1. The Fed uses intermediate targets to guide policy as a step between its tools or instruments

(such as open-market purchases) and its goals or ultimate targets of price stability and stable

economic growth

2. Intermediate targets are variables the Fed can’t directly control but can influence predictably,

Chapter 14 Monetary Policy and the Federal Reserve System 347

Figure 14.1

a. This strategy works well if the main shocks to the economy are to the LM curve

(shocks to money supply or money demand)

d. Suppose a shock shifts the IS curve to the right from IS1 to IS2 (Figure 14.2; text

Figure 14.9)

(1) If the Fed were to maintain the real interest rate, it would increase the money supply,

shifting the LM curve from LM1 to LM2, thus making output rise even more, which

348 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

6. The LR curve

a. If the Fed is targeting a real interest rate, then a modification of the LM curve will

simplify our analysis

Chapter 14 Monetary Policy and the Federal Reserve System 349

Analytical Problem 3 examines how various shocks shift the LR curve and how the economy

responds.

Policy Application

Monetary policymakers sometimes distinguish intermediate targets from what are called

operating targets. In this context an operating target is a variable that is closely affected by the

IV. Making Monetary Policy in Practice (Sec. 14.4)

A. The IS–LM model makes monetary policy look easy—just change the money supply to move

the economy to the best point possible

B. Lags in the effects of monetary policy

1. It takes a fairly long time for changes in monetary policy to have an impact on

350 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

6. Because of the lags, policy must be made based on forecasts of the future, but forecasts are

often inaccurate

Policy Application

Alan Blinder, an economist from Princeton University who served several years in the Federal

C. Conducting Monetary Policy Under Uncertainty

1. Uncertainty about state of economy

a. Conflicting signals from data

2. Incomplete models of the economy

a. No one knows the best model that describes the economy (classical vs. Keynesian,

slopes and locations of curves, levels of full-employment output and natural rate of

3. Uncertainty about how expectations of public will be affected by shocks and policy

actions

D. Monetary Policy in the Great Recession

1. The housing crisis, which began in 2007, led to losses at financial institutions, but no one

thought it would lead to a major financial crisis

2. In the Great Recession, the economy deteriorated rapidly in late 2008 and early 2009; the

recession rivaled those of 1973–1975 and 1981–1982, and the recovery from the

recession was weak

3. The Zero Lower Bound

Chapter 14 Monetary Policy and the Federal Reserve System 351

(b) Quantitative easing also reduces long-term interest rates

E. Application: The financial crisis of 2008

1. Financial institution troubles that began in 2007 represented a shock, shifting the IS curve

down and to the left as housing investment declined

2. Banks began to reduce credit availability because of worries that some financial

V. The Conduct of Monetary Policy: Rules Versus Discretion (Sec. 14.5)

A. Monetarists and classical macroeconomists advocate the use of rules

1. Rules make monetary policy automatic, as they require the central bank to set policy based

352 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

B. Most Keynesian economists support discretion

1. Discretion means the central bank looks at all the information about the economy and uses its

C. The monetarist case for rules

1. Monetarism is an economic theory emphasizing the importance of monetary factors

in the economy

2. The leading monetarist is Milton Friedman, who has argued for many years (since 1959)

that the central bank should follow rules for setting policy

3. Friedman’s argument for rules comes from four main propositions

a. Proposition 1: Monetary policy has powerful short-run effects on the real economy. In the

longer run, however, changes in the money supply have their primary effect on the price

b. Proposition 2: Despite the powerful short-run effect of money on the economy, there is

little scope for using monetary policy actively to try to smooth business cycles

(1) First, the information lag makes it difficult to know the current state of the economy

c. Proposition 3: Even if there is some scope for using monetary policy to smooth business

cycles, the Fed cannot be relied on to do so effectively

(1) Friedman believes the Fed responds to political pressure and tends to stimulate the

economy in election years

(2) Historically, monetary policy has tended to destabilize, rather than stabilize, the

economy; so eliminating monetary policy as a source of instability would improve

D. Rules and central bank credibility

1. New arguments for rules suggest that rules are valuable even if the central bank has a lot of