Monetary Policy and

the Economy
Maimoona sajid butt
 Introduction
• The Fed determines the level of short-term
interest rates and lends money to financial
institutions, thereby profoundly affecting
financial markets, wealth, output employment
and prices.
• The Federal Reserve’s central goals are to ensure
• low inflation,
• steady growth in national output,
• low unemployment,
• and orderly financial markets.
• If output is growing rapidly and inflation is
rising, the Federal Reserve Board is likely to raise
interest rates,putting a brake on the economy
and reducing price pressures.
• Every country has a central bank that is
responsible for managing the country’s
monetary affairs.
 A. CENTRAL BANKING AND
THE FEDERAL RESERVE SYSTEM
• an overview of central banking.
• The next section provides the details about
the different tools employed by the central
bank and explains how they can be used to
affect short-term interest rates.
 THE ESSENTIAL ELEMENTS OF
CENTRAL BANKING
• A central bank is a government organization
that is primarily responsible for the monetary
affairs of a country.
 History
• During the nineteenth century, the United
States was plagued by banking panics. These
occurred when large numbers of people
attempted to convert their bank deposits into
currency all at the same time.
• Federal Reserve Act of 1913
 Structure
• 12 regional Federal Reserve Banks, located in New York,
Chicago, Richmond, Dallas, San Francisco, and other major
cities. The regional structure was originally designed in the
populist age to ensure that different areas of the country
would have an equal voice in banking matters and to avoid
a great concentration of central-banking powers in
Washington or in the hands of the Eastern bankers.
• Today, the Federal Reserve Banks supervise banks in their
districts, operate the national payments system, and
participate in the making of national monetary policy.
• The key decision-making body in the Federal
Reserve System is the Federal Open Market
Committee (FOMC).
 Goals of Central Banks
• Multiple objectives. Many central banks have
general goals, such as to maintain economic
stability. Among the specific objectives
pursued might be low and stable inflation, low
unemployment, rapid economic growth,
coordination with fiscal policy, and a stable
exchange rate.
 Inflation targeting.
• In recent years, many countries have adopted
explicit inflation targets. Under such a
mandate, the central bank is directed to
undertake its policies so as to ensure that
inflation stays within a range that is generally
low but positive. For example, the Bank of
England has been directed to set monetary
policy to maintain a 2 percent annual inflation
rate.
 Exchange-rate targeting.
• In a situation where a country has a fixed
exchange rate and open financial markets, it
can no longer conduct an independent
monetary policy. In such a case, the central
bank can be described as setting its monetary
policy to attain an exchange-rate target.
• Today this is interpreted as a dual mandate to
maintain low and stable inflation along with a
healthy real economy.
 Functions of the Federal Reserve
• The Federal Reserve has four major functions:
● Conducting monetary policy by setting short term
interest rates
● Maintaining the stability of the financial system
and containing systemic risk as the lender of last
resort
● Supervising and regulating banking institutions
● Providing financial services to banks and the
government
 Central-Bank Independence
• The Federal Reserve is an independent agency. While it
consults with Congress and the president, in the end the
Fed decides monetary policy according to its own views
about the nation’s economic interests. As a result, the Fed
sometimes comes into conflict with the executive branch.
Almost every president has words of advice for the Fed.
When Fed policies clash with the administration’s goals,
presidents occasionally use harsh words. The Fed listens
politely but generally chooses the path it deems best for
the country, for its decisions do not have to be approved
by anybody.
• Defenders of the Fed’s independence respond
that an independent central bank is the guardian of
a nation’s currency and the best protector against
Inflation
Historical studies show that countries with
independent central banks have generally been
more successful in keeping inflation down than
have those whose central banks are under the
control of elected officials.
 HOW THE CENTRAL BANK
DETERMINES SHORT-TERM
INTEREST RATES
• Central banks are at the center stage of
macroeconomics because they largely
determine short-term interest rates.
 Overview of the Fed’s Operations
• The Federal Reserve conducts its policy through
changes in an important short-term interest rate
called the federal funds rate .
• This is the interest rate that banks charge each other
to trade reserve balances at the Fed. It is a short-
term (overnight) risk free interest rate in U.S. dollars.
• The Fed controls the federal funds rate by exercising
control over the following important instruments of
monetary policy:
 Open-market operations
• buying or selling U.S. government securities in
the open market to influence the level of bank
reserves
 Advantages of
Open Market Operations
• The Fed has complete control over
the volume
• Flexible and precise
• Easily reversed
• Quickly implemented

Copyright © 2007 Pearson Addison-Wesley.

18-20
All rights reserved.
 Discount-window lending
• setting the interest rate, called the discount rate, and
the collateral requirements with which commercial
banks, other depository institutions, and, more
recently, primary dealers can borrow from the Fed.
• The discount window is an instrument of
monetary policy (usually controlled by central banks)
that allows eligible institutions to borrow money
from the central bank, usually on a short-term basis,
to meet temporary shortages of liquidity caused by
internal or external disruptions.
 Reserve-requirements policy
• setting and changing the legal reserve-ratio
requirements on deposits with banks and
other financial institutions
 Basic description of monetary policy
• When economic conditions change, the Fed
determines whether the economy is departing from
the desired path of inflation, output, and other
goals. If so, the Fed announces a change in its target
interest rate, the federal funds rate. To implement
this change, the Fed undertakes open-market
operations and changes the discount rate. These
changes then drop through the entire range of
interest rates and asset prices, and eventually
change the overall direction of the economy.
 Balance Sheet of the Federal
Reserve Banks
• There are two unique items among the Fed’s liabilities:
currency and reserves. Currency is the Fed’s
principal liability. This item comprises the coins and
the paper bills we use every day. The other major liability
is reserve balances of banks, which are balances
kept on deposit by commercial banks. These deposits,
along with the banks’ vault cash, are designated as
bank reserves .
 HOW THE FEDERAL RESERVE
AFFECTS BANK RESERVES
• The most important element of monetary
policy is the determination of bank reserves
through Fed policy.
 Open-Market Operations
• Open-market operations are a central bank’s
primary tool for implementing monetary
policy. These are activities whereby the Fed
affects bank reserves by buying or selling
government securities on the open market.
• How does the Fed decide how much to buy or
sell? The Fed looks at the factors underlying reserve
demand and supply and determines whether those
trends are consistent with its target for the federal
funds rate. On the basis of this forecast, the Fed will
buy or sell a quantity of government securities that
will help keep the funds rate near the target.
 Discount-Window Policy: A Backstop
for Open-Market Operations
• The Fed has a second set of instruments that it
can use to meet its targets. The discount
window is a facility from which banks, and more
recently primary dealers, can borrow when they
need additional funds.
• The Fed charges a “discount rate” on borrowed
funds, although the discount rate will vary slightly
among different uses and institutions.
The discount window serves two purposes.

• It complements open-market operations by

making reserves available when they are
needed on short notice.
• It also serves as a backstop source of liquidity
for institutions when credit conditions may
suddenly become tight.
 Lender of Last Resort.
• Financial intermediaries like banks are inherently unstable
because, as we have seen, their liabilities are short-term and
subject to rapid withdrawal while their assets are often long
term and even illiquid. From time to time, banks and
other financial institutions cannot meet their obligations
to their customers. Perhaps there are seasonal
needs for cash, or perhaps, depositors may lose faith in
their banks and withdraw their deposits all at once. In this
situation, when the bank has run out of liquid assets and
lines of credit, a central bank may step in to be the lender of
last resort
The Role of Reserve Requirements
• In an earlier period, reserve requirements were an
important part of controlling the quantity of money .In
today’s environment, where the Fed primarily targets
interest rates, reserve requirements are a relatively
unimportant instrument of monetary policy.
• Reserve requirements apply to all types of checking
deposits. Under Federal Reserve regulations, banks are
required to hold a fixed fraction of their checking deposits
as reserves. This fraction is called the required reserve
ratio. Bank reserves take the form of vault cash (bank
holdings of currency) and deposits by banks with the
Federal Reserve System.
Determination of the Federal Funds Rate

• we can analyze how the Fed determines short-term

interest rates
• First, consider the demand for bank reserves.
banks are required to hold reserves as determined
by the total value of their checking deposits and the
required reserve ratio. Because the demand for
checking deposits is an inverse function of the
interest rate, this implies that the demand for bank
reserves will also decline as interest rates rise.
 supply of reserves
• This is determined by open-market operations. By purchasing
and selling securities, the Fed controls the level of reserves in
the system. A purchase of securities by the Fed increases the
supply of bank reserves, while a sale does the opposite.
• The equilibrium federal funds interest rate is determined where
desired supply and demand are equal.
• The important insight here is that the Fed can achieve its target
through the judicious purchase and sale of securities—that is,
through open-market operations. The Fed has a target interest
rate at if f*. By supplying the appropriate quantity of reserves at
R* through open-market operations, the Fed achieves its target.
But Figure 24-3 shows only
the very short run
supply and demand. Because
the Fed intervenes in
the market daily, and
because market participants
know the Fed’s interest-rate
target, the Fed can keep
the federal funds rate close
to its target
 By Constant Intervention the Fed Can
Achieve Its Interest-Rate Target
• Because the Fed intervenes daily, undertaking
open-market operations as illustrated in
Figure 24-3, it can achieve its target with a
narrow margin.
 B. THE MONETARY
TRANSMISSION MECHANISM
• We sketched the mechanism at the beginning of the
previous chapter, and now we describe the mechanism in
greater detail.
• The central bank raises the interest-rate target. The
central bank announces a target short-term interest rate
chosen in light of its objectives and the state of the
economy. The Fed may also change the discount rate and
the terms of its lending facilities. These decisions are
based on current economic conditions, particularly
inflation, output growth, employment, and financial
conditions.
• The central bank undertakes open-market operations.
The central bank undertakes daily open-market
operations to meet its federal funds target. If the Fed
wished to slow the economy, it would sell securities,
thereby reducing reserves and raising short-term
interest rates; if a recession threatened, the Fed
would buy securities, increasing the supply of
reserves and lowering short-term interest rates.
Through open-market operations, the Fed keeps the
short-term interest rate close to its target on average
• Asset markets react to the policy changes. As the
short term interest rate changes, given expectations
about future financial conditions, banks adjust their
loans and investments, as well as their interest rates
and credit terms. Changes in current and expected
future short-term interest rates , along with other
financial and macroeconomic influences, determine
the entire spectrum of longer-term interest rates.
Higher interest rates tend to reduce asset prices
(such as those of stocks, bonds, and houses). Higher
interest rates also tend to raise foreign-exchange
rates in a flexible-exchange-rate system.
• Investment and other spending react to interest-rate
changes. Suppose the Fed has raised interest rates to
reduce inflation. The combination of higher interest
rates, tighter credit, lower wealth, and a higher
exchange rate tends to reduce investment,
consumption, and net exports. Businesses scale down
their investment plans. Similarly, when mortgage
interest rates rise, people may postpone buying a
house, lowering housing investment. In addition, in
an open economy, the higher foreign-exchange rate
of the dollar will depress net exports. Hence, tight
money will reduce spending on interest-sensitive
components of aggregate demand.
• Monetary policy will ultimately affect output and
price inflation. The aggregate supply-and-demand
analysis (or, equivalently, the multiplier analysis)
showed how changes in investment and other
autonomous spending affect output and
employment.
• If the Fed tightens money and credit, the
decline in AD will lower output and cause prices
to rise less rapidly, thereby curbing inflationary
forces.
We can summarize the steps as follows:

• Change in monetary policy

• → change in interest rates, asset prices,
exchange rates
• → impact on I, C, X
• → effect on AD
• → effect on Q , P
 The Effect of Changes in Monetary
Policy on Output
• Interest Rates and the Demand for
Investment This diagram puts together two
diagrams we have met before: the supply of
and demand for reserves in ( a ) and the
demand for investment in ( b ).
We
have simplified our analysis by
assuming that there In this simplified situation, the
is no inflation, no taxes, and no real interest rate ( r ) equals
risk, with the result the central bank’s interest
that the federal funds interest rate ( iff ). Monetary policy
rate in (a) is the same leads to interest rate
as the cost of capital paid by r *, which then leads to the
business and residential corresponding level of
investors in ( b ). investment I *.
• Next, consider what happens when economic
conditions change. Suppose that economic
conditions deteriorate. This could be the result of a
decline in military spending after a war, or the result
of a decline in investment due to the burst of a
bubble, or the result of a collapse in consumer
confidence after a terrorist attack. The Fed would
examine economic conditions and determine that it
should lower short term interest rates through
open-market purchases.
• This would lead to the downward shift in interest
rates from r* to r** shown in Figure 24-6(a).
As interest
rates decline and holding
other things constant, the
demand for investment
would increase from I * to
I **.
Changes in Investment and Output
• The final link in the mechanism is the impact
on aggregate demand as shown in Figure 24-7.
This is the same diagram we used to illustrate
the multiplier mechanism in Chapter22.
We have shown the C I G curve of
total
expenditure as a function of total
output on the horizontal
axis. With the original interest rate r
*, output
is at the depressed level Q * before
the central bank
undertakes its expansionary policy.

This diagram
shows how the sequence
of monetary steps has
led to higher output, just
as the Fed desired in the
face of deteriorating
economic conditions.
 The Challenge of a Liquidity Trap
• arises as nominal interest rates approach zero. This is referred
to as the liquidity trap. Such a situation occurred in the Great
Depression of the 1930s and then again in 2008 –2009 in the
United States. When short-term safe interest rates are zero,
short-term safe securities are equivalent to money.
• The demand for money becomes infinitely elastic with respect
to the interest rate. In this situation, banks have no reason to
economize on their reserve holdings; they get essentially the
same interest rates on reserves as on riskless short-term
investments. For example, in early 2009, banks could earn 0.10
percent annually on reserves and 0.12 percent on Treasury bills.
 Monetary Policy in the AS-AD
Framework
• Figures 24-5, 24-6, and 24-7 illustrate how a
change in monetary policy could lead to an
increase in aggregate demand. We can now
show the effect of such an increase on the
overall macroeconomic equilibrium by using
aggregate supply and aggregate demand
curves.
• The complete sequence of impacts from
expansionary monetary policy is therefore as
follows: Open-market operations lower market
interest rates. Lower interest rates stimulate
interest-sensitive spending on business investment,
housing, net exports, and the like. Aggregate
demand increases via the multiplier mechanism,
raising output and prices above the levels they
would otherwise attain.
• Therefore, the basic sequence is
r down → I, C, X up → AD up → Q and P up