ECON 0110 Lecture Notes - Lecture 8: Federal Funds Rate, Taylor Rule, Money Multiplier
Chapter 15
Money
Any asset that can easily be used to purchase goods and services.
ā
In economics, money is made up of two things: cash & checking account.
ā
What can you use to pay for groceries?
Currency in Circulation
Cash held by the public
ā”
Ā§
Checkable Bank Deposits
Bank accounts on which people can write checks
ā”
Ā§
ā
Non-money assets
Savings account, stocks, bonds
Ā§
ā
ā¢
Money Demand
Money is like any other good: people demand readily available money so they can
purchase things.
ā
The price of money = Interest Rate
ā
Holding cash isn't free.
When you decide to carry cash or keep money in your non-interest-gaining
checking account, you are choosing convenience over earning interest off that
money (in CD, savings account, etc.)
Ā§
The trade off between holding money vs holding a non-monetary asset is affected
by the interest rate.
Ā§
ā
ā¢
Money Demand
Shows the relationship between the quantity of money demanded and the interest
rate.
Ā§
ā
Shifts in Money Demand
There are 4 factors that shift the money demand curve:
Changes in the Aggregate Price Level
The demand for money is proportional to the aggregate price level.
If the aggregate price level INCREASES by 20%, the quantity of money
demanded at any given interest rate also RISES by 20%.
Ā®
ā”
Inflation causes individuals to demand more money.
ā”
Ā§
Changes in Real GDP
The larger the quantity of goods and services individuals buy (real GDP) the
more money they have to hold.
ā”
An INCREASE in real GDP must INCREASE the money demand curve.
ā”
Ā§
Changes in Credit Markets and Banking Technology
Credit cards greatly REDUCE the demand for money, since you did not need
the cash to pay for the purchase.
ā”
ATMs DECREASE the demand for money by making it easier and more
convenient to withdrawal money when you need to.
ā”
Ā§
Changes in Institutions
Banks were allowed to begin offering interest on checking accounts in 1980.
This decreased the cost of holding money.
Ā®
The demand for money INCREASED
Ā®
ā”
Ā§
ā
ā¢
Practice Problem
Explain how each of the following would affect the quantity of money demanded. Does
the change cause a movement along the money demand curve or a shift of the money
demand curve?
ā
Short-term interest rate rises from 5% to 30%.
a.
All prices fall by 10%.
b.
New wireless technology automatically charges supermarket purchases to credit
cards, eliminating the need to stop at the cash register.
c.
Merchants charge a 1% fee on debit/credit card transactions for purchases of less than
$50.
d.
ā¢
Equilibrium in the Money Market
Liquidity Preference Model (Money Market)
The interest rate is determined by the supply and demand for money
Ā§
ā
Money Demand Curve
Downward sloping because of the opportunity cost of holding money
Ā§
ā
Money Supply Curve
Vertical because it is determined by the Federal Reserve
Ā§
Shows how the nominal quantity of money supplied varies with the interest rate.
Ā§
ā
ā¢
The Federal Reserve System (The Fed)
Central Bank
An institution that oversees and regulates the banking system and controls the
monetary base
Ā§
ā
The central bank of the United States
Created in 1913
Ā§
Not part of the US government
Ā§
Also, not a private institution
Ā§
ā
Consists of 2 parts:
Board of Governors (Washington DC)
Ā§
12 regional Federal Reserve Banks
Ā§
ā
Ā§
Board of Governors
The "government" part of the Fed
Ā§
7 members
Ā§
Appointed by president to 14 year terms
Ā§
Chairman of the Board of Governors is the head
Appointed every 4 years
ā”
Currently is Jerome Powell
ā”
Ā§
ā
Regional Banks
The "private" part of the Fed.
Ā§
Run by a board of directors chosen from the local banking community.
Ā§
Loan at the discount window to banks in their region.
Ā§
Audit banks in their region to ensure their financial health.
Ā§
The Federal Reserve Bank of New York is the most important regional bank
because it conducts open-mark operations.
The main tool of monetary policy.
ā”
Ā§
ā
Federal Open Market Committee (FOMC)
Make decisions about monetary policy.
Ā§
Consists of the Board of Governors plus 5 regional bank presidents.
Ā§
Four of the regional bank presidents serve on rotating basis.
Ā§
The president of the Federal Reserve Bank of New York has a permanent seat on
the committee.
Ā§
ā
ā¢
Equilibrium in the Money Market
ā
At rL, interest rates are low.
MD > MS.
Ā§
Shortage of money.
Ā§
Surplus of other assets such as bonds.
Ā§
Investors selling bonds will try to make them more attractive to buyers by raising
rates.
Ā§
ā
At rH, interest rates are high.
MD < MS.
Ā§
Surplus of money.
Ā§
Shortage of other assets such as bonds.
Ā§
Investors selling bonds will realize they can reduce interest rates and still find
buyers.
Ā§
ā
ā¢
The Fed in Action
We can use this liquidity preference model (MS & MD) to show how the Fed sets the
Federal Funds Rateā¦
ā
ā
ā¢
The Fed has 3 main policy tools:
Reserve Requirements (Reserve Ratio)
Rules set by the federal Reserve that determines the minimum reserve ratio
for banks.
ā”
The reserve ratio for checkable bank deposits in the United States is 10%.
ā”
Example
If the reserve ratio is 10% and a bank has $1 million in deposits, they
must hold $100,000 in reserve.
Ā®
ā”
Excess Reserves
A bank's reserves over and above its required reserves.
Ā®
ā”
DECREASE in Reserve Ratio, INCREASE in Money Supply
ā”
Ā§
Discount Rate
What does a bank do if it can't meet the Fed's reserve requirement?
ā”
The Federal Funds Market allows banks to fall short of the reserve
requirement to borrow funds from banks with excess reserves.
The Federal Funds Rate is the interest rate determined in the federal
funds market.
Ā®
ā”
The Discount Rate is the rate of interest the Fed charges on loans to banks.
Normally, the discount rate is set 1% above the federal funds rate in
order to discourage banks from turning to the Fed when they are in
need of reserves.
Ā®
ā”
DECREASE in Discount Rate, INCREASE in Money Supply
ā”
Ā§
ā
Open-Market Operations
A purchase or sale of government debt (usually Treasury bills) by the Fed
ā”
When the Fed PURCHASE government debt from banks (typically
commercial banks) it credits the banks reserves by the amount it purchased.
This starts the money multiplier in motion, INCREASING money supply.
ā”
When the Fed SELLS government debt to banks it removes reserves by the
amount of the sale. Bank reserves fall, DECREASING the money supply.
ā”
Ā§
Expansionary Monetary
Policy
Contractionary Monetary
Policy
Reserve Requirements
Decrease
Increase
Discount Rate
Decrease
Increase
Open-Market Operations
Purchase Govt. Debt
Sell Govt. Debt
Monetary Policy & Aggregate Demand
Just as Congress can use fiscal policy to "stabilize" the economy, the Fed can use
monetary policy to do the same thing.
ā
There are several steps to an Expansionary Monetary Policy:
The money supply INCREASES.
Ā§
The interest rate DECREASES.
Ā§
This encourages MORE investment spending.
Ā§
This leads to MORE income, which INCREASES consumption through the
multiplier effect.
Ā§
This INCREASES aggregate demand.
Ā§
AD curve moves RIGHT
Ā§
ā
There are several steps to a Contractionary Monetary Policy:
The money supply DECREASES.
Ā§
The interest rate INCREASES.
Ā§
This encourages LESS investment spending.
Ā§
This leads to LESS income, which DECREASES consumption through the
multiplier effect.
Ā§
This DECREASES aggregate demand.
Ā§
AD curve moves LEFT.
Ā§
ā
ā¢
The Fed's Dual Mandate
Sometimes the Fed has to choose between boosting the economy in recessions and
keeping prices stable (fighting inflation):
ā
ā
ā¢
Rules for Conducting Monetary Policy
There are 2 different approaches to handling monetary policy:
Taylor Rule
A rule that sets the (target) federal funds rate according to the level of the
inflation rate and either the output gap or the unemployment rate.
ā”
Federal Funds Rate = 2.07 + 1.28*Inflation Rate - 1.95*(Unemployment
Rate - Natural Rate of Unemployment)
Unemployment Rate > Natural Rate
Recession
ā
Expansionary Monetary Policy
ā
Ā®
Unemployment Rate < Natural Rate
Expansion
ā
Contractionary Monetary Policy
ā
Ā®
ā”
Example
Inflation Rate = 3%
Ā®
Unemployment Rate = 7%
Ā®
Natural Rate = 5%
Ā®
ā”
Ā§
ā
ā¢
Inflation Targeting
Many central banks have explicitly set inflation targets.
ā”
Prior to 2012, the Fed never openly stated their inflation target.
ā”
The Fed's inflation target is now 2%.
ā”
Ā§
Lecture 8
Wednesday,+June+20,+2018
12:42+PM
Document Summary
Any asset that can easily be used to purchase goods and services. In economics, money is made up of two things: cash & checking account. Bank accounts on which people can write checks. Money is like any other good: people demand readily available money so they can purchase things. When you decide to carry cash or keep money in your non-interest-gaining checking account, you are choosing convenience over earning interest off that money (in cd, savings account, etc. ) The trade off between holding money vs holding a non-monetary asset is affected by the interest rate. Shows the relationship between the quantity of money demanded and the interest rate. There are 4 factors that shift the money demand curve: The demand for money is proportional to the aggregate price level. If the aggregate price level increases by 20%, the quantity of money demanded at any given interest rate also rises by 20%.
