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Monetary Policy and Bank Regulation FIGURE Eccles Federal Reserve Headquarters , Washington . Some of the most influential decisions regarding monetary policy in the United States are made behind these doors . Credit of work by Eccles Federal Reserve by Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about The Federal Reserve Banking System and Central Banks Bank Regulation How a Central Bank Executes Monetary Policy Monetary Policy and Economic Outcomes Pitfalls for Monetary Policy Introduction to Monetary Policy and Bank Regulation BRING IT HOME The Problem of the Zero Percent Interest Rate Lower Bound Most economists believe that monetary policy ( the manipulation of interest rates and credit conditions by a central bank ) has a powerful influence on a nation economy . Monetary policy works when the central bank reduces interest rates and makes credit more available , As a result , business investment and other types of spending increase , causing and employment to grow . However , what if the interest rates banks pay are close to zero already ?
They can not be made negative , can they ?
That would mean that lenders pay borrowers for the privilege of taking their money , Yet , this was the situation the 358 15 Monetary Policy and Bank Regulation Federal Reserve found itself in both at the end of the recession and during the recession of 2020 . The federal funds rate , which is the interest rate for banks that the Federal Reserve targets with its monetary policy , was slightly above in 2007 . By 2009 , it had fallen to . It then fell again from over to in March 2020 . During the Great Recession , the Federal Reserve situation was further complicated because policy , the other major tool for managing the economy , was constrained by fears that the federal budget and the public debt were already too high . What were the Federal Reserve options ?
How could the Federal Reserve use monetary policy to stimulate the economy ?
And while fiscal policy was more aggressive in 2020 , the economic situation has in some cases been more severe and additional support was necessary . The solution to the problem of the lower bound in both , as we will see in this chapter , was to change the rules of the game . Money , loans , and banks are all interconnected . Money is deposited in bank accounts , which is then loaned to businesses , individuals , and other banks . When the interlocking system of money , loans , and banks works well , economic transactions smoothly occur in goods and labor markets and savers are connected with borrowers . If the money and banking system does not operate smoothly , the economy can either fall into recession or suffer prolonged . The government of every country has public policies that support the system of money , loans , and banking . However , these policies do not always work perfectly . This chapter discusses how monetary policy works and what may prevent it from working perfectly . The Federal Reserve Banking System and Central Banks LEARNING OBJECTIVES By the end of this section , you will be able to Explain the structure and organization of the Federal Reserve Discuss how central banks impact monetary policy , promote stability , and provide banking services In making decisions about the money supply , a central bank decides whether to raise or lower interest rates and , in this way , to policy , whose goal is low unemployment and low . The central bank is also responsible for regulating all or part of the nation banking system to protect bank depositors and insure the health of the bank balance sheet . We call the organization responsible for conducting monetary policy and ensuring that a nation system operates smoothly the central bank . Most nations have central banks or currency boards . Some prominent central banks around the world include the European Central Bank , the Bank , and the Bank of England . In the United States , we call the central bank the Federal abbreviated as just the Fed . This section explains the Federal Reserve organization and the major central responsibilities . of the Federal Reserve Unlike most central banks , the Federal Reserve is , mixing government appointees with representation from banks . At the national level , it is run by a Board of Governors , consisting of seven members appointed by the President of the United States and by the Senate . Appointments are for terms and they are arranged so that one term expires January 31 of every year . The purpose of the long and staggered terms is to insulate the Board of Governors as much as possible from political pressure so that governors can make policy decisions based only on their economic merits . Additionally , except when an term , each member only serves one term , further insulating from politics . The Feds policy decisions do not require congressional approval , and the President can not ask for a Federal Reserve Governor to resign as the President can with cabinet positions . Access for free at
The Federal Reserve Banking System and Central Banks 359 One member of the Board of Governors is designated as the Chair . For example , from 1987 until early 2006 , the Chair was Alan . From 2006 until 2014 , Ben held the post . From 2014 to 2018 , Janet was the Chair . The current Chair is Jerome Powell . See the following Clear It Up feature to out more about the former and current Chair . CLEAR IT UP Who has the most immediate economic power in the world ?
FIGURE Chair of the Federal Reserve Board Jerome Powell ( Credit by Board of Governors of the Federal Reserve , Public Domain ) What individual can make a market crash or by making a public statement ?
It is not Bill Gates or Warren . It is not even the President of the United States . The answer is the Chair of the Federal Reserve Board of Governors . In 2018 , President Donald Trump appointed Jerome Powell to a term as chair of the Federal Reserve , replacing Janet , who served as the first female chair of the Federal Reserve from and who now serves as the Treasury Secretary in the administration . In November 2021 , Powell was nominated for a second term by President this appointment was confirmed in . Powell played a pivotal role during the recession and its aftermath in March 2020 , under his leadership the Fed acted quickly to reduce the effective federal funds rate and expand its lending and actions , similar to what Ben did Great Recession . A centrist at heart , Powell has been criticized for fueling asset prices , even though in his many speeches and testimony before Congress he has consistently emphasized low unemployment rates and has been more tolerant of inflation than others on the Federal Reserve Board . Powell is not an academic economist by training or has a . from Georgetown Law and worked for many years at investment banks and on corporate this lack of ivory tower influences has helped guide a practical approach to economic problems , for which he is best known . The Fed Chair is first among equals on the Board of Governors . While they have only one vote , the Chair controls the agenda , and is the Fed public voice , so they have more power and than one might expect . LINK up Visit this website Governors to see who the current members of the Federal Reserve Board of Governors are . You can follow the links provided for each board member to learn more about their backgrounds , experiences , and when their terms on the board will end . The Federal Reserve is more than the Board of Governors . The Fed also includes 12 regional Federal Reserve
360 15 Monetary Policy and Bank Regulation banks , each of which is responsible for supporting the commercial banks and economy generally in its district . Figure 153 shows the Federal Reserve districts and the cities where their regional headquarters are located . The commercial banks in each district elect a Board of Directors for each regional Federal Reserve bank , and that board chooses a president for each regional Federal Reserve district . Thus , the Federal Reserve System includes both federally and appointed leaders . Boston New York . 802111 at Alaska and Hawaii I are pan I San Francisco . FIGURE The Twelve Federal Reserve Districts There are twelve regional Federal Reserve banks , each with its district . What Does a Central Bank Do ?
The Federal Reserve , like most central banks , is designed to perform three important functions . To conduct monetary policy . To promote stability of the system . To provide banking services to commercial banks and other depository institutions , and to provide banking services to the federal government . The two functions are sufficiently important that we will discuss them in their own modules . The third function we will discuss here . The Federal Reserve provides many of the same services to banks as banks provide to their customers . For example , all commercial banks have an account at the Fed where they deposit reserves . Similarly , banks can obtain loans from the Fed through the discount window facility , which we will discuss in more detail later . The Fed is also responsible for check processing . When you write a check , for example , to buy groceries , the grocery store deposits the check in its bank account . Then , the grocery store bank returns the physical check ( or an image of that actual check ) to your bank , after which it transfers funds from your bank account to the grocery store account . The Fed is responsible for each of these actions . On a more mundane level , the Federal Reserve ensures that enough currency and coins are circulating through the system to meet public demands . For example , each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January . Finally , the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws . For example , banks are forbidden from discriminating on the basis of age , race , sex , or marital status . Banks are also required to disclose publicly information about the loans they make for buying houses and how they distribute the loans geographically , as well as by sex and race of the loan applicants . Access for free at
Bank Regulation 361 Bank Regulation LEARNING OBJECTIVES By the end of this section , you will be able to Discuss the relationship between bank regulation and monetary policy Explain bank supervision Explain how deposit insurance and lender of last resort are two strategies to protect against bank runs A safe and stable national system is a critical concern of the Federal Reserve . The goal is not only to protect individuals savings , but to protect the integrity of the system itself . This esoteric task is usually behind the scenes , but came into view during the crisis , when for a of time , critical parts of the system failed and became unable to obtain for ordinary parts of their business . Imagine if suddenly you were unable to access the money in your bank accounts because your checks were not accepted for payment and your debit cards were declined . This gives an idea of a failure of the system . Bank regulation is intended to maintain banks solvency by avoiding excessive risk . Regulation falls into a number of categories , including reserve requirements , capital requirements , and restrictions on the types of investments banks may make . In Money and Banking , we learned that banks are required to hold a minimum percentage of their deposits on hand as reserves . On hand is a bit of a misnomer because , while a portion of bank reserves are held as cash in the bank , the majority are held in the bank account at the Federal Reserve , and their purpose is to cover desired withdrawals by depositors . Another part of bank regulation is restrictions on the types of investments banks are allowed to make . Banks are permitted to make loans to businesses , individuals , and other banks . They can purchase Treasury securities but , to protect depositors , they are not permitted to invest in the stock market or other assets that are perceived as too risky . Bank capital is the difference between a bank assets and its liabilities . In other words , it is a bank net worth . A bank must have positive net worth otherwise it is insolvent or bankrupt , meaning it would not have enough assets to pay back its liabilities . Regulation requires that banks maintain a minimum net worth , usually expressed as a percent of their assets , to protect their depositors and other creditors . LINK up Visit this website ( to read the brief article , Stop Confusing Monetary Policy and Bank Bank Supervision Several government agencies monitor banks balance sheets to make sure they have positive net worth and are not taking too high a level of risk . Within the Department of the Treasury , the of the Comptroller of the Currency has a national staff of bank examiners who conduct reviews of the or so of the largest national banks . The bank examiners also review any foreign banks that have branches in the United States . The of the Comptroller of the Currency also monitors and regulates about 800 savings and loan institutions . The National Credit Union Administration ( supervises credit unions , which are banks that their members run and own . There are about credit unions in the economy today , although the typical credit union is small compared to most banks . The Federal Reserve also has some responsibility for supervising institutions . For example , we call conglomerate that own banks and other businesses bank holding While other regulators like the of the Comptroller of the Currency supervises the banks , the Federal Reserve supervises the holding companies .
362 15 Monetary Policy and Bank Regulation When bank supervision ( and institutions such as savings and loans and credit unions ) works well , most banks will remain healthy most of the time . If the bank supervisors that a bank has low or negative net worth , or is making too high a proportion of risky loans , they can require that the bank change its , in extreme cases , even force the bank to close or be sold to a healthy bank . Bank supervision can run into both practical and political questions . The practical question is that measuring the value of a bank assets is not always straightforward . As we discussed in Money and Banking , a assets are its loans , and the value of these assets depends on estimates about the risk that customers will not repay these loans . These issues can become even more complex when a bank makes loans to banks or in other countries , or arranges deals that are much more complex than a basic loan . The political question arises because a bank supervisor decision to require a bank to close or to change its investments is often controversial , and the bank supervisor often comes under political pressure from the bank owners and the local politicians to keep quiet and back off . For example , many observers have pointed out that Japan banks were in deep trouble through most of the however , nothing substantial had been done about it by the early . A similar unwillingness to confront problems with struggling banks is visible across the rest of the world , in East Asia , Latin America , Eastern Europe , Russia , and elsewhere . In the United States , the government passed laws in the 19903 requiring that bank supervisors make their open and public , and that they act as soon as they identify a problem . However , as many US . banks were staggered by the recession , critics of the bank regulators asked pointed questions about why the regulators had not foreseen the banks shakiness earlier , before such large losses had a chance to accumulate . Bank Runs Back in the nineteenth century and during the few decades of the twentieth century ( around and during the Great Depression ) putting your money in a bank could be . Imagine that the net worth of your bank became negative , so that the banks assets were not enough to cover its liabilities . In this situation , whoever withdrew their deposits received all of their money , and those who did not rush to the bank quickly enough , lost their money . We call depositors racing to the bank to withdraw their deposits , as Em shows a bank run . In the movie his a Wonderful Life , the bank manager , played by Jimmy Stewart , faces a mob of worried bank depositors who want to withdraw their money , but manages to allay their fears by allowing some of them to withdraw a portion of their the money from his own pocket that was supposed to pay for his honeymoon . FIGURE Run on the Bank Bank runs during the Great Depression only served to worsen the economic Access for free at
How a Central Bank Executes Monetary Policy 363 situation . Credit Depression Runs on Banks by National Archives and Records Administration , Public Domain ) The risk of bank runs created instability in the banking system . Even a rumor that a bank might experience negative net worth could trigger a bank run and , in a bank run , even healthy banks could be destroyed . Because a bank loans out most of the money it receives , and because it keeps only limited reserves on hand , a bank run of any size would quickly drain any of the bank available cash . When the bank had no cash remaining , it only the fears of remaining depositors that they could lose their money . Moreover , a bank run at one bank often triggered a chain reaction of runs on other banks . In the late nineteenth and early twentieth century , bank runs were typically not the original cause of a they could make a recession much worse . Deposit Insurance To protect against bank runs , Congress has put two strategies into place deposit insurance and the lender of last resort . Deposit insurance is an insurance system that makes sure depositors in a bank do not lose their money , even if the bank goes bankrupt . About 70 countries around the world , including all of the major economies , have deposit insurance programs . In the United States , the Federal Deposit Insurance Corporation ( is responsible for deposit insurance . Banks pay an insurance premium to the . The insurance premium is based on the banks level of deposits , and then adjusted according to the riskiness ofa situation . In 2009 , for example , a fairly safe bank with a high net worth might have paid cents in insurance premiums for every 100 in bank deposits , while a risky bank with very low net worth might have paid cents for every 100 in bank deposits . Bank examiners from the evaluate the banks balance sheets , looking at the asset and liability values to determine the risk level . The provides deposit insurance for about banks ( as of the third quarter of 2021 ) Even ifa bank fails , the government guarantees that depositors will receive up to of their money in each account , which is enough for almost all individuals , although not sufficient for many businesses . Since the United States enacted deposit insurance in the 19305 , no one has lost any of their insured deposits . Bank runs no longer happen at insured banks . Lender of Last Resort The problem with bank runs is not that insolvent banks will fail they are , after all , bankrupt and need to be shut down . The problem is that bank runs can cause solvent banks to fail and spread to the rest of the system . To prevent this , the Fed stands ready to lend to banks and other institutions when they can not obtain funds from anywhere else . This is known as the lender resort role . For banks , the central bank acting as a lender of last resort helps to reinforce the effect of deposit insurance and to reassure bank customers that they will not lose their money . The lender of last resort task can arise in other crises , as well . During the 1987 stock market crash panic , when stock values fell by 25 in a single day , the Federal Reserve made a number of emergency loans so that the system could keep functioning . During the recession , we can interpret the Fed quantitative easing policies ( discussed below ) as a willingness to make credit available as needed in a time when the banking and system was under stress . How a Central Bank Executes Monetary Policy LEARNING OBJECTIVES By the end of this section , you will be able to Explain the reason for open market operations Evaluate reserve requirements and discount rates Interpret and show bank activity through balance sheets The Federal Reserve most important function is to conduct the nation monetary policy . Article I , Section of the Constitution gives Congress the power to coin money and to regulate the value thereof . As part of
364 15 Monetary Policy and Bank Regulation the 1913 legislation that created the Federal Reserve , Congress delegated these powers to the Fed . Monetary policy involves managing interest rates and credit conditions , which the level of economic activity , as we describe in more detail below . A central bank has three traditional tools to implement monetary policy in the economy Open market operations Changing reserve requirements Changing the discount rate In discussing how these three tools work , it is useful to think of the central bank as a bank for banks is , each bank has its own account at the central bank . We will discuss each of these monetary policy tools in the sections below . Open Market Operations Since the early , the most common monetary policy tool in the has been open market operations . These take place when the central bank sells or buys Treasury bonds in order to the quantity of bank reserves and the level of interest rates . The interest rate targeted in open market operations is the federal funds rate . The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks . As such , it is a very short term interest rate , but one that credit conditions in markets very well . The Federal Open Market Committee ( makes the decisions regarding these open market operations . The comprises seven members of the Federal Reserve Board of Governors . It also includes voting members who the Board draws , on a rotating basis , from the regional Federal Reserve Banks . The New York district president is a permanent voting member and the Board other four spots on a rotating , annual basis , from the other 11 districts . The typically meets every six weeks , but it can meet more frequently if necessary . The tries to act by consensus however , the Federal Reserve chairman has traditionally played a very powerful role in and shaping that consensus . For the Federal Reserve , and for most central banks , open market operations have , over the last few decades , been the most commonly used tool of monetary policy . LINK up Visit this website ( policy ) for the Federal Reserve to learn more about current monetary policy . To understand how open market operations affect the money supply , consider the balance sheet of Happy Bank , displayed in Figure . Figure ( a ) shows that Happy Bank starts with 460 million in assets , divided among reserves , bonds and loans , and 400 million in liabilities in the form of deposits , with a net worth of 60 million . When the central bank purchases 20 million in bonds from Happy Bank , the bond holdings Bank fall by 20 million and the bank reserves rise by 20 million , as Figure ( shows . However , Happy Bank only wants to hold 40 million in reserves ( the quantity of reserves with which it started in Figure ( a ) so the bank decides to loan out the extra 20 million in reserves and its loans rise by 20 million , as Figure ( shows . The central bank open market operation causes Happy Bank to make loans instead of holding its assets in the form of government bonds , which expands the money supply . As the new loans are deposited in banks throughout the economy , these banks will , in turn , loan out some of the deposits they receive , triggering the money multiplier that we discussed in Money and Banking . Access for free at
How a Central Bank Executes Monetary Policy 365 Assets Liabilities Net Worth Reserves 40 Deposits 400 Bonds 120 Loans 300 Net Worth 80 ( a ) The original balance sheet Assets Liabilities Net Worth Reserves 40 20 60 Deposits 400 Bonds 120 20 100 Loans 300 Net Worth 60 ( The central bank buys bonds Assets Liabilities Net Worth 60 20 40 Deposits 400 Bonds 100 Loans 300 20 320 Net Worth 60 ( The bank makes additional loans FIGURE Where did the Federal Reserve get the 20 million that it used to purchase the bonds ?
A central bank has the power to create money . In practical terms , the Federal Reserve would write a check to Happy Bank , so that Happy Bank can have that money credited to its bank account at the Federal Reserve . In truth , the Federal Reserve created the money to purchase the bonds out of thin with a few clicks on some computer keys . Open market operations can also reduce the quantity of money and loans in an economy . Figure ( a ) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market . When Happy Bank purchases 30 million in bonds , Happy Bank sends 30 million of its reserves to the central bank , but now holds an additional 30 million in bonds , as Figure ( shows . However , Happy Bank wants to hold 40 million in reserves , as in Figure ( a ) so it will adjust down the quantity of its loans by 30 million , to bring its reserves back to the desired level , as Figure 156 ( shows . In practical terms , a bank can easily reduce its quantity of loans . At any given time , a bank is receiving payments on loans that it made previously and also making new loans . If the slows down or halts making new loans , and instead adds those funds to its reserves , then its overall quantity of loans will decrease . A decrease in the quantity of loans also means fewer deposits in other banks , and other banks reducing their lending as well , as the money multiplier that we discussed in Money and Banking takes effect . What about all those bonds ?
How do they affect the money supply ?
Read the following Clear It Up feature for the answer .
366 15 Monetary Policy and Bank Regulation Assets Liabilities Net Worth Reserves 40 Deposits 400 Bonds 120 Loans 300 Net Worth 60 ( a ) The original balance sheet Assets Liabilities Net Worth Reserves 40 30 10 Deposits 400 Bonds 120 30 150 Loans 300 Net Worth 60 ( The central bank sells bonds to the bank Assets Liabilities Net Worth 10 30 40 Deposits 400 Bands 150 Loans 300 30 270 Net Worth 60 ( The bank makes fewer loans FIGURE CLEAR IT UP Does selling or buying bonds increase the money supply ?
Is it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank ?
The easy way to keep track of this is to treat the central bank as being outside the banking system . When a central bank buys bonds , money is flowing from the central bank to individual banks in the economy , increasing the money supply in circulation . When a central bank sells bonds , then money from individual banks in the economy is flowing into the central the quantity of money in the economy . The Federal Reserve was founded in the aftermath of the 1907 Financial Panic when many banks failed as a result runs . As mentioned earlier , since banks make by lending out their deposits , no bank , even those that are not bankrupt , can withstand a bank run . As a result of the Panic , the Federal Reserve was founded to be the lender of last In the event of a bank run , sound banks , banks that were not bankrupt ) could borrow as much cash as they needed from the Fed discount window to quell the bank run . We call the interest rate banks pay for such loans the discount rate . They are so named because the bank makes loans against its outstanding loans at a discount of their face value . Once depositors became convinced that the bank would be able to honor their withdrawals , they no longer had a reason to make a run on the bank . In short , the Federal Reserve was originally intended to provide credit passively , but in the years since its founding , the Fed has taken on a more active role with monetary policy . The second traditional method for conducting monetary policy is to raise or lower the discount rate . If the central bank raises the discount rate , then commercial banks will reduce their borrowing of reserves from the Fed , and instead call in loans to replace those reserves . Since fewer loans are available , the money supply falls and market interest rates rise . If the central bank lowers the discount rate it charges to banks , the process works in reverse . In recent decades , the Federal Reserve has made relatively few discount loans . Before a bank borrows from the Federal Reserve to out its required reserves , the bank is expected to borrow from other available sources , like other banks . This is encouraged by the Fed charging a higher discount rate than the federal funds rate . Given that most banks borrow little at the discount rate , changing the discount rate up or down has little Access for free at
Monetary Policy and Economic Outcomes 367 impact on their behavior . More importantly , the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy . Changing Reserve Requirements A potential third method of conducting monetary policy is for the central bank to raise or lower the reserve requirement , which , as we noted earlier , is the percentage of each bank deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank . are required to hold a greater amount in reserves , they have less money available to lend out . are allowed to hold a smaller amount in reserves , they will have a greater amount of money available to lend out . Until very recently , the Federal Reserve required banks to hold reserves equal to of the million in deposits , then to hold reserves equal to of the deposits up to million , and 10 of any amount above million . The Fed makes small changes in the reserve requirements almost every year . For example , the million dividing line is sometimes bumped up or down by a few million dollars . Today , these rates are no longer in effect as of March 2020 ( when the recession hit ) the 10 and requirements were reduced to , effectively eliminating the reserve requirement for all depository institutions . The Fed rarely uses large changes in reserve requirements to execute monetary policy the pandemic was an exception for obvious reasons . Also , a sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply . While loosening requirements too much might create a danger of banks inability to meet withdrawal demands , the of reducing the reserve requirements in March 2020 exceeded the risks . Changing the Discount Rate In the Federal Reserve Act , the phrase to afford means of commercial paper is contained in its long title . This was the main tool for monetary policy when the Fed was initially created . Today , the Federal Reserve has even more tools at its disposal , including quantitative easing , overnight repurchase agreements , and interest on excess reserves . This illustrates how monetary policy has evolved and how it continues to do so . LINK up While these topics are beyond the scope of an introductory textbook , ifyou re interested in learning more about the Federal Reserve newest policy tools , visit the Federal Reserve Bank of New York page on large scale asset purchases and the Federal Reserve Bank . Louis FRED Bloc post on the textbook lag to learn more . Monetary Policy and Economic Outcomes LEARNING OBJECTIVES By the end of this section , you will be able to Contrast expansionary monetary policy and monetary policy Explain how monetary policy impacts interest rates and aggregate demand Evaluate Federal Reserve decisions over the last forty years Explain the of quantitative easing ( QE ) A monetary policy that lowers interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy . Conversely , a monetary policy that raises interest rates and reduces borrowing in the economy is a monetary policy or tight monetary policy . This module will discuss how expansionary and monetary policies affect interest rates and aggregate demand , and how such policies will affect goals like unemployment and . We will conclude with a look at the
368 15 Monetary Policy and Bank Regulation Fed monetary policy practice in recent decades . The Effect of Monetary Policy on Interest Rates Consider the market for loanable bank funds in Figure . The original equilibrium ( occurs at an interest rate and a quantity of funds loaned and borrowed of 10 billion An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve ( to , leading to an equilibrium ( with a lower interest rate and a quantity 14 billion in loaned funds Conversely , a monetary policy will shift the supply of loanable funds to the left from the original supply curve ( to , leading to an equilibrium ( with a higher 10 interest rate and a quantity of billion in loaned funds . monetary policy . 12 10 ( I , 10 12 14 16 Billions of Dollars FIGURE Monetary Policy and Interest Rates The original equilibrium occurs at . An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve ( 50 ) to the new supply curve ( 51 ) and to a new equilibrium of , reducing the interest rate from to . A monetary policy will shift the supply of loanable funds to the left from the original supply curve ( to the new supply ( 52 ) and raise the interest rate from to 10 . How does a central bank raise interest rates ?
When describing the central bank monetary policy actions , it is common to hear that the central bank raised interest rates or lowered interest We need to be clear about this more precisely , through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds . As a result , Figure shows that interest rates change . If they do not meet the Fed target , the Fed can supply more or less reserves until interest rates do . Recall that the interest rate the Fed targets is the federal funds rate . The Federal Reserve has , since 1995 , established its target federal funds rate in advance of any open market operations . Of course , markets display a wide range of interest rates , representing borrowers with different risk premiums and loans that they must repay over different periods of time . In general , when the federal funds rate drops substantially , other interest rates drop , too , and when the federal funds rate rises , other interest rates rise . However , a fall or rise of one percentage point in the federal funds remember is for borrowing typically have an effect of less than one percentage point on a loan to purchase a house or a loan to purchase a car . Monetary policy can push the entire spectrum of interest rates higher or lower , but the forces of supply and demand in those markets for lending and borrowing set the interest rates . The Effect of Monetary Policy on Aggregate Demand Monetary policy affects interest rates and the available quantity of loanable funds , which in turn affects several components of aggregate demand . Tight or monetary policy that leads to higher interest rates Access for free at
Monetary Policy and Economic Outcomes and a reduced quantity of loanable funds will reduce two components of aggregate demand . Business investment will decline because it is less attractive for to borrow money , and even that have money will notice that , with higher interest rates , it is relatively more attractive to put those funds in a investment than to make an investment in physical capital . In addition , higher interest rates will discourage consumer borrowing for items like houses and cars . Conversely , loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for items . If the economy is suffering a recession and high unemployment , with output below potential , expansionary monetary policy can help the economy return to potential . Figure ( a ) illustrates this situation . This example uses a aggregate supply curve ( The original equilibrium during a recession of EO occurs at an output level of 600 . An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending , causing the original aggregate demand curve ( ADO ) to shift right to , so that the new equilibrium ( occurs at the potential level of was A A , i up , I lill ) 99 ' Ell A ' AD ' RU an Tin ant 700 Real Output ( constant dollars ) Real Output ( constant dollars ) la ' Hal , FIGURE Expansionary or Monetary Policy ( a ) The economy is originally in a recession with the equilibrium output and price shown at EO . Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from ADO to , leading to the new equilibrium ( at the potential level of output with a relatively small rise in the price level . The economy is originally producing above the potential level of output at the equilibrium EO and is experiencing pressures for an inflationary rise in the price level . monetary policy will shift aggregate demand to the left from ADO to , thus leading to a new equilibrium ( at the potential level of output . Conversely , if an economy is producing at a quantity of output above its potential , a monetary policy can reduce the pressures for a rising price level . In Figure ( the original equilibrium ( EO ) occurs at an output of 750 , which is above potential . A monetary policy will raise interest rates , discourage borrowing for investment and consumption spending , and cause the original demand curve ( ADO ) to shift left to , so that the new equilibrium ( occurs at the potential level of 700 . These examples suggest that monetary policy should be that is , it should act to counterbalance the business cycles of economic and . The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when threatens . Of course , policy does pose a danger of overreaction . If loose monetary policy seeking to end a recession goes too far , it may push aggregate demand so far to the right that it triggers . If tight 369
370 15 Monetary Policy and Bank Regulation monetary policy seeking to reduce goes too far , it may push aggregate demand so far to the left that a recession begins . Figure ( a ) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level . a ) Expansionary monetary policy real i FIGURE The Pathways of Monetary Policy ( a ) In expansionary monetary policy the central bank causes the ( monetary policy supply of money and loanable funds to increase , which lowers the interest rate , stimulating additional borrowing for investment and consumption , and shifting aggregate demand right . The result is a higher price level and , at least in the short run , higher real . In monetary policy , the central bank causes the supply of money and credit in the economy to decrease , which raises the interest rate , discouraging borrowing for investment and consumption , and shifting aggregate demand left . The result is a lower price level and , at least in the short run , lower real . Federal Reserve Actions Over Last Four Decades For the period from 1970 through 2020 , we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations . Of course , telling the story of the economy since 1970 in terms of Federal Reserve actions leaves out many other factors that were unemployment , recession , economic growth , and over this time . The ten episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors the macro economy . As we noted earlier , the single person with the greatest power to the US . economy is probably the Federal Reserve chairperson . Figure shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades . The graph shows the federal funds interest rate ( remember , this interest rate is set through open market operations ) the unemployment rate , and the rate since 1970 . Different episodes of monetary policy during this period are indicated in the . Access for free at
Monetary Policy and Economic Outcomes Episode ' Episode Episode Episode Episode IO ( I I 14 , 12 , Ill , I I min , I . I . I it ' i il , I i i i . 29 ) I i i 23 Year FIGURE Monetary Policy , Unemployment , and Inflation Through the episodes here , the Federal Reserve typically reacted to higher inflation with a monetary policy and a higher interest rate , and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate . Episode Consider Episode in the late . The rate of was very high , exceeding 10 in 1979 and 1980 , so the Federal Reserve used tight monetary policy to raise interest rates , with the federal funds rate rising from in 1977 to in 1981 . By 1983 , was down to , but aggregate demand contracted sharply enough that occurred in 1980 and in , and the unemployment rate rose from in 1979 to in 1982 . Episode In Episode , when economists persuaded the Federal Reserve in the early that was declining , the Fed began slashing interest rates to reduce unemployment . The federal funds interest rate fell from in 1981 to in 1986 . By 1986 or so , had fallen to about and the unemployment rate had come down to , and was still falling . Episode However , in Episode in the late , appeared to be creeping up again , rising from in 1986 up toward by 1989 . In response , the Federal Reserve used monetary policy to raise the federal funds rates from in 1987 to in 1989 . The tighter monetary policy stopped , which fell from above in 1990 to under in 1992 , but it also helped to cause the recession , and the unemployment rate rose from in 1989 to by 1992 . Episode In Episode , in the early , when the Federal Reserve was that was back under control , it reduced interest rates , with the federal funds interest rate falling from in 1990 to in 1992 . As the economy expanded , the unemployment rate declined from in 1992 to less than by 1997 . Episodes and In Episodes and , the Federal Reserve perceived a risk of and raised the federal funds rate from to from 1993 to 1995 . did not rise , and the period of economic growth during the continued . Then in 1999 and 2000 , the Fed was concerned that seemed to be creeping up so it raised the federal funds interest rate from in December 1998 to in June 2000 . By early 2001 , was declining again , but a recession occurred in 2001 . Between 2000 and 2002 , the unemployment rate rose from
372 15 Monetary Policy and Bank Regulation to . Episodes and In Episodes and , the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from in 2000 to just in 2002 , and then again to in 2003 . They actually did this because of fear of . This persuaded them to lower the Fed funds further than they otherwise would have . The recession ended , but , unemployment rates were slow to decline in the early . Finally , in 2004 , the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until it reached by 2007 . Episode In Episode , as the Great Recession took hold in 2008 , the Federal Reserve was quick to slash interest rates , taking them down to in 2008 and to nearly in 2009 . When the Fed had taken interest rates down to , the economy was still deep in recession . Open market operations could not make the interest rate turn negative . The Federal Reserve had to think outside the box . Episode 10 In Episode 10 , which started in March 2020 , the Fed cut interest rates again , reducing the target federal funds rate from to between in a matter . Limited by the zero lower bound , the Fed once again had to think outside the box in order to further support the system . Quantitative Easing The most powerful and commonly used of the three traditional tools of monetary market by expanding or contracting the money supply in a way that the interest rate . In late 2008 , as the economy struggled with recession , the Federal Reserve had already reduced the interest rate to . With the recession still ongoing , the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing ( QE ) This is the purchase of government and private securities by central banks to make credit available so as to stimulate aggregate demand . Quantitative easing differed from traditional monetary policy in several key ways . First , it involved the Fed purchasing long term Treasury bonds , rather than short term Treasury bills . In 2008 , however , it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get . Read the closing Bring it Home feature for more on this . Therefore , Chairman sought to lower rates utilizing quantitative easing . This leads to a second way QE is different from traditional monetary policy . Instead of purchasing Treasury securities , the Fed also began purchasing private securities , something it had never done before . During the crisis , which precipitated the recession , securities were termed toxic assets , because when the housing market collapsed , no one knew what these securities were worth , which put the institutions which were holding those securities on very shaky ground . By offering to purchase securities , the Fed was both pushing long term interest rates down and also removing possibly toxic assets from the balance sheets , which would strengthen the system . Quantitative easing ( QE ) occurred in three episodes . During , which began in November 2008 , the Fed purchased 600 billion in securities from government enterprises Mae and Freddie Mac . In November 2010 , the Fed began , in which it purchased 600 billion in Treasury bonds . began in September 2012 when the Fed commenced purchasing 40 billion of additional mortgage backed securities per month . This amount was increased in December 2012 to 85 billion per month . The Fed stated that , when economic conditions permit , it will begin tapering ( or reducing the monthly Access for free at
Pitfalls for Monetary Policy purchases ) By October 2014 , the Fed had announced the 15 billion bond purchase , ending Quantitative Easing . We usually think of the quantitative easing policies that the Federal Reserve adopted ( as did other central banks around the world ) as temporary emergency measures . If these steps are to be temporary , then the Federal Reserve will need to stop making these additional loans and sell off the securities it has accumulated . The concern is that the process of quantitative easing may prove more to reverse than it was to enact . The evidence suggests that was somewhat successful , but that OE and have been less so . Fast forward to March 2020 , when the Fed under the leadership of Jerome Powell promised another round of asset purchases which was dubbed by some as , intended once again to provide liquidity to a distressed system in the wake of the pandemic . This round was much faster , increasing Fed assets by trillion injust a few months . Recently , the Fed has begun to slow down the purchase of these assets once again through a taper , and the pace of the tapering is expected to increase through 2022 . But as of the end of 2021 , total Fed assets exceed trillion , compared to trillion in February 2020 . Pitfalls for Monetary Policy LEARNING OBJECTIVES By the end of this section , you will be able to Analyze whether monetary policy decisions should be made more democratically Calculate the velocity of money Evaluate the central banks on , unemployment , asset bubbles , and leverage cycles Calculate the effects of monetary stimulus In the real world , effective monetary policy faces a number of hurdles . Monetary policy affects the economy only after a time lag that is typically long and of variable length . Remember , monetary policy involves a chain of events the central bank must perceive a situation in the economy , hold a meeting , and make a decision to react by tightening or loosening monetary policy . The change in monetary policy must percolate through the banking system , changing the quantity of loans and affecting interest rates . When interest rates change , businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars . Then it takes time for these changes to through the rest of the economy . As a result of this chain of events , monetary policy has little effect in the immediate future . Instead , its primary effects are felt perhaps one to three years in the future . The reality of long and variable time lags does not mean that a central bank should refuse to make decisions . It does mean that central banks should be humble about taking action , because of the risk that their actions can create as much or more economic instability as they resolve . Banks are legally required to hold a minimum level of reserves , but no rule prohibits them from holding additional excess reserves above the legally mandated limit . For example , during a recession banks may be hesitant to lend , because they fear that when the economy is contracting , a high proportion of loan applicants become less likely to repay their loans . When many banks are choosing to hold excess reserves , expansionary monetary policy may not work well . This may occur because the banks are concerned about a deteriorating economy , while the central bank is trying to expand the money supply . If the banks prefer to hold excess reserves above the legally required level , the central bank can not force individual banks to make loans . Similarly , sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession , because they recognize that sales and employees jobs are more insecure in a recession , and they do not want to face the need to make interest payments . The result is that during an especially deep recession , an expansionary monetary policy
374 15 Monetary Policy and Bank Regulation may have little effect on either the price level or the real . Japan experienced this situation in the and early . Japan economy entered a period slow growth , dipping in and out of recession , in the early . By February 1999 , the Bank of Japan had lowered the equivalent of its federal funds rate to . It kept it there most of the time through 2003 . Moreover , in the two years from March 2001 to March 2003 , the Bank also expanded the country money supply by about 50 enormous increase . Even this highly expansionary monetary policy , however , had no substantial effect on stimulating aggregate demand . Japan economy continued to experience extremely slow growth into the . CLEAR IT UP Should monetary policy decisions be made more democratically ?
Should a nation Congress or legislature comprised of elected representatives conduct monetary policy or should a politically ed central bank that is more independent of voters take charge ?
Here are some of the arguments . The Case for Greater Democratic Control of Monetary Policy Elected pass taxes and spending bills to conduct policy by passing tax and spending bills . They could handle monetary policy in the same way . They will sometimes make mistakes , but in a democracy , it is better to have elected officials who are accountable to voters make mistakes instead of political appointees . After all , the people appointed to the top governing positions at the Federal to most central banks around the bankers and economists . They are not representatives of borrowers like small businesses or farmers nor representatives of labor unions . Central banks might not be so quick to raise interest rates if they had to pay more attention to and people in the real economy . The Case for an Independent Central Bank Because the cen ral bank has some insulation from politics , its members can take a nonpartisan look at specific economic situations and make tough , immediate decisions when necessary . The idea of giving a legislature the ability to create money and hand out loans is likely to end up badly , sooner or later . It is simply too tempting for lawmakers to the money supply to fund their projects . The long term result will be rampant inflation . Also , a central bank , acting according to the laws passed by elected officials , can respond far more quickly than a legislature . For example , the budget takes months to debate , pass , and sign into law , but monetary policy decisions happen much more rapidly . democratic control of monetary policy is impractical and seems likely to lead to an overly expansionary monetary policy and higher inflation . The problem of excess reserves does not affect policy . Central bankers have an old saying that monetary policy can be like pulling and pushing on a string when the central bank pulls on the string and uses monetary policy , it can raise interest rates and reduce aggregate demand . However , when the central bank tries to push on the string of expansionary monetary policy , the string may sometimes just fold up limp and have little effect , because banks decide not to loan out their excess reserves . Do not take this analogy too monetary policy usually does have real effects , after that inconveniently long and variable lag . There are also times , like Japan economy in the late and early , when expansionary monetary policy has been insufficient to lift a economy . Unpredictable Movements of Velocity Velocity is a term that economists use to describe how quickly money circulates through the economy . We the velocity of money in a year as nominal Velocity money supply measurements depend on the of the money supply used . Consider the velocity of Access for free at
Pitfalls for Monetary Policy , the total amount of currency in circulation and checking account balances . In 2009 , for example , was trillion and nominal was trillion , so the velocity of was ( which is trillion ) A higher velocity of money means that the average dollar circulates more times in a year A lower velocity means that the average dollar circulates fewer times in a year . See the following Clear It Up feature for a discussion of how could affect monetary policy . CLEAR IT UP What happens during episodes of deflation ?
Deflation occurs when the rate of inflation is negative that is , instead of money having less purchasing power over time , as occurs with inflation , money is worth more . Deflation can make it very for monetary policy to address a recession . Remember that the real interest rate is the nominal interest rate minus the rate of inflation . If the nominal interest rate is and the rate of inflation is , then the borrower is effectively paying a real interest rate . If the nominal interest rate is and there is deflation of , then the real interest rate is actually . In this way , an unexpected deflation raises the real interest payments for borrowers . It can lead to a situation where borrowers do not repay an unexpectedly high number of loans , and banks that their net worth is decreasing or negative . When banks are suffering losses , they become less able and eager to make new loans . Aggregate demand declines , which can lead to recession . Then the After causing a recession , deflation can make it difficult for monetary policy to work . Say that the central bank uses expansionary monetary policy to reduce the nominal interest rate all the way to the economy has deflation . As a result , the real interest rate is , and because a central bank can not make the nominal interest rate negative , expansionary policy can not reduce the real interest rate further . In the economy early , deflation was per year from , which caused many borrowers to default on their loans and many banks to end up bankrupt , which in turn contributed substantially to the Great Depression . Not all episodes of deflation , however , end in economic depression . Japan , for example , experienced deflation of slightly less than per year from , which hurt the Japanese economy , but it still grew by about per year over this period . There is at least one historical example of deflation coexisting with rapid growth . The economy experienced deflation of about per year over the from , but real also expanded at a rapid clip of per year over this time , despite some occasional severe . The central bank should be on guard against deflation and , if necessary , use expansionary monetary policy to prevent any or extreme deflation from occurring . Except in severe cases like the Great Depression , deflation does not guarantee economic disaster . Changes in velocity can cause problems for monetary policy . To understand why , rewrite the of velocity so that the money supply is on the side of the equation . That is Money supply velocity Nominal Recall from The Perspective that Nominal Price Level ( or ) Real . Therefore , Money Supply velocity Nominal Price Level Real . We sometimes call this equation the basic quantity equation of money but , as you can see , it is just the written in a different form . This equation must hold true , by .
376 15 Monetary Policy and Bank Regulation is constant over time , then a certain percentage rise in the money supply on the side of the basic quantity equation money will inevitably lead to the same percentage rise in nominal this change could happen through an increase in , or an increase in real , or some combination of the two . If velocity is changing over time but in a constant and predictable way , then changes in the money supply will continue to have a predictable effect on nominal . If velocity changes unpredictably over time , however , then the effect changes in the money supply on nominal becomes unpredictable . Figure illustrates the actual velocity of money in the economy as measured by using , the most common of the money supply . From 1960 up to about 1980 , velocity appears fairly predictable that is , it is increasing at a fair constant rate . In the early , however , velocity as calculated with becomes more variable . The reasons for these sharp changes in velocity remain a puzzle . Economists suspect that the changes in velocity are re to innovations in banking and which have changed how we are using money in making economic transactions for example , the growth of electronic payments a rise in personal borrowing and credit usage and accounts that make it easier for people to hold money in savings accounts , where it is counted as , right up to the moment that they want to write a check on the money and transfer it to . So far at east , it has proven to draw clear links between these kinds of factors and the fluctuations in . Given many changes in banking and the prevalence of electronic banking , economists now favor as a measure of money rather than the narrower . 12 Velocity ?
i ?
Year FIGURE Velocity Calculated Using Velocity is the nominal divided by the money supply for a given year . We can calculate different measures of velocity by using different measures of the money supply . Velocity , as calculated by using , has lacked a steady trend since the , instead bouncing up and down . Note also that the of to include savings deposits in 2020 ( see Money and Banking drastically increased in 2020 , causing velocity to plummet . credit Federal Reserve Bank of Louis ) Click to view content ( books paces Velocity Calculated Using In the 19703 , when velocity as measured by seemed predictable , a number of economists , led by Nobel laureate Milton ( argued that the best monetary policy was for the central bank to increase the money supply at a constant growth rate . These economists argued that with the long and variable lags of monetary policy , and the political pressures on central bankers , central bank monetary policies were as likely to have undesirable as to have desirable effects . Thus , these economists believed that the monetary policy should seek steady growth in the money supply of per year . They argued that a steady monetary growth rate would be correct over longer time periods , since it would roughly match the growth of the real economy . In addition , they argued that giving the central bank less discretion to conduct monetary policy would prevent an overly activist central bank from becoming a source instability and uncertainty . In this spirit , wrote in 1967 The and most important lesson that history teaches about what Access for free at
Pitfalls for Monetary Policy monetary policy can it is a lesson of the most profound that monetary policy can prevent money itself from being a major source of economic As the velocity of began to in the , having the money supply grow at a predetermined and unchanging rate seemed less desirable , because as the quantity theory of money shows , the combination of constant growth in the money supply and velocity would cause nominal to rise and fall in unpredictable ways . The jumpiness in the caused many central banks to focus less on the rate at which the quantity of money in the economy was increasing , and instead to set monetary policy by reacting to whether the economy was experiencing or in danger of higher or unemployment . Unemployment and Inflation Ifyou were to survey central bankers around the world and ask them what they believe should be the primary task of monetary policy , the most popular answer by far would be . Most central bankers believe that the neoclassical model of economics accurately represents the economy over the medium to long term . Remember that in the neoclassical model of the economy , we draw the aggregate supply curve as a vertical line at the level , as Figure 1512 shows . In the neoclassical model , economists determine the level ( and the natural rate of unemployment that exists when the economy is producing at potential ) by real economic factors . If the original level of aggregate demand is , then an expansionary monetary policy that shifts aggregate demand to only creates an increase in the price level , but it does not alter or unemployment . From this perspective , all that monetary policy can do is to lead to low or high low provides a better climate for a healthy and growing economy . After all , low means that businesses making investments can focus on real economic issues , not on out ways to protect themselves from the costs and risks of . In this way , a consistent pattern of low can contribute to growth . Price Level Real FIGURE Monetary Policy in a Neoclassical Model In a neoclassical view , monetary policy affects only the price level , not the level of output in the economy . For example , an expansionary monetary policy causes aggregate demand to shift from the original ADO to . However , the adjustment of the economy from the original equilibrium ( to the new equilibrium ( represents an inflationary increase in the price level from to , but has no effect in the long run on output or the unemployment rate . In fact , no shift in AD will affect the equilibrium quantity of output in this model . This vision of focusing monetary policy on a low rate of is so attractive that many countries have rewritten their central banking laws since in the to have their bank practice targeting , which means that the central bank is legally required to focus primarily on keeping low . By 2014 , central banks in 28 countries , including Austria , Brazil , Canada , Israel , Korea , Mexico , New Zealand , Spain , Sweden , Thailand , and the United Kingdom faced a legal requirement to target the rate . A notable exception is the Federal Reserve in the United States , which does not practice . Instead , the law governing the Federal Reserve requires it to take both unemployment and into account .
378 15 Policy and Bank Regulation Economists have no consensus on whether a central bank should be required to focus only on or should have greater discretion . For those who subscribe to the targeting philosophy , the fear is that politicians who are worried about slow economic growth and unemployment will constantly pressure the central bank to conduct a loose monetary if the economy is already producing at potential . In some countries , the central bank may lack the political power to resist such pressures , with the result of higher , but no reduction in unemployment . The Federal Reserve has a tradition of independence , but central banks in other countries may be under greater political pressure . For all of these and variable lags , excess reserves , unstable velocity , and controversy over economic policy in the real world is often . The basic message remains , however , that central banks can affect aggregate demand through the conduct of monetary policy and in that way outcomes . Asset Bubbles and Leverage Cycles One concern about having the central bank focus on and unemployment is that it may be overlooking certain other economic problems that are coming in the future . For example , from 1994 to 2000 during what was known as the boom , the stock market , which the Dow Jones Industrial Index measures ( which includes 30 very large companies from across the economy ) nearly tripled in value . The index , which includes many smaller technology companies , increased in value by a multiple of from 1994 to 2000 . These rates of increase were clearly not sustainable . Stock values as measured by the Dow Jones were almost 20 lower in 2009 than they had been in 2000 . Stock values in the index were 50 lower in 2009 than they had been in 2000 . The in stock market values contributed to the 2001 recession and the higher unemployment that followed . We can tell a similar story about housing prices in the . During the , and , housing prices increased at about per year on average . During what came to be known as the housing bubble from 2003 to 2005 , housing prices increased at almost double this annual rate . These rates of increase were clearly not sustainable . When housing prices fell in 2007 and 2008 , many banks and households found that their assets were worth less than they expected , which contributed to the recession that started in 2007 . At a broader level , some economists worry about a leverage cycle , where leverage is a term economists use to mean When economic times are good , banks and the sector are eager to lend , and people and are eager to borrow . Remember that a money multiplier determines the amount of money and credit in an economy process of loans made , money deposited , and more loans made . In good economic times , this surge of lending exaggerates the episode of economic growth . It can even be part ofwhat lead prices of certain stock prices or housing rise at high annual rates . At some point , when economic times turn bad , banks and the sector become much less willing to lend , and credit becomes expensive or unavailable to many potential borrowers . The sharp reduction in credit , perhaps combined with the prices ofa stock price bubble or a housing bubble , makes the economic downturn worse than it would otherwise be . Thus , some economists have suggested that the central bank should notjust look at economic growth , and unemployment rates , but should also keep an eye on asset prices and leverage cycles . Such proposals are quite controversial . If a central bank had announced in 1997 that stock prices were rising too fast or in 2004 that housing prices were rising too fast , and then taken action to hold down price increases , many people and their elected political representatives would have been outraged . Neither the Federal Reserve nor any other central banks want to take the responsibility of deciding when stock prices and housing prices are too high , too low , orjust right . As further research explores how asset price bubbles and leverage cycles can affect an economy , central banks may need to think about whether they should conduct monetary policy in a way that would seek to moderate these effects . Let end this chapter with a Work it Out exercise in how the any central stir up the economy by increasing the money supply . Access for free at
Pitfalls for Monetary Policy Calculating the Effects of Monetary Stimulus Suppose that the central bank wants to stimulate the economy by increasing the money supply . The bankers estimate that the velocity of money is , and that the price level will increase from 100 to 110 due to the stimulus . Using the quantity equation of money , what will be the impact of an 800 billion dollar increase in the money supply on the quantity of goods and services in the economy given an initial money supply of trillion ?
Step . We begin by writing the quantity equation of money . We know that initially , billion ) and 100 . Substituting these numbers in , we can solve for Step . Now we want to the effect of the addition 800 billion in the money supply , together with the increase in the price level . The new equation is 1309 Step . If we take the difference between the two quantities , we that the monetary stimulus increased the quantity of goods and services in the economy by billion . The discussion in this chapter has focused on domestic monetary policy that is , the View of monetary policy within an economy . Exchange Rates and International Capital Flows explores the international dimension of monetary policy , and how monetary policy becomes involved with exchange rates and international of capital . BRING IT HOME The Problem of the Zero Percent Interest Rate Lower Bound In 2008 , the Federal Reserve found itself in a difficult position . The federal funds rate was on its way to near zero , which meant that traditional open market operations , by which the Fed purchases Treasury Bills to lower short term interest rates , was no longer viable . This so called zero bound problem , prompted the Fed , Chair Ben , to attempt some unconventional policies , collectively called quantitative easing . By early 2014 , quantitative easing nearly quintupled the amount of bank reserves . This likely contributed to the recovery , but the impact was muted , probably due to some of the hurdles mentioned in the last section of this module . The unprecedented increase in bank reserves also led to fears of inflation , which never bore out . Throughout the there have been no serious signs of inflation with core inflation around a stable . As of early 2015 , however , there have been no serious signs of a boom , with core inflation around a stable . The Zero Lower Bound was encountered again in 2020 due to the pandemic , when the target federal funds rate dropped by over two percentage points in a matter of weeks . The Fed further responded by increasing asset purchases by an even greater amount , and at a faster rate , than in 2009 . When the started experiencing inflation in 2021 , the Fed chair Jerome Powell responded to criticisms by saying that the Fed was poised to consider rate increases and start rate of asset purchases into 2022 . It remains to be seen whether inflation can be tamed moving forward , or if more aggressive policy measures will be required .
380 15 Key Terms Key Terms bank run when depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost basic quantity equation of money money supply velocity nominal central bank institution which conducts a nation monetary policy and regulates its banking system monetary policy a monetary policy that reduces the supply of money and loans moving in the opposite direction of the business cycle of economic and deposit insurance an insurance system that makes sure depositors in a bank do not lose their money , even if the bank goes bankrupt discount rate the interest rate charged by the central bank on the loans that it gives to other commercial banks excess reserves reserves banks hold that exceed the legally mandated limit expansionary monetary policy a monetary policy that increases the supply of money and the quantity of loans federal funds rate the interest rate at which one bank lends funds to another bank overnight targeting a rule that the central bank is required to focus only on keeping low lender resort an institution that provides emergency loans in conditions of crisis loose monetary policy see expansionary monetary policy open market operations the central bank selling or buying Treasury bonds to the quantity of money and the level of interest rates quantitative easing ( QE ) the purchase of long term government and private securities by central banks to make credit available in hopes of stimulating aggregate demand reserve requirement the percentage amount of its total deposits that a bank is legally obligated to either hold as cash in their vault or deposit with the central bank tight monetary policy see monetary policy velocity the speed with which money circulates through the economy calculated as the nominal divided by the money supply Key Concepts and Summary The Federal Reserve Banking System and Central Banks The most prominent task ofa central bank is to conduct monetary policy , which involves changes to interest rates and credit conditions , affecting the amount of borrowing and spending in an economy . Some prominent central banks around the world include the Federal Reserve , the European Central Bank , the Bank of Japan , and the Bank of England . Bank Regulation A bank run occurs when there are rumors ( possibly true , possibly false ) that a bank is at financial risk of having negative net worth . As a result , depositors rush to the bank to withdraw their money and put it someplace safer . Even false rumors , if they cause a bank run , can force a healthy bank to lose its deposits and be forced to close . Deposit insurance guarantees bank depositors that , even if the bank has negative net worth , their deposits will be protected . In the United States , the Federal Deposit Insurance Corporation ( collects deposit insurance premiums from banks and guarantees bank deposits up to . Bank supervision involves inspecting the balance sheets of banks to make sure that they have positive net worth and that their assets are not too risky . In the United States , the of the Comptroller of the Currency ( is responsible for supervising banks and inspecting savings and loans and the National Credit Union Administration ( is responsible for inspecting credit unions . The and the Federal Reserve also play a role in bank supervision . When a central bank acts as a lender of last resort , it makes loans available in situations of severe Access for free at
15 Questions 381 panic or stress . The failure ofa single bank can be treated like any other business failure . Yet if many banks fail , it can reduce aggregate demand in a way that can bring on or deepen a recession . The combination of deposit insurance , bank supervision , and lender of last resort policies help to prevent weaknesses in the banking system from causing . How a Central Bank Executes Monetary Policy A central bank has three traditional tools to conduct monetary policy open market operations , which involves buying and selling government bonds with banks reserve requirements , which determine what level of reserves a bank is legally required to hold and discount rates , which is the interest rate charged by the central bank on the loans that it gives to other commercial banks . The most commonly used tool is open market operations . Monetary Policy and Economic Outcomes An expansionary ( or loose ) monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates , boosting aggregate demand , and thus countering recession . A monetary policy , also called a tight monetary policy , reduces the quantity of money and credit below what it otherwise would have been and raises interest rates , seeking to hold down . During the recession , central banks around the world also used quantitative easing to expand the supply of credit . Pitfalls for Monetary Policy Monetary policy is inevitably imprecise , for a number of reasons ( a ) the effects occur only after long and variable lags ( decide to hold excess reserves , monetary policy can not force them to lend and ( velocity may shift in unpredictable ways . The basic quantity equation of money is , where is the money supply , is the velocity of money , is the price level , and is the real output of the economy . Some central banks , like the European Central Bank , practice targeting , which means that the only goal of the central bank is to keep within a low target range . Other central banks , such as the Federal Reserve , are free to focus on either reducing or stimulating an economy that is in recession , whichever goal seems most important at the time . Questions . Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in than elected , like the President ?
Given the danger runs , why do banks not keep the majority of deposits on hand to meet the demands ?
Bank runs are often described as prophecies . Why is this phrase appropriate to bank runs ?
If the central bank sells 500 in bonds to a bank that has issued in loans and is exactly meeting the reserve requirement of 10 , what will happen to the amount of loans and to the money supply in general ?
What would be the effect of increasing the banks reserve requirements on the money supply ?
Why does monetary policy cause interest rates to rise ?
Why does expansionary monetary policy causes interest rates to drop ?
Why might banks want to hold excess reserves in time of recession ?
Why might the velocity of money change unexpectedly ?
382 15 Review Questions Review Questions 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . 21 . 22 . 23 . 24 . 25 . 26 . 27 . 28 . 29 . 30 . How is a central bank different from a typical commercial bank ?
List the three traditional tools that a central bank has for controlling the money supply . How is bank regulation linked to the conduct of monetary policy ?
What is a bank run ?
In a program of deposit insurance as it is operated in the United States , what is being insured and who pays the insurance premiums ?
In government programs supervision , what is being supervised ?
What is the lender of last resort ?
Name and describe the responsibilities of each of the following agencies , and . Explain how to use an open market operation to expand the money supply . Explain how to use the reserve requirement to expand the money supply . Explain how to use the discount rate to expand the money supply . How do the expansionary and monetary policy affect the quantity of money ?
How do tight and loose monetary policy affect interest rates ?
How do expansionary , tight , and loose monetary policy affect aggregate demand ?
Which kind of monetary policy would you expect in response to high expansionary or ?
Why ?
Explain how to use quantitative easing to stimulate aggregate demand . Which kind of monetary policy would you expect in response to recession expansionary or ?
Why ?
How might each of the following factors complicate the implementation of monetary policy long and variable lags , excess reserves , and movements in velocity ?
Define the velocity of the money supply . What is the basic quantity equation of money ?
How does a monetary policy of target work ?
Critical Thinking Questions 31 . 32 . 33 . 34 . Why do presidents typically reappoint Chairs of the Federal Reserve Board even when they were originally appointed by a president ofa different political party ?
In what ways might monetary policy be superior to policy ?
In what ways might it be inferior ?
The term moral hazard describes increases in risky behavior resulting from efforts to make that behavior safer . How does the concept of moral hazard apply to deposit insurance and other bank regulations ?
Explain what would happen were they had to increase their required reserves by one percentage point from , say , of deposits . What would their options be to come up with the cash ?
Access for free at 35 . 36 . 37 . 15 Problems 383 A economic model called the Phillips Curve ( discussed in The chapter ) describes the short run tradeoff typically observed between and unemployment . Based on the discussion of expansionary and monetary policy , explain why one of these variables usually fails when the other rises . How does monetary policy differ from discretionary monetary policy ( that is , monetary policy not based on a rule ) What are some of the arguments for each ?
Is it preferable for central banks to primarily target or unemployment ?
Why ?
Problems 38 . 39 . 40 . 41 . 42 . 43 . 44 . Suppose the Fed conducts an open market purchase by buying 10 million in Treasury bonds from Acme Bank . Sketch out the balance sheet changes that will occur as Acme converts the bond sale proceeds to new loans . The initial Acme bank balance sheet contains the following information Assets reserves 30 , bonds 50 , and loans 50 Liabilities deposits 100 and equity 30 . Suppose the Fed conducts an open market sale by selling 10 million in Treasury bonds to Acme Bank . Sketch out the balance sheet changes that will occur as Acme restores its required reserves ( 10 of deposits ) by reducing its loans . The initial balance sheet for Acme Bank contains the following information Assets reserves 30 , bonds 50 , and loans 250 Liabilities deposits 300 and equity 30 . All other things being equal , by how much will nominal expand if the central bank increases the money supply by 100 billion , and the velocity of money is ?
Use this information as necessary to answer the following questions . Suppose now that economists expect the velocity of money to increase by 50 as a result of the monetary stimulus . What will be the total increase in nominal ?
is and the money supply is 400 , what is velocity ?
now rises to , but the money supply does not change , how has velocity changed ?
now falls back to and the money supply falls to 350 , what is velocity ?