monetarypolicy

Introduction to Monetary Policy

• Lecture 18 by Emmanuel Saez, Fall 2024

• Focus on monetary policy in economic contexts.

Overview (Page 2)

• Understanding how monetary policy influences the economy.

Determination of Short-Run Output: The "Keynesian Cross" (Page 3)

• Short-run outputs influenced by aggregate demand.

• Planned Aggregate Expenditure (PAE) depicted against output.

Shifting PAE (Page 4)

• Factors influencing shifts in PAE:

  • Monetary Policy: Central bank actions impacting nominal and real interest rates.

  • Financial Market Disruptions: Such as financial crises affecting overall stability.

Interest Rates, Money, and the Federal Reserve (Page 5)

• Examining various aspects of interest rates and the role of the Fed.

Different Interest Rates (Page 6)

• Presence of various nominal interest rates influenced by:

  • Riskiness of Bonds/Loans: Riskier investments yield higher returns.

  • Maturity: Length of time till the bond matures affects interest rates.

  • Interest rates generally move together, representing overall trends.

Evaluating Bond Riskiness (Page 7)

• Bond risk rated by agencies (Moody's, S&Ps, Fitch):

  • AAA (safest) to C/D (junk bonds).

Quiz on Interest and Risk (Page 8)

• Evaluating attractiveness of bonds based on risk and return.

• Example: Safe Federal Government bond vs riskier corporate bonds.

Interest Rates on Bonds of Different Maturities (Page 9)

• Long-term bonds reflect expected average short-term interest returns.

Understanding Bond Savings (Page 10)

• Illustration of saving mechanisms via Treasury bonds for different periods.

Quiz on Treasury Bond Expectations (Page 11)

• Interpretation of current interest rate trends and future expectations.

Characteristics of Money (Page 12)

• Money defined by three main characteristics:

  • Medium of Exchange: Used in transactions.

  • Unit of Account: Standard measurement for prices.

  • Store of Value: Holds value over time.

• Historical vs contemporary definitions of money.

Crypto Currency and Its Characteristics (Page 13)

• Quiz on how Bitcoin measures against the defined characteristics of money.

Role of Commercial Banks (Page 14)

• Functions of commercial banks in the economy:

  • Safeguarding deposits and lending practices.

  • Risks related to liquidity and bank runs.

Federal Reserve's Role in Monetary Policy (Page 15)

• Open-market operations: The Fed's purchase and sale of government bonds to control money supply.

Functions of the Federal Reserve (Page 16)

• Price Stability: Maintaining low inflation (around 2%).

• Maximum Employment: Ensuring low unemployment at normal output levels.

• Financial Stability: Acting as a lender of last resort.

Money Production and Government (Page 17)

• Transition from costly precious metal production to modern, cost-effective money creation.

Risks of Money Mismanagement (Page 18)

• Excessive money creation can lead to inflation or hyperinflation.

• Importance of an independent central bank to mitigate these risks.

Modern Monetary Policy Analysis (Page 19)

• The Fed can influence short-run nominal interest rates by:

  • Adjusting interest on bank reserves.

  • Engaging in open market operations.

Federal Funds Rate (Pages 20-21)

• Monitoring the federal funds effective rate and its correlation with Treasury Bill rates.

Money Demand Curve (Pages 23-25)

• Illustrates how money demand decreases with increasing interest rates.

The Fed’s Impact on Real Interest Rates (Page 26)

• Discusses the relationship between nominal interest rates set by the Fed and their impact on real rates.

Takeaways on Monetary Policy Influence (Page 28)

• Tools available to the Fed to affect nominal interest rates and their broader economic implications.

PAE and Real Interest Rate Dynamics (Pages 29-34)

• How changes in the real interest rate affect Planned Aggregate Expenditure (PAE) and economic output:

  • Investment Decrease: Higher rates discourage business investment.

  • PAE Shifts: Changes in aggregate consumption and investment based on interest rate adjustments.

Expansionary and Contractionary Monetary Policy (Pages 37-38)

• Definitions of contractionary and expansionary policies and their effects on output.

Interest Rate Trends During Economic Conditions (Pages 39-40)

• Fed's actions to reduce rates during recessions and increase during economic booms.

Response to Output Decline (Pages 41-44)

• Consequences of reduced PAE on recession and recovery patterns.

Historical Monetary Policy Analysis: The Great Depression (Pages 45-49)

• Review of Fed actions during the Great Depression and their effectiveness.

Limitations of Monetary Policy (Page 49)

• Discussion on the Zero Lower Bound.

• Barriers to further rate cuts during severe economic downturns.

Financial Crisis Overview (Pages 53-54)

• Definition and implications of financial crises on the economy.

Causes and Effects of Financial Institution Failures (Pages 55-58)

• Mechanisms leading to insolvency in financial institutions and examples of recent failures like Silicon Valley Bank.

Contagion Effects in Financial Crises (Pages 59-60)

• How issues in one financial institution can affect the broader market.

Effects of Financial Crises on PAE (Page 61)

• Impact on lending conditions and consumer confidence, reducing aggregate demand.

Policy Recommendations to Prevent Financial Crises (Page 65)

• Suggestions for improving stability in the banking system through deposit insurance and regulation.

Unconventional Monetary Policies (Page 66-74)

• Description of unconventional tools used by the Fed in recent crises (quantitative easing and forward guidance).

Comparison of Monetary and Fiscal Policies (Page 76)

• Exploration of the deployment and effectiveness of monetary vs. fiscal policy in stabilizing the economy.

References (Page 77)

• Suggested readings and additional resources related to the topics discussed.