Study Notes on Chapter 16 - Monetary Policy

Key Concepts
- Negative Real Shock Dilemma
- Situations when the Fed may act excessively

The Federal Reserve (the Fed) only controls the monetary base, which consists of
- Currency
- Bank reserves
Important monetary aggregates for aggregate demand (AD) include
- M1 (transactions money)
- M2 (broader measure of money supply)
Functioning of banks in the economy
- Banks profit by making loans.
- When deposits increase, banks hold some as reserves (fractional reserve banking) and lend the rest.
  - Process of fractional reserve banking:
  - Funds lent by one bank become deposits in another bank.
  - A portion of these new deposits can also be lent out.
  - This increases the amount of transactions money by a multiple of the monetary base.

The relationship between the monetary base and M1 is described by the simple money multiplier formula: $\Delta M_1 = \Delta\left(\frac{1}{RR}\right)$
- Where RR is the reserve ratio.
Effects of an increase in the monetary base:
- Leads to a change in M1 that is greater than one-for-one.
Example:
- If $RR = 0.10$ and the monetary base increases by $10$ , then M1 increases to
  $100 = 10 \times \left(\frac{1}{0.10}\right)$

Business fluctuations arise from shocks to aggregate demand (AD) and aggregate supply (AS).
A severe negative shock can lead to recession through declines in either AD or AS.
The Fed conducts monetary policy to mitigate business fluctuations by controlling the
- Money supply
- Interest rates
The Fed can influence AD but not AS.

Instruments:
1. Open Market Operations (buying or selling bonds)
2. Paying Interest on Bank Reserves
Targets:
- Intermediate:
1. Monetary Aggregates
2. Interest Rates
- Ultimate Goals:
1. Increased total spending and reduced unemployment (Real GDP growth)
2. Reduced inflation and price stability

The Fed influences the federal funds rate to also affect other interest rates.
- Broad influence on aggregate expenditures through interest rates.

Beginning in October 2008, the Fed started paying interest on reserves.
Effects of changing the interest rate on reserves:
- If increased, banks have less incentive to lend, affecting loan volumes.
- If decreased, banks will make more loans, increasing M1 and shifting AD outward.

Focus shifts to
- When should the Fed influence AD?
- When can the Fed effectively influence AD?
- When do these actions lead to higher GDP growth rates?

Scenario: Entrepreneurs and lenders become pessimistic, leading to reduced borrowing and lending.
Result: Decrease in money supply growth causes a decline in AD and output growth.
The Fed can act using:
- Open market operations to raise the money supply growth.
- Targeting lower federal funds rate and reducing interest rates on reserves.

Initial conditions at long-run equilibrium (point a).
- A decrease in AD leads to a short-run equilibrium at point b.
- Quick Fed action to increase money supply growth can reduce recession duration.
- Recovery leads back to long-run equilibrium (point a).

Real-time operation while economic conditions are uncertain.
Control over money supply is incomplete; effects can have variable lags of 6 to 18 months.
- $MS = MB \times MM$ (Money Supply = Monetary Base x Money Multiplier)
Timing and amount of policy are crucial for successful outcomes.

Possible scenarios of policy errors:
- Undershooting (too little response) or Overshooting (too much response).
Historical example:
- 1970s over-stimulation led to inflation reaching 13.5% by 1980; recession followed with unemployment over 10%.
- Disinflation measures led to lower inflation but initially resulted in a severe recession.

Post-9/11 actions
- Fed lent substantial amounts to stabilize banks, e.g., increasing lending on September 12, 2001, to $45.5 billion from $34 million before the attacks.
This maintained stability and confidence in the economy.

When faced with a negative real shock:
- Inflation increases while real GDP growth decreases.
- If the Fed decreases AD by reducing money supply, inflation rates drop but so does real GDP growth.
- On the other hand, increasing money supply raises GDP growth but increases inflation significantly.
- Conclusion: The Fed cannot meet both high GDP growth and low inflation targets simultaneously during a real shock; monetary policy is less effective in these situations compared to AD shocks.

Even in favorable scenarios, timing, and effectiveness of monetary policy remain challenged by lags and uncertainty.
In cases of negative real shocks, fulfilling dual mandates becomes practically impossible.

From one year to the next, inflation rises from 4 to 5 percent, while unemployment falls from 6 to 5 percent. Possible responsible events include:
- Central government reducing expenditures.
- Good weather improving capital and labor efficiency.
- Central bank increasing growth rate of money supply.
- Newly discovered oil reserves plummeting world oil prices.

The economy is growing at a long-run potential growth rate of 3% with an inflation rate of 4%. If a positive AD shock occurs and the Fed responds by decreasing money growth, but fails to offset the aggregate demand shock, in the short run:
- Inflation: __ 4%.
- Real GDP growth rate: __ 3%.