Monetary Policy and Economic Theories

Monetary Policy: Fed Tools (Keynesian Theory)

• Monetary policy, based on Keynesian theory, focuses on using the Federal Reserve's tools to influence economic activity.

Why Monetary Policy?

• Monetary policy is used to address:

  • Recessions: When actual GDP is less than potential GDP.

  • Inflation: When actual GDP is greater than potential GDP.

Recession

• Caused by a lack of effective demand (Keynes).

• Money is a prime determinant of demand.

• Actual GDP < Potential GDP

• Policy: Promote more demand.

• Banks tend to lend less during a recession, holding onto reserves.

• Individuals and businesses also reduce spending.

Inflation

• Economy is growing rapidly.

• Actual GDP > Potential GDP

• Policy: Reduce demand.

• Banks may be more willing to lend, increasing the money supply.

• Bank lending patterns reflect the business cycle:

  • During downturns, banks are less willing to make loans, holding onto reserves.

  • During upturns, banks increase loans and hold fewer reserves.

• Bank lending policies can counteract what is needed to stabilize the economy.

The Fed

• Main Functions:

  • Issuing currency.

  • Conducting monetary policy.

  • Emergency lending.

  • Financial regulation.

• Monetary policy goals:

  • Maximum employment.

  • Price stability (inflation target of 2%).

  • Moderate long-term interest rates.

• Monetary tools used by the Fed:

  • Open-market operations.

  • The discount rate.

  • Reserve requirements.

• The objective of these tools is to influence the excess reserves of banks, affecting their ability to make loans.

  • Excess reserves are the amount above what banks need to keep for daily transactions.

Monetary Tools

1. Open-Market Operations

• The Fed's purchase or sale of government securities (e.g., bonds) in the open market.

• Most important tool.

• Exchange between banks and Federal Reserve:

  • Fed purchases securities from banks:

    • Fed gets securities.

    • Banks get money.

  • Fed sells securities to banks:

    • Banks get securities.

    • Fed gets money.

• To increase the money supply:

  • Fed purchases securities (bonds) from private individuals and banks, increasing excess reserves of banks.

• To decrease the money supply:

  • Fed sells securities, decreasing excess reserves.

• Money from loans goes to excess reserves because banks don't have to keep a percentage of it as a deposit.

2. The Discount Rate

• Interest rate on Fed money loans to banks.

• Inverse relationship between the interest rate (discount rate) and demand for money (loans).

• To encourage banks to borrow, the Fed should lower the discount rate.

• To decrease loans to banks, the Fed should increase the discount rate.

• To increase the supply of money:

  • Fed decreases discount rate.

  • Banks borrow more money, increasing their excess reserves.

• To decrease the supply of money:

  • Fed increases the discount rate.

  • Banks borrow less money decreasing their ability to make more loans.

3. Reserve Requirements

• Currently, around 10% (on average).

• Therefore excess reserves is 90% (available for loans).

• To increase banks' ability to make more loans (increase excess reserves):

  • Fed should decrease the reserve requirement.

• To decrease the excess reserves of the banks:

  • Fed should increase the reserve requirement.

• To increase the supply of money:

  • Fed decreases the ratio, increasing excess reserves.

• To decrease the supply of money:

  • Fed increases the ratio, decreasing excess reserves.

Monetary Policy

• Recession: Fed should increase the supply of money.

• Inflation: Fed should decrease the supply of money.

Monetary Policy Tools Summary

• Open Market Operations

  • Recession: Fed buys securities from banks.

  • Inflation: Fed sells securities to banks.

• Discount Rate

  • Recession: Fed decreases the rate.

  • Inflation: Fed increases the rate.

• Reserve Ratio Requirement

  • Recession: Fed decreases the ratio.

  • Inflation: Fed increases the ratio.

Conclusion

• The Fed uses monetary tools to control the money supply and interest rates by manipulating the excess reserves of banks.

Money Market

• The price of money is the interest rate.

• Determined by the demand for money and the supply of money.

Demand for Money (Keynes)

• Reasons or motives for holding cash:

  • Transactions motive: daily transactions.

  • Precautionary motive: emergency funds.

  • Speculative motive: financial markets.

• Speculative motive:

  • Demand for money is a choice between holding wealth as money and holding it in other financial assets.

  • As interest rates increase, people prefer to purchase financial assets (bonds) and hold less money.

  • Inverse relationship between demand for money and interest rates.

Demand for Liquidity (Money)

$Interest Rate \qquad Quantity of Money / Cash Balances$
$i$

$Total Demand = Transcations \ Demand + Precautionary \ Demand + Speculative \ Demand$
$Q$

Supply of Money

• Controlled by the central bank (The Fed).

• Inelastic (independent) to interest rate.

• Vertical curve.

Equilibrium

$Interest \atop Rate$
$i<em>E$ Money Market Money Supply Total Demand $Q</em>E$
Quantity of
Money / Cash
Balances

Aggregate Expenditure (AE)

• Recession: YE < YF

• Increase or decrease total demand (AE)?

• Increase or decrease the supply of money?

• Policy by the Fed?

  • Open market operations: Fed sells or buys securities from banks?

  • Discount rate: increase or decrease?

  • Reserve requirement: increase or decrease?

• We want to increase total demand (AE).

• We want to increase the supply of money.

• Policy by the Fed?

  • Open market operations: buy securities from banks.

  • Discount rate: decrease.

  • Reserve requirement: decrease.

Recession

• Fed to increase supply of money using any of the monetary policy tools

Increase in Money Supply

• Decrease in interest rate

• Investment increases

• AE (total demand) increases

• GDP (total production) increases
  Monetary Tool: Recession

Discount Rate: decrease
Banks borrow more money from the Fed à increase in excess reserves

• Reserve Requirement: decrease
  Excess reserves increases
  In both cases excess reserves of banks increase à increase in loans à increase in supply of money

• ↑ Excess Reserves à ↑ Loans à ↑ Money Supply à Money Supply shifts right è ↓ interest rate è ↑ Investment è ↑ AE è ↑ GDP (closing the recessionary gap)

Inflation

• Do we want to increase or decrease total demand?

• Do we want to increase or decrease the supply of money?

• Policy by the Fed?

  • Open market operations: sell or buy securities?

  • Discount rate: increase or decrease?

  • Reserve requirement: increase or decrease?
    Monerary Tool During Inflation

Policy:
Decrease supply of money in order to decrease total demand

Open market operations: sell securities to banks
Discount rate: increase
3. reserve requirement: increase
Recession
Fed should increase or decrease the supply of money
Increase
Inflation
Fed should increase or decrease the supply of money
decrease

Monetary Tool during Inflation

• Policy: Decrease supply of money in order to decrease total demand.

  • Open market operations: sell securities to banks

  • Discount rate: increase

  • Reserve requirement: increase

• Fed decreases supply of money by reducing excess reserves of banks

• Shift of supply of money to the left • (see money market)

• Increase in interest rate • Investment decreases

• AE decreases

• GDP decreases
  Monetary Policy - Inflation
  ↓ Excess Reserves à ↓ Loans à ↓ Money Supply à Money Supply shifts left è ↑ interest rate è ↓ Investment è ↓ AE è ↓ GDP (closing the inflationary gap)

Summary

• Any of the monetary tools by affecting banks reserves and therefore funds for loans will have an effect on the supply of money

• Shift of supply curve è ∆ interest rate è ∆ Investment è ∆ AE è ∆ GDP

Keynesians consider monetary policy less effective than fiscal policy since indirect means of implementing changes in aggregate spending

Critique to Keynesian Theory

• Banks don’t want to take risk lending during recession regardless of how much excess reserves they have.

  • What do banks do with that extra cash/money?

• What do banks, corporations and wealthy people do during time of crisis given the high risks in investing in the real economy?

• What was the effect of recent increase in the supply on money during the last recession resulting from government economic relief funds?

• According to keynesian theory it should result in an increase in production/GDP.

• Stock Market
  Stock Market Soars and Billionaire Wealth Swells by $1 Trillion as Food Lines Stretch 'As Far As the Eye Can See‘, 11/25/20, Common Dreams
  "So, we have all this money being created… Where does the money go if it doesn't go into producing goods and services since the demand isn't there? It goes into the stock market, where it bids up the price of stocks, which is what the rich people are happy about because it makes them richer still. That's why the billionaires in America amassed another two trillion dollars while the rest of us were struggling with the Covid-19 disaster." (The disconnect between the stock market and the economic reality for the rest of us - Richard Wolff, 1/23/21)

Inflation

• “Between December 2019 and August 2021, the U.S. money supply, measured by M2, grew by 5.5 trillion$, a stunning$35.7\%$$ increase in only a year and a half, driven primarily by the Fed's purchases of Treasury’s and mortgage-backed securities.”

• “President Biden says we are facing a temporary bout of price increases caused by supply-chain glitches and bottlenecks that are themselves temporary. But while supply-chain problems affect prices of specific commodities, they have little effect on the overall price level if monetary growth is stable.”

• Source: The Monetary Bathtub Is Overflowing, Wall Street Journal, Oct. 21, 2021

Marx

• Money functions as capital when advanced to make profits.

• Three circuits of capital:

  • industrial circuit (real economy)

  • commercial circuit

  • financial circuit

• No production or creation of surplus in the commercial and financial circuits.

• production conditions are the main determinants of economic fluctuations (business cycles/recessions)

  • Rate of profit determines investment

  • Rate of profit = Profits / Capital Advanced

• the tendency for a falling rate of profit:
  competition forces firms to increase the proportion of capital advanced for plant and equipment relative to the proportion advanced to employ labor.
  Capitalist will try to restore profitability by reducing wages

• Money as capital
  Advanced to make profit in industrial, commercial or financial circuit

• Money as revenue:
  Consumption: food, rent, etc.

Under conditions of declining profit rate
capital can migrate from production (industrial) circuits towards financial markets
Purchase of securities (stocks, bonds, etc.)
asset ‘bubbles’
Real Estate market
housing bubble
Marxist Critique
Government intervention under conditions of declining profit rate
Increase in transfer payments

• Money as revenue

• ↑ Sm (Supply of money) à ↑AE à ↑ Price level (inflation)
  This was the situation of stagflation in the 1970s.
  -Crisis in Keynesian economics
  -Replaced by Neoliberalism
  1970’s Crisis
  “Keynesianism as an economic practice, rather than an ideology, was not put to the test until the first serious economic crisis in 40 years erupted in the mid-1970s – and it proved incapable of dealing with it. Capitalists were faced with a combination of recession and rising prices known as “stagflation”.
  Within three or four years Keynesianism had been replaced as the orthodoxy by reborn versions of the ideas it had pushed aside four decades earlier.”
  “There was a structural crisis of capitalism. That is, the policies, practices and institutions that had been serving well capitalism’s goal of capital accumulation ceased to do so.
  More narrowly, one can say that capitalism abandoned the Keynesian compromise in the face of a falling rate of profit, under the belief that neoliberalism could improve its profit and accumulation performance.”