Monetary Policy In-Depth Notes

Monetary Policy Goals

  • Dual Mandate: Maximum employment and stable prices.

    • Long Run: Goals reinforce each other.

    • Short Run: Can be in conflict.

    • Key Goal: Price stability, as it is essential for maximum employment.

Decision-Making Strategy

  • Assessment: Intensive evaluation of the current economic state.

  • Forecasting Variables:

    • Inflation rate

    • Unemployment rate

    • Output gap

Policy Tools of the Central Bank

  • Main Tools to Control Short-Term Interest Rates:

    • Open Market Operations: Buying and selling of government securities.

    • Last Resort Loans: Providing loans to commercial banks at a discount rate.

    • Required Reserve Ratios: Regulation of the fraction of deposits that banks must hold in reserve.

Open Market Operations

  • Mechanism:

    • Purchases: Central bank buys securities, increasing money supply.

    • Example: Central bank purchases bonds; money is injected into the economy.

    • Sales: Central bank sells securities, decreasing money supply.

    • Example: Central bank sells bonds; money is withdrawn from circulation.

Bonds as Financial Securities

  • Definition: Bonds are a form of borrowing issued by governments.

  • Characteristics:

    • Fixed interest rate (coupon) paid annually.

    • Principal amount (face value) repaid at maturity (e.g., 5 years).

Discount Rate and Loans

  • Discount Rate: Interest rate at which banks borrow from the central bank.

  • Effect on Money Supply:

    • Higher discount rate leads to decreased money supply.

    • Lower reserve requirements increase banks' lending capacity, raising money supply.

Effects of Central Bank Actions

  • Open Market Purchase: Increases bank reserves and encourages lending.

  • Open Market Sale: Decreases bank reserves and limits lending.

Monetary Base and Money Supply

  • Monetary Base (M0): Currency + bank reserves at central bank.

  • Money Supply (M1): Currency + checkable deposits.

  • An increase in the monetary base leads to an increase in money supply, influencing interest rates.

The Money Market Overview

  • Model Framework: Based on supply and demand for money as a commodity.

  • Interest Rate (i): Determined by money demand (Md) and money supply (Ms).

  • Types of Money Market:

    • Real Money Market: Adjusted for inflation.

    • Nominal Money Market: Not adjusted for inflation.

Demand for Real Money

  • Determining Factors:

    • Nominal interest rate (i)

    • Real GDP (Y)

    • Financial innovation (e.g., debit cards)

  • Liquidity Preference Theory:

    • Explains why people prefer holding money (most liquid asset).

Theoretical Underpinnings of Money Demand

  • Motives for Holding Money:

    • Transaction Demand: Money for daily transactions.

    • Precautionary Demand: Money for unforeseen expenses.

    • Speculative Demand: Holding cash to buy bonds later when prices are more favorable.

Movement in the Money Demand Curve

  • Interest Rates Impact:

    • Rise in interest rates leads to a decrease in real money demanded.

    • Fall in interest rates results in an increase in real money demanded.

Shifts in the Demand for Money Curve

  • Rightward Shift: Increase in real GDP increases money demand.

  • Leftward Shift: Decrease in real GDP or financial innovation decreases money demand.

Supply of Real Money

  • Supply Determinants: Set by the central bank using policy tools, vertically aligned regardless of interest rates.

  • Real Money Supply Equation: Ms=MPMs = \frac{M}{P} (where M = nominal money supply, P = price level).

Money Market Equilibrium

  • Condition for Equilibrium: Quantity of money demanded equals quantity supplied.

  • Long Run Adjustments: Differ from short run, primarily involves the loanable funds market.

Short-Run Equilibrium Example

  • If the Fed sets MsMs to $3 billion and interest rate is 5%, equilibrium is established.

Surplus and Shortage in the Money Market

  • Surplus: When Ms > Md, leads to decreased interest rates as people buy bonds.

  • Shortage: When Ms < Md, leading to increased interest rates as people sell bonds.

Effects of Open Market Operations

  • Purchases Raise Money Supply: Increased bond demand raises bond prices, lowering interest rates.

  • Sales Lower Money Supply: Increased bond supply lowers bond prices, raising interest rates.

Monetary Policy Transmission

  • Effects on Aggregate Expenditure (PAE): Consumption, investment, and net exports influenced by adjusted interest rates.

Long-Term Implications of Monetary Policy

  • Money Neutrality: In the long run, changes in money supply do not affect real variables (e.g., RGDP).

Liquidity Trap & Zero Lower Bound Issues

  • Ineffectiveness: When interest rates are near zero, the effectiveness of monetary policy diminishes as individuals are indifferent between holding money and bonds.