Econ 102 March 12 chapter 11 lecture

Central Bank Policy and Monetary Policy Overview

• Monetary Policy Impact

  • Affects the economy by managing interest rates and liquidity in the market.

  • Recent actions by the European Central Bank include cutting interest rates to stimulate economic growth.

  • Upcoming FOMC (Federal Open Market Committee) meeting may not result in policy change, but increasing discussions on global economic factors including inflation and trade wars will be held.

Federal Reserve System Structure

• Federal Reserve System

  • Blueprint for many other central banks worldwide (Europe, England, Canada, Australia).

  • The Federal Funds Rate (FFR) is the key focus, representing short-term loans between banks.

Federal Funds Market

• Demand and Supply in Federal Funds Market

  • Horizontal axis: Quantity of reserves (bank reserves).

  • Federal Reserve sets a minimum required reserve ratio; larger banks have higher requirements.

  • FFR is determined at the intersection of demand and supply curves in this market.

Demand Curve Shifters

• Factors Affecting Demand for Reserves:

  • Supervision and Regulation: Federal Reserve requires banks to hold enough reserves to meet liquidity needs.

  • Interest on Reserves (IoR): Higher interest rate on reserves leads banks to demand more reserves.

  • Spending Plans: Increased consumer and business spending reduces the amount available for lending, thus increasing demand for reserves.

Interest Rates and Relationships

• Interest Rates Discussion

  • Interest on reserves serves as a lower bound for any interest rate in the economy.

  • Fed influences the federal funds rate by adjusting minimum reserve requirements and the IoR.

  • FFR influences long-term interest rates by affecting bank lending behavior.

Discount Rate

• Discount Rate Explained

  • Used as an emergency measure and typically set around zero.

  • Example scenarios include financial crises when banks need immediate liquidity (e.g., post-9/11)

Monetary Policy Goals and Challenges

• Dual Mandate of the Fed

  • Objectives: Maximize employment and maintain price stability.

  • Trade-offs between inflation and unemployment are common.

  • Stagflation Risk: Economic condition where stagnation and inflation occur simultaneously.

Monetary Policy Tools

• Open Market Operations

  • Buying and selling government bonds to influence reserves.

  • Quantitative Easing: Similar to open market operations but focuses on longer-term securities like mortgage-backed securities.

• Shifts in Demand and Supply

  • Demand for bank reserves can shift due to changes in required reserve ratios or IoR.

  • Open market operations directly increase the supply of bank reserves.

Long-term Effects of Monetary Policy

• Long-run Dynamics

  • Although monetary policy has significant short-term impacts, its long-term influence primarily leads to inflation without altering real economic factors.

  • Real Wages and Employment: During cyclical expansions, employment may rise due to increased borrowing, which boosts GDP in the short term. In the long run, returns to the equilibrium should restore original conditions.

Expectations and Behavior

• Rational Expectations Theory

  • Suggests that labor supply shifts reflect expectations about future economic conditions.

  • Not all individuals may act on this rationally, leading to debates in macroeconomic circles regarding labor market responses.

Conclusion

• Summary of Key Points

  • The role of the Fed and its policies in influencing both short and long-term economy. Understanding monetary policy's tools and their effects on the economy is crucial.

  • Continuous practice with these concepts is advised as they will be revisited in future classes.