Monetary Policy and Bank Regulation

15.1 The Federal Reserve Banking System and Central Banks

  • Central bank: an organization responsible for conducting monetary policy and ensuring a nation’s financial system operates smoothly.
  • In the U.S., the central bank is the Federal Reserve (“the Fed”).
  • The Fed is semi-decentralized, mixing government appointees with representation from private-sector banks.
  • It is run by a Board of Governors, consisting of seven members appointed by the President and confirmed by the Senate.
  • The Chair of the Federal Reserve Board controls the agenda and is the Fed's public voice.
  • The Fed includes 12 regional Federal Reserve banks, each supporting commercial banks and the economy in its district.
  • The Federal Reserve performs three important functions:
    • Conduct monetary policy.
    • Promote stability of the financial system.
    • Provide banking services to commercial banks and the federal government.

15.2 Bank Regulation

  • Bank regulation maintains banks' solvency by avoiding excessive risk.
  • Regulation categories:
    • Reserve requirements.
    • Capital requirements.
    • Restrictions on investments.
  • Regulation requires banks to maintain a minimum net worth, usually as a percentage of assets, to protect depositors and creditors.

Bank Supervision

  • Government agencies monitor banks' balance sheets.
    • Office of the Comptroller of the Currency (within the U.S. Department of the Treasury).
    • National Credit Union Administration (NCUA).
    • The Federal Reserve.

A Run on the Bank

  • Bank run: depositors rush to withdraw deposits, fearing loss.
  • Bank runs during the Great Depression worsened the economic situation.

Deposit Insurance and Lender of Last Resort

  • Risk of bank runs can create instability.
  • Strategies to protect against bank runs:
    • Deposit insurance: ensures depositors do not lose money if the bank fails. Banks pay premiums to the Federal Deposit Insurance Corporation (FDIC).
    • Lender of last resort: provides short-term emergency loans during financial crises.

15.3 How a Central Bank Executes Monetary Policy

  • The Federal Reserve's main function: conduct monetary policy.
  • Monetary policy: manages interest rates and credit conditions, influencing economic activity.
  • Common monetary policy tool:
    • Open market operations: the central bank sells or buys Treasury bonds to influence the money supply and interest rates.
    • Federal Open Market Committee (FOMC): makes decisions on open market operations, including 7 members of the Board of Governors and 5 members from regional Federal Reserve Banks.

How Open Market Operations Increase the Money Supply

  • When the central bank purchases 20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by 20 million and the bank’s reserves rise by 20 million.
  • Happy Bank loans out the extra 20 million in reserves and its loans rise by 20 million, causing an expansion of the money supply.

How Open Market Operations Decrease the Money Supply

  • When Happy Bank purchases 30 million in bonds, it sends 30 million of its reserves to the central bank and holds an additional 30 million in bonds.
  • Happy Bank adjusts down the quantity of its loans by 30 million, bringing its reserves back to the desired level, which causes the money supply to decrease.

Changing Reserve Requirements

  • The central bank can raise or lower the reserve requirement.
    • Reserve requirement: the percentage of deposits banks must hold as cash or on deposit with the central bank.
    • Greater reserve requirement = less money available to lend out.
    • Smaller reserve requirement = greater amount of money available to lend out.
  • The Fed rarely uses large changes in reserve requirements, except during the pandemic.

Changing the Discount Rate

  • The central bank can raise or lower the discount rate.
    • Discount rate: the interest rate charged by the central bank on loans to commercial banks.
    • If the central bank raises the discount rate, commercial banks reduce borrowing from the Fed and call in loans to replace reserves, decreasing the money supply and raising market interest rates.
    • If the central bank lowers the discount rate, the process works in reverse.

15.4 Monetary Policy and Economic Outcomes

  • Expansionary monetary policy (or loose monetary policy): increases the supply of money and loans.
  • Contractionary monetary policy (or tight monetary policy): reduces the supply of money and loans.

The Effect of Monetary Policy on Interest Rates

  • Federal funds rate: the interest rate at which banks lend funds to each other overnight.
  • The central bank changes bank reserves through open market operations, affecting the supply curve of loanable funds.
  • The Federal Reserve establishes its target federal funds rate before open market operations.
  • If open market operations do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.

Monetary Policy and Interest Rates

  • Expansionary monetary policy shifts the supply of loanable funds to the right (e.g., from S0 to S1), reducing the interest rate (e.g., from 8% to 6%).
  • Contractionary monetary policy shifts the supply of loanable funds to the left (e.g., from S0 to S2), raising the interest rate (e.g., from 8% to 10%).

The Effect of Monetary Policy on Aggregate Demand

  • Monetary policy affects interest rates and loanable funds, influencing aggregate demand.
  • Tight or contractionary monetary policy reduces:
    • Business investment (less borrowing).
    • Consumer borrowing for big-ticket items.
  • Loose or expansionary monetary policy increases business investment and consumer borrowing.

Expansionary or Contractionary Monetary Policy

  • Expansionary monetary policy reduces interest rates and shifts aggregate demand to the right (e.g., from AD0 to AD1), leading to a new equilibrium at the potential GDP level with a small rise in the price level.
  • Contractionary monetary policy shifts aggregate demand to the left (e.g., from AD0 to AD1), leading to a new equilibrium at the potential GDP level.

Countercyclical

  • Monetary policy should be countercyclical, moving in the opposite direction of the business cycle.

The Pathways of Monetary Policy

  • Expansionary monetary policy: increases the money supply (M), lowering the interest rate (r), stimulating borrowing for investment (I) and consumption (C), and shifting aggregate demand to the right, resulting in a higher price level (P) and higher real GDP.
  • Contractionary monetary policy: decreases the money supply (M), raising the interest rate (r), discouraging borrowing for investment (I) and consumption (C), and shifting aggregate demand to the left, resulting in a lower price level (P) and lower real GDP.

Federal Reserve Actions Over Last Four Decades

  • The Federal Reserve typically reacted:
    • To higher inflation with contractionary monetary policy and a higher interest rate.
    • To higher unemployment with expansionary monetary policy and a lower interest rate.

Quantitative Easing

  • Quantitative easing (QE): the purchase of long-term government and private mortgage-backed securities by central banks to stimulate aggregate demand.
  • Used in the 2008 recession.
  • Quantitative easing differs from traditional monetary policy:
    • The Fed purchases long-term Treasury bonds rather than short-term Treasury bills.
    • The Fed also purchases private mortgage-backed securities.

15.5 Pitfalls for Monetary Policy

  • Banks can hold excess reserves above the legally required minimum.
    • Excess reserves: reserves banks hold that exceed the legally mandated limit.
  • Velocity: the speed with which money circulates through the economy.
    • Velocity = {Nominal GDP \over money supply}

Unpredictable Movements of Velocity

  • Basic quantity equation of money: Money supply × velocity = Nominal GDP
  • Nominal GDP = Price Level (or GDP Deflator) × Real GDP
  • Therefore, Money Supply × velocity = Price Level × Real GDP
  • Changes in velocity can cause problems for monetary policy.

Velocity Calculated Using M1

  • Velocity is the nominal GDP divided by the money supply for a given year.
  • Different measures of velocity can be calculated using different measures of the money supply.
  • Velocity, as calculated by using M1 money supply, has lacked a steady trend since the 1980s, instead bouncing up and down.

Unemployment and Inflation

  • Central bankers believe the primary task of monetary policy should be fighting inflation.
  • Inflation targeting: a rule that the central bank is required to focus only on keeping inflation low.
  • Economists have no final consensus on whether a central bank should be required to focus only on inflation or should have greater discretion.

Monetary Policy in a Neoclassical Model

  • Monetary policy affects only the price level, not the level of output in the economy.
  • Expansionary monetary policy shifts aggregate demand from AD0 to AD1, representing an inflationary increase in the price level from P0 to P1, but has no long-run effect on output or the unemployment rate.
  • No shift in AD will affect the equilibrium quantity of output in this model.