Mac CH 14

Macroeconomics
Dr. Karim Kobeissi

Arts, Sciences and Technology
University in Lebanon
Chapter 14: Monetary Policy
Keyword: Federal Funds Rate
The interest rate at which a commercial bank lends funds

maintained at the Central Bank to another commercial
bank overnight.
The federal funds rate is generally only applicable to the
most creditworthy institutions when they borrow and
lend overnight funds to each other. The federal funds
rate is one of the most influential interest rates in the
U.S. economy, since it affects monetary and financial
conditions, which in turn have a bearing on key aspects
of the broad economy including employment, growth
Goals of Monetary policy

Monetary policy has two basic goals:
1) To
promote
maximum
output and employment .

2) To promote stable prices.
sustainable
What do Maximum Sustainable Output

and Employment Mean?
In the long run, the amount of goods and services the economy
produces (output) and the number of jobs it generates
(employment) both depend on factors other than monetary
policy. These factors include technology and peoples
preferences for saving, risk, and work effort. So, maximum
sustainable output and employment mean the levels consistent
with these factors in the long run.
But the economy goes through business cycles in which output
and employment are above or below their long-run levels. Even
though monetary policy cant affect either output or employment
in the long run, it can affect them in the short run. For example,
when demand weakens and theres a recession, the Fed can
stimulate the economytemporarilyand help push it back
toward its long-run level of output by lowering interest rates.
Thats why stabilizing the economythat is, smoothing out the
peaks and valleys in output and employment around their longrun growth pathsis a key short-run objective for central banks.
Tools of Monetary Policy

1. Open-market
operations:
buying
and
selling treasury bonds, notes, and bills.

2. Reserve ratio: % of deposits that must be
held by a bank as vault cash or on
account with the Central Bank .
3. Discount rate: Interest rate banks are
charged
when
Central Bank .
they
borrow
from
the

1. Open-Market
Operations
Open
market
quantity
of
operations
banks
monetary base.
affect
reserves
and
the
the
Open-Market Operations
Buying Securities
From
commercial
bank
Banks gives up securities

Central Bank pays bank
Banks have increased reserves
From the public...

Public gives up securities
Public deposits checks in banks
Banks have increased reserves
Selling Securities
To
commercial
banks..
Central Bank gives up securities

Bank pays for securities
Banks have decreased reserves
To the public...
Central Bank gives up securities

Public pays by check from bank
Banks have decreased reserves
Purchase of Bonds From commercial
banks
New reserves
$200
Purchase of a
$1000 bond
from a bank...
$800
Excess
Reserves
$4000
Bank System Lending
Required
reserves
$1000
Initial
Deposit
Tot a l I n c r e a s e i n M o n e y S u p p l y ( $ 5 0 0 0 )
The monetary base has increased of ($ 5000)
Advantages of Open Market

Operations
The Central Bank has complete control over the
volume
Compare this to discount lending, in which the Central

Bank sets the price of borrowing, but does not directly
control how much banks actually borrow.
Flexible and precise
Can be used to enact both small and large changes in

the monetary base.
Easily reversed
Mistakes can be quickly corrected in a way that would

not have been possible with reserve requirements or
discount lending.
Quickly implemented
There is no administrative delay to conducting open

market operations. Orders go to the trading desk and

2. Changes in the reserve ratio
Changes in the reserve ratio affect the
money multiplier.
Changes in The Reserve

Ratio
Raising the Reserve Ratio
Banks must hold more reserves
Banks decrease lending
Money supply decreases
Lowering the Reserve Ratio
Banks may hold less reserves
Banks increase lending
Money supply increases
TOOLS OF MONETARY POLICY
hanges in the discount rate
nges in the discount rate affect the monetary
thus the money supply.
The Central Bank as a Lender of Last Resort
One of the most important functions of the Central Bank is

its role as a lender of last resort to the banking system.
Banks in need of liquidity may borrow from the Central

Bank at the discount rate.
A large increase in the demand for reserves (demand for

liquidity) by banks is tempered by the Central Bank ability
to step in and lend at the discount rate.
The federal funds rate is actually capped by the discount rate.
While this role has helped prevent some bank panics, it

may have created moral hazard costs
Banks know they will be bailed out by the Central Bank if they
fail
Encourages them to take on high-return/high-risk loans
If the loan comes in, they keep all the profits
If the loan fails, the Central Bank will support financially the
losses.
Changes in the Discount

Rate
The discount rate is adjusted to complement open
market operations and to support the direction the
Central Bank is taking in monetary policy.
Changes in the Discount

Changing the discount Rate
rate will only affect reserves (and
thus the money supply) and the federal funds rate (iff ) if
It is lowered below the federal funds rate
It was previously below iff, but is raised above iff.
The Fed persistently keeps the discount rate above iff

As a result, changes in the discount rate rarely have
an effect on the money supply.
Rarely, the discount rate has been used to inject
liquidity into the financial system (Stock Market
Crash in 10/87, directly after 9/11); accordingly, the
discount rate was lowered below the federal funds
rate (iff).
MONETARY POLICY
Easy Money Policy

- Buy Securities
- Decrease Reserve
Ratio
- Lower Discount Rate
MONETARY POLICY (con)
Tight Money Policy

- Sell Securities
- Increase Reserve
Ratio
- Raise Discount Rate
MONETARY POLICY, REAL GDP,

AND THE PRICE LEVEL
Cause-Effect Chain
1) Money supply impacts interest rates 2)
Interest
rates
affect
investment
3)
Investment is a component of AD 4)
Equilibrium GDP is changed.
MONETARY POLICY AND EQUILIBRIUM GDP

Real rate of interest, i
Sm1 Sm2
Sm3
10
10
Investment
Demand
Dm
0
Quantity of money demanded and suppliedAmount of investment, i
Price level
AS
P3
P2
P1
If the Money Supply

Increases to Stimulate
the Economy
Interest Rate Decreases

Investment Increases
AD & GDP Increases
with slight inflation
AD3(I=$2
AD5)
Increasing money
2(I=$20)
supply
AD1(I=$15)
continues the growth
Real domestic output, GDP
but,
MONETARY POLICY AND EQUILIBRIUM GDP
Money Market
Investment
Equilibrium GDP
Effects of an easy money
policy
Effects of a tight money
MONETARY POLICY IN ACTION

Strengths of monetary policy
Speed and flexibility

Isolation from political
pressure
Lags
Problems and
Complications
Changes in Velocity
Cyclical Asymmetry
Inflation
Management
MONETARY POLICY AND THE

INTERNATIONAL ECONOMY
Net export effect

Macro stability and the
trade balance
The Big Picture

Mac CH 14

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Mac CH 14

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Macroeconomics

Dr. Karim Kobeissi

Chapter 14: Monetary Policy

Keyword: Federal Funds Rate

The interest rate at which a commercial bank lends funds

Goals of Monetary policy

output and employment .

What do Maximum Sustainable Output

Tools of Monetary Policy

selling treasury bonds, notes, and bills.

Tools of Monetary Policy

Banks gives up securities

From the public...

Central Bank gives up securities

Central Bank gives up securities

Advantages of Open Market

Compare this to discount lending, in which the Central

Flexible and precise

Can be used to enact both small and large changes in

Mistakes can be quickly corrected in a way that would

There is no administrative delay to conducting open

Tools of Monetary Policy

Changes in The Reserve

TOOLS OF MONETARY POLICY

hanges in the discount rate

nges in the discount rate affect the monetary

thus the money supply.

The Central Bank as a Lender of Last Resort

One of the most important functions of the Central Bank is

Banks in need of liquidity may borrow from the Central

A large increase in the demand for reserves (demand for

While this role has helped prevent some bank panics, it

Changes in the Discount

Changes in the Discount

The Fed persistently keeps the discount rate above iff

Easy Money Policy

MONETARY POLICY (con)

Tight Money Policy

MONETARY POLICY, REAL GDP,

MONETARY POLICY AND EQUILIBRIUM GDP

Quantity of money demanded and suppliedAmount of investment, i

If the Money Supply

Interest Rate Decreases

MONETARY POLICY AND EQUILIBRIUM GDP

MONETARY POLICY IN ACTION

Speed and flexibility

MONETARY POLICY AND THE

Net export effect

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