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MONETARY POLICY
15
CHAPTER
The Central Bank: CB
The Federal Reserve System, commonly known as “the
Fed”, is the central bank of the United States.
A Central Bank (CB) is the public authority that, typically,
regulates a nation’s depository institutions and controls the
quantity of the nation’s money. The degree of
independence the central bank has from the government
of the day varies a great deal from one country to another.
The Central Bank: CB
The CB’s Goals and Targets
 The CB conducts the nation’s monetary policy, which means that,
among other things, it adjusts the quantity of money in circulation.
 The CB’s goals are to keep inflation in check, maintain full
employment, moderate the business cycle, and contribute to
achieving long-term growth.
 In pursuit of its goals, in the U.S., the Fed pays close attention to
interest rates and sets a target for the federal funds rate that is
consistent with its goals. The federal funds rate is the interest rate
that commercial banks in the U.S. charge each other on overnight
loans of reserves [“federal funds”]. In Canada, this rate is called the
“Overnight lending rate”. In Bangladesh, it is called the “Call Money
Rate”.
Controlling the Quantity of Money
The CB’s Policy Tools
In theory, the CB could use three monetary policy tools:
 Required reserve ratios
 The discount rate
 Open market operations
Controlling the Quantity of Money
 The CB sets required reserve ratios, which are the
minimum percentages of deposits that depository
institutions must hold as reserves.
 The CB does not change these ratios very often.
 The discount rate is the interest rate at which the CB
stands ready to lend reserves to depository institutions.
 An open market operation is the purchase or sale of
government securities —Treasury bills and bonds — by
the CB in the open market.
Controlling the Quantity of Money
How Required Reserve Ratios Work
An increase in the required reserve ratio boosts the reserves that
banks must hold, decreases their lending, and decreases the
quantity of money. However, this is a sudden discontinuous
change, so can be disruptive.
How the Discount Rate Works
An increase in the discount rate raises the cost of borrowing
reserves from the CB and decreases banks’ reserves, which
decreases their lending and decreases the quantity of money.
But banks try to avoid borrowing from the CB [why?], so discount
rate changes act mainly as a signal.
Controlling the Quantity of Money
How an Open Market Operation Works
 When the CB conducts an open market operation by buying a
government security, it increases banks’ reserves.
 Banks loan the excess reserves.
 By making loans, they create money.
 The reverse occurs when the CB sells a government security.
 Changing the supply of reserves to the banking system changes the
interbank lending/borrowing rate, the interest rate at which banks
lend and borrow reserves among themselves. So in practice, the CB
announces a target rate for the interbank lending rate, and then
uses Open Market Operations to get close to its target.
The Demand for Money
This Figure illustrates the
demand for money curve.
The demand for money curve
slopes downward—a rise in the
interest rate raises the
opportunity cost of holding
money and brings a decrease in
the quantity of money
demanded, which is shown by a
movement along the demand for
money curve.
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The Supply of Money
This Figure shows the supply of
money as a vertical line at the
quantity of money that is largely
determined by the CB. The money
supply is largely but not exclusively
determined by the CB because
both banks and the public are
important players in the money
supply process (as explained in
earlier chapters). For example,
when banks do not lend their entire
excess reserves, the money supply
is not as large as it is when they
do.
Money market equilibrium
determines the interest rate.
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Interest Rate Determination
 An interest rate is the percentage yield on a financial security such
as a bond or a stock [or savings account].
 The price of a bond and the interest rate are inversely related.
 If the price of a bond falls, the interest rate on the bond rises.
 If the price of a bond rises, the interest rate the bond yields falls.
 We can study the forces that determine the interest rate in the
market for money.
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Money Market Equilibrium
This Figure
illustrates the
equilibrium
interest rate.
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Money Market Equilibrium
If the interest rate is
above the equilibrium
interest rate, the
quantity of money that
people are willing to
hold is less than the
quantity supplied.
They try to get rid of
their “excess” money by
buying financial assets.
This action raises the
price of these assets
and lowers the interest
rate.
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Money Market Equilibrium
If the interest rate is
below the equilibrium
interest rate, the
quantity of money
that people want to
hold exceeds the
quantity supplied.
They try to get more
money by selling
financial assets.
This action lowers the
price of these assets
and raises the
interest rate.
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Money Market Equilibrium
Changing the
Interest Rate
This Figure shows
how the CB
changes the
interest rate.
If the CB conducts
an open market
sale, the money
supply decreases,
the money supply
curve shifts
leftward, and the
interest rate rises.
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Money Market Equilibrium
If the CB
conducts an
open market
purchase, the
money supply
increases, the
money supply
curve shifts
rightward, and
the interest rate
falls.
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Transmission Mechanisms
 Changes in one market can often ripple outward to affect
other markets. The routes, or channels, that these ripple
effects travel are known as the transmission mechanism.
 Monetary policy transmission mechanism: The routes,
or channels, traveled by the ripple effects that the money
market creates and that affect the goods and services
market (represented by the aggregate demand and
aggregate supply curves in the AD–AS framework).
 In this chapter we discuss two transmission mechanisms:
the Keynesian and the Monetarist.
Transmission Mechanisms
The Money Market in the Keynesian Transmission
Mechanism: Indirect
If the CB increases money supply, the interest rate
decreases. Then, three events follow:
 Investment and consumption expenditures increase.
 The value of the dollar in terms of foreign currency falls
and net exports increase.
 Aggregate demand increases (through a multiplier
effect).
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Transmission Mechanisms
The Keynesian
Transmission
Mechanism: Indirect
This Figure
summarizes these
ripple effects.
The final step
depends on the
shape of the
aggregate supply
curve
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Transmission Mechanisms
Transmission Mechanisms
The Keynesian
Mechanism May
Get Blocked
Interest-Insensitive
Investment
(a) If investment is totally
interest sensitive, a
change in the interest
rate will not change
investment; therefore,
aggregate demand and
Real GDP will not
change.
Transmission Mechanisms
The Keynesian
Mechanism May
Get Blocked
The Liquidity Trap
(b) If the money market
is in the liquidity trap, an
increase in the money
supply will not lower the
interest rate. It follows
that there will be no
change in investment,
aggregate demand, or
Real GDP.
Transmission Mechanisms
The Keynesian View of Monetary Policy
Transmission Mechanisms
Bond prices, interest rates, and the liquidity trap
 Remember that The price of a bond and the interest rate are
inversely related. So, when money supply increases, people
use the extra money supply to buy bonds, price of bonds
increases and interest rate falls.
 However, when interest rate is very low, this relationship may
break down. At a low interest rate, the money supply
increases but does not result in an excess supply of money.
Interest rates are very low, and so bond prices are very high.
Would-be buyers believe that bond prices are so high that
they have no place to go but down. So individuals would
rather hold all the additional money supply than use it to buy
bonds.
Transmission Mechanisms
The Monetarist
Transmission
Mechanism: Direct
The monetarist transmission
mechanism is short and
direct. Changes in the money
market directly affect
aggregate demand in the
goods and services market.
For example, an increase in
the money supply leaves
individuals with an excess
supply of money that they
spend on a wide variety of
goods.
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Expansionary Monetary Policy: To reduce unemployment
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Contractionary Monetary Policy: To reduce inflation
Monetary Policy and the Activist–
Nonactivist Debate
 Activists argue that monetary policy should be deliberately used to
smooth out the business cycle. They are in favor of economic finetuning, which is the (usually frequent) use of monetary policy to
counteract even small undesirable movements in economic activity.
Sometimes, the monetary policy they advocate is called either activist
or discretionary monetary policy.
 Nonactivists argue against the use of activist or discretionary monetary
policy. Instead, they propose a rules-based monetary policy.
Sometimes, the monetary policy they propose is called either
nonactivist, or rules-based, monetary policy. An example of a rulesbased monetary policy is one based on a predetermined steady growth
rate in the money supply, such as allowing the money supply to grow 3
percent a year, no matter what is happening in the economy.
Monetary Policy and the Activist–
Nonactivist Debate
The Case for Activist (or Discretionary) Monetary Policy
1. The economy does not always equilibrate quickly enough
at Natural Real GDP.
 Activists argue that the economy takes too long to self-regulate
and that in the interim too much output is lost and too high an
unemployment rate must be tolerated (in case of recessionary
gap).
 They believe that an activist monetary policy speeds things
along so that higher output and a lower unemployment rate can
be achieved more quickly.
Monetary Policy and the Activist–
Nonactivist Debate
The Case for Activist (or Discretionary) Monetary Policy
2. Activist monetary policy works; it is effective at smoothing out
the business cycle.
 Activists are quick to point to the undesirable consequences of the
constant monetary policy of the mid-1970s. In 1973, 1974, and 1975,
the money supply growth rates were 5.5%, 4.3%, and 4.7%,
respectively.
 These percentages represent a nearly constant growth rate in the
money supply. The economy, however, went through a recession
during this time; Real GDP fell between 1973 and 1974 and between
1974 and 1975.
 Activists argue that an activist and flexible monetary policy would
have reduced the high cost the economy had to pay in terms of lost
output and high unemployment.
Monetary Policy and the Activist–
Nonactivist Debate
The Case for Activist (or Discretionary) Monetary Policy
3. Activist monetary policy is flexible; nonactivist (rules-based)
monetary policy is not.
 Activists argue that flexibility is a desirable quality in monetary policy;
inflexibility is not. Implicitly, activists maintain that the more closely
monetary policy can be designed to meet the particulars of a given
economic environment, the better.
 For example, at certain times the economy requires a sharp increase in
the money supply and at other times, a sharp decrease; at still other
times, only a slight increase or decrease is needed.
 Activists argue that activist (discretionary) monetary policy can change
as the monetary needs of the economy change; nonactivist, rulesbased, or the-same-for-all-seasons monetary policy cannot.
Monetary Policy and the Activist–
Nonactivist Debate
The Case for Nonactivist (Rules-Based) Monetary Policy
1. In modern economies, wages and prices are sufficiently flexible to
allow the economy to equilibrate at reasonable speed at Natural Real
GDP.
 For example, nonactivists point to the sharp drop in union wages in 1982
in response to high unemployment.
 In addition, they argue that Government policies largely determine the
flexibility of wages and prices. For example, when government decides to
cushion people’s unemployment (e.g., through unemployment
compensation), wages will not fall as quickly as when government does
nothing.
 Nonactivists believe that a laissez-faire, hands-off approach by
government promotes speedy wage and price adjustments and thus a
quick return to Natural Real GDP.
Monetary Policy and the Activist–
Nonactivist Debate
The Case for Nonactivist
(Rules-Based) Monetary
Policy
2. Activist monetary policies may
not work if they are anticipated
by the public
If expansionary monetary policy is
anticipated (thus, a higher price
level is anticipated), workers may
bargain for and receive higher
wage rates. Possibly, the SRAS
curve will shift leftward to the same
degree that expansionary monetary
policy shifts the AD curve rightward.
Result: No change in Real GDP.
Monetary Policy and the Activist–
Nonactivist Debate
The Case for Nonactivist (RulesBased) Monetary Policy
3. Activist monetary policies are likely
to be destabilizing rather than
stabilizing; they are likely to make
matters worse, not better.
In this scenario, the 𝑆𝑅𝐴𝑆 curve is
shifting rightward (ridding the economy
of its recessionary gap), but CB officials
do not realize this is happening. They
implement expansionary monetary
policy, and the 𝐴𝐷 curve ends up
intersecting 𝑆𝑅𝐴𝑆2 at point 2 instead of
intersecting 𝑆𝑅𝐴𝑆1 at point 1′. CB
officials end up moving the economy
into an inflationary gap and thus
destabilizing the economy.
Nonactivist Monetary Proposals
The five nonactivist (rules-based) monetary proposals are
as follows:
1. Constant-money-growth-rate rule
2. Predetermined-money-growth-rate rule
3. The Taylor rule
4. Inflation targeting
5. (Nominal) GDP targeting
Nonactivist Monetary Proposals
1. Constant-money-growth-rate rule
 Many nonactivists argue that the sole objective of monetary policy is to
stabilize the price level. To this end, they propose a constant-moneygrowth-rate rule. One version of the rule is:
“The annual money supply growth rate will be constant at the average
annual growth rate of Real GDP”
 For example, if the average annual Real GDP growth rate is
approximately 3.3 percent, the money supply should be put on
automatic pilot and be permitted to grow at an annual rate of 3.3
percent.
Nonactivist Monetary Proposals
1. Constant-money-growth-rate rule
 Some economists predict that a constant-money-growth-rate rule
will bring about a stable price level over time because of the
equation of exchange (𝑀𝑉 ≡ 𝑃𝑄).
 If the average annual growth rate in Real GDP (𝑄) is 3.3% and the
money supply (𝑀) grows at 3.3%, the price level should remain
stable over time.
 Advocates of this rule argue that in some years the growth rate in
Real GDP will be below its average rate, causing an increase in the
price level, and that in other years the growth rate in Real GDP will
be above its average rate, causing a fall in the price level, but over
time, the price level will be stable.
Nonactivist Monetary Proposals
2. Predetermined-money-growth-rate rule
 Critics of the constant-money-growth-rate rule point out that it makes two
assumptions: (1) Velocity is constant; (2) the money supply is defined
correctly.
 Critics argue that velocity has not been constant in some periods. Also,
not yet clear is which definition of the money supply is the proper one
and therefore which money supply growth rate should be fixed: M1, M2,
or some broader monetary measure.
 Largely in response to the charge that velocity is not always constant,
some nonactivists prefer the following rule:
“The annual growth rate in the money supply will be equal to the average
annual growth rate in Real GDP minus the growth rate in velocity.” In other
words,
%∆𝑀 = %∆𝑄 − %∆𝑉
Nonactivist Monetary Proposals
2. Predetermined-money-growth-rate rule
 With this rule, the growth rate of the money supply is not fixed. It can
vary from year to year, but it is predetermined in that it is dependent
on the growth rates of Real GDP and velocity. For this reason, we
call it the predetermined-money-growth-rate rule.
 To illustrate the workings of this rule, consider the following
extended version of the equation of exchange: %∆𝑀 + %∆𝑉 =
%∆𝑃 + %∆𝑄
 Suppose %Δ𝑄 is 3% and %Δ𝑉 is 1%. The rule specifies that the
growth rate in the money supply should be 2%. This growth rate
would keep the price level stable; there would be a 0% change in 𝑃:
%∆𝑀 + %∆𝑉 = %∆𝑃 + %∆𝑄
2 % + 1% = 0% + 3 %
Nonactivist Monetary Proposals
3. The Taylor rule
 Economist John Taylor has argued for a middle ground, of sorts,
between activist and nonactivist monetary policy. He has proposed that
monetary authorities use a rule to guide them in making their
discretionary decisions.
 His rule has come to be known as the Taylor rule, which specifies how
policy makers should set the federal funds rate target. The economic
thinking implicit behind the Taylor rule is that there is some federal
funds rate target that is consistent with (1) stabilizing inflation around a
rather low inflation rate and (2) stabilizing Real GDP around its fullemployment level. The aim is to find this target and then to use the
Fed’s tools to hit it.
Nonactivist Monetary Proposals
3. The Taylor rule
 Here is how John Taylor, for whom the Taylor rule is named, defines
the particulars of the rule: The federal funds rate target “should be oneand-a-half times the inflation rate plus one-half times the GDP gap plus
one.” Algebraically, the Taylor rule specifies:
Federal funds rate target = 1.5 (inflation rate) + 0.5 (GDP gap) + 1
 In this equation, the GDP gap measures the percentage deviation of
Real GDP from its potential level. Let’s use the rule to find the federal
funds rate target that Taylor recommends to the Fed. Suppose the
inflation rate is 5 percent and the GDP gap is 3 percent.
 Putting these percentages in our equation, we get:
Federal funds rate target = 1.5 (5%) + 0.5 (3%) + 1
= 7.5 + 1.5 + 1
= 10%
Nonactivist Monetary Proposals
4. Inflation targeting
 Many economists recommend inflation targeting, which requires that
the Fed try to keep the inflation rate near a predetermined level.
 Three major issues surround inflation targeting.
 The first deals with whether the inflation rate target should be a
specific percentage rate (e.g., 2.5%) or a narrow range (e.g., 1.0–
2.5%).
 Second, whether it is a specific percentage rate or range, what
should the rate or range be? For example, if it is specific
percentage rate, should it be, say, 2.0 percent or 3.5 percent?
 The last issue deals with whether the inflation rate target should
be announced or not. In other words, if the CB adopts an inflation
rate target of, say, 2.5 percent, should the target be disclosed to
the public?
Nonactivist Monetary Proposals
4. Inflation targeting
 Numerous central banks in the world practice inflation targeting, and
they announce their targets. For example, the Bank of Canada has set a
target of 2 percent (inflation), and it has been announcing its inflation
target since 1991.
 For an inflation rate target approach, the Fed would undertake monetary
policy actions to keep the actual inflation rate near or at its target. For
example, if its target rate is 2% and the actual inflation rate is, say, 5%, it
would cut back the growth rate in the money supply (or the absolute
money supply) to bring the actual inflation rate nearer to the target.
 The proponents of inflation targeting argue that such a policy is more in
line with the CB’s objective of maintaining near price stability. The critics
of inflation targeting often argue that such a policy would constrain the
CB at times, such as when it might need to overlook the target to deal
with a financial crisis.
Nonactivist Monetary Proposals
5. (Nominal) GDP targeting
 A new economic school arose in the late 2000s: market monetarism. It
originated not in the academic journals or in a university economics
department, but in the blogosphere.
 Market monetarists argued that the 2007-09 recession was caused by
monetary policy that was too tight or not expansionary enough.
 Economist Scott Sumner (Bentley University) strongly advocates
market monetarist ideas in his blog The Money Illusion. Sumner, like
other market monetarists, argues that the optimal monetary policy is
for the Fed to set a nominal GDP target, such as a rise in nominal GDP
of 5 to 6 percent a year, and then to adjust money supply growth in
such a way as to hit the target.
Nonactivist Monetary Proposals
5. (Nominal) GDP targeting
 We can understand the policy prescription in terms of the equation of
exchange which states that the money supply times velocity must
equal (nominal) GDP: 𝑀 × 𝑉 ≡ 𝐺𝐷𝑃.
 Now suppose a financial crisis occurs, and as a result, people try to
hold more money (spend less). This reaction is likely to reduce
velocity, and if the Fed doesn’t sufficiently offset this decline in
velocity, GDP will decline. If velocity declines by, say, 8%, and the
money supply rises by 6%, GDP will decline by 2%. If the objective is
to raise GDP by 5%, an 8% decline in velocity would obligate the Fed
to increase the money supply by 13%.
 Any less of an increase would prompt market monetarists to argue
that the monetary policy is “too tight.”