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

Tools of Monetary Policy

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

Open-Market Operations
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

Open-Market Operations
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

Tools of Monetary Policy

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