The money market FED open market operations

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The money market FED open market operations Powered By Docstoc
					•Demand and supply of money
•The supply of money and the equilibrium
interest rate
•The monetary transmission mechanism
•The Quantity theory of money
•The record of monetary policy
Earlier we said that the interest rate
(i) influences aggregate spending—
      specifically investment and
consumption. However, we have yet
 to develop a theory of the interest
                   rate



       The interest rate is
       governed by the
       demand and supply of
       money.
1. To make planned
   expenditures/payments
2. To be prepared for unexpected
   expenditures/payments.
3. To store wealth.
 The higher the interest rate,
the more interest I give up by
holding my wealth in money-
 - as opposed to an interest-
        bearing asset.
                                    The money demand, Dm, slopes
Interest rate




                                    downward. As the interest rate
                                    falls, other things constant, so
                                    does the opportunity cost of
                                    holding money; the quantity of
                                    money demanded increases.


                           Dm


   0            Quantity of money




                                                                 5
                            Demand for Money
Nominal Interest Rate (%)
                                      •As we move along MD, the price
                                      level and real GDP are held constant.
                                      •The movement from point E to F is
                                  E
                                      a change in the demand for money
                                      as a store of value in reaction to a
        6%                            decrease in the yield of bonds.



                                            F
        3%


                                                          MD


          0                 1.0       1.2                           Money
                                                                    ($Trillions)
                                 Effect of a Change in Price Level (P) or Real
                                 GDP (Y)

                                                      MD1 MD2
                                                      •Increase in P, ceteris paribus.
                                                      •Increase in Y, ceteris paribus
Nominal Interest Rate (%)




                                         E        G
                            6%



                                                       F              H
                            3%

                                                                                    MD2
                                                                          MD1



                             0         1.0    1.12    1.2       1.5                Money
                                                                                   ($Trillions)
Bond Prices and the Rate Of Interest


                Bond prices and
               interest rates (or
                 yields), move
                   inversely
   Suppose you paid $800 for a bond that promises to pay $1,000 to its
holder one year from today. What is the interest rate or percentage yield of
the bond? Notice first that your interest income would be equal to $200.
Hence to compute the yield, use the following equation:
            Yield (%) = (interest income/price of the bond)  100
Thus, we have:
                   Yield (%) = (200/800)  100 = 25 percent
   Now suppose, instead of paying $800 for the bond, you paid $900. What is
the yield now?
                   Yield (%) = (100/900)  100 = 11 percent
We assume that the Fed (or
 central banks generally)
 determines the supply of
          money
           Effect of an increase in the money supply

                                                     Because the money supply is
                                                     determined by the Federal Reserve,
Interest




               Sm        S’m
                                                     it can be represented by a vertical
 rate




                                                     line.
                                                     At point a, the intersection of the
                    a                                money supply, Sm, and the money
       i
                                                     demand, Dm, determines the market
                           b                         interest rate, i.
      i’
                                                     Following an increase in the money
                                         Dm          supply to S’m, the quantity of money
                                                     supplied exceeds the quantity
                                                     demanded at the original interest
                                     Quantity of
       0       M         M’                          rate, i.
                                        money

People attempt to exchange money for bonds or other financial assets. In doing so,
they push down the interest rate to i’, where quantity demanded equals quantity
supplied. This new equilibrium occurs at point b.
                                                                                     11
        Effects of an increase in the money supply on
          interest rates, investment, and aggregate
          demand
                (a) Supply and demand                        (b) Demand for                       (c) Aggregate demand




                                             Interest rate
Interest rate




                 for money                                    investment
                      Sm




                                                                                    Price level
                               S’m


  i                        a                   i                    a
                                                                                                                 b
                                 b                                      b           P
i’                                           i’                                                     a
                                        Dm                                                                                 AD’
                                                                                                                         AD
                                                                              DI

  0         M         M’ Money     0     I     I’                                          0            Y   Y’       Real GDP
An increase in the money              Investment                                   This sets off the spending
supply drives the interest With the cost of borrowing                              multiplier process, so the
rate down to i'.           lower, the amount invested                              aggregate output demanded at
                           increases from I to I‘.                                 price level P increases from Y to
                                                                                                              12
                                                                                   Y‘
M↑→i↓→I↑→AD↑→Y↑
Fed open market purchase injects reserves into the
                banking system

 Commercial banks, thrifts, etc. expand loans and
                    deposits


           The money supply increases

     The equilibrium interest rate decreases


      Consumption and investment increase

Real GDP, employment, and (perhaps ) the price level
                    increase
   Expansionary monetary policy to correct a
     contractionary gap
              Potential output                     At a, the economy is producing less
                   LRAS                            than its potential in the short run,
                                                   resulting in a contractionary gap of
level
Price




                            SRAS130
                                                   $0.2 trillion.

                                                   If the Federal Reserve increases the
                                                   money supply by just the right
130                     b                          amount, the aggregate demand
                                                   curve shifts rightward from AD to
          a
                                                   AD’. A short-run and long-run
125
                                                   equilibrium is established at b, with
                                         AD’       the pride level at 130 and output at
                                                   the potential level of $14.0 trillion
                              AD

  0      13.8       14.0                  Real GDP
                              (trillions of dollars)
        Contractionary gap                                                         15
   The FOMC sets a
target for the “federal
 funds” rate, which is
  the rate that banks
charge other banks for
“borrowed” reserves.
    Recent ups and downs in the federal funds rate

              Rate increased to slow red-
              hot economy



              Global financial                       Rate increase to        Rate cuts
              crisis prompts                         head off inflation       to limit
              rate cuts                                                      impact of
                                    Rate cuts                                mortgage
                                     to combat                               defaults on
                                    recession                                economy




Since the early 1990s, the Fed has pursued monetary policy primarily through changes in
the federal funds rate, the rate that banks charge one another for borrowing and lending
excess reserves overnight.                                                          17
The Equation of Exchange

   M V  P  Y
  Where
  •M is the quantity of money
  •V is the velocity of circulation
  •P is the price level
  •Y is real GDP
     What is velocity (V)?
 Velocity (V) is the average number of times
per year a unit of money is spent for new goods
and services. Let

                V  (P Y )  M
 (P  Y) is nominal GDP. Let P = 1.25; Y = $8 trillion;
 and M= $2 trillion. Thus:

  V  (1.25  $8 trillion)  $2 trillion
    Or, V = 5
     Money and Aggregate Demand in LR
• Velocity depends on
     – Customs and convention of commerce
        • Innovations facilitate exchange
        • Higher velocity
     – Frequency
        • The more often workers get paid
           – Higher velocity
     – Stability (store of value)
        • The better store of value
           – Lower velocity


21
Equation of Exchange is Always True

             The equation simply states that
               what is spent for new goods
             and services (M  V) is equal to
             the market value of new goods
              and services produced (P  Y).
                    Illustration
Using the numbers on a preceding slide, we can see that

       P Y  1.25 $8 trillion  $10 trillion

 and
       M V  $2 trillion  5  $10 trillion
thus

       M V  P Y  $10 trillion
“Monetarist” interpretation
of the equation of exchange
The monetarists believe
that price level changes
(hence inflation) can be
explained by changes in
  quantity of money



 “Inflation is always and everywhere a monetary
phenomenon.”
                    Example

 Assume that V = 5 and is
 constant. Y is $8 trillion
   (also assumed to be
constant). Initially, let M =
         $2 trillion
         Our basic equation can be rearranged as follows:
                P  ( M V )  Y
        Now solve for the price level (P):

      P  ($2 trillion  5)  $8 trillion  1.25
  Now let the money supply increase to $2.4 trillion. Notice
  that:
($2.4 trillion - $2 trillion) 100  $2 trillion  20 percent
          Thus we have:
   P  ($2.4 trillion  5)  $8 trillion  1.50
           Notice that:
            (1.5 - 1.25)100 1.25  20 percent
     Hence a 20 percent
   increase in the money
  supply causes the price
   level to increase by 20
 percent. Monetarists put
  the blame for inflation
squarely at the doorstep of
 the monetary authorities
    (in the U.S., the FED).
              In the long run, an increase in the money
              supply results in a higher price level, or
              inflationPotential output
                         LRAS
Price level




                                                             The quantity theory of money
                                                             predicts that if velocity is stable, then
                                                             an increase in the supply of money in
                                                             the long run results in a higher price
140                             b                            level, or inflation. Because the long-
                                                             run aggregate supply curve is fixed,
                                                             increases in the money supply affect
130                             a                            only the price level, not real output.
                                               AD’

                                            AD


     0                    14.0                  Real GDP
                                    (trillions of dollars)
                                                                                               28
             (a) Velocity of M1




M1 velocity fluctuated so much during the 1980s that M1 growth was abandoned
as a short-run policy target.
                                                                               29
          (b) Velocity of M2




M2 velocity appears more stable than M1 velocity, but both are now considered by the Fed
as too unpredictable for short-run policy use.
                                                                                  30
German Hyperinflation and Money
      Record indicates that nations with high rates of
     monetary growth also suffer high rates of inflation

• A decade of annual inflation and money
  growth in 85 countries (average annual
  percent)




34
     Targeting interest rate vs. targeting the money
     supply
                                                     An increase in the price level or in real GDP,
                     Sm        S’m                   with velocity stable, shifts rightward the money
                                                     demand curve from Dm to D'm.

                                                      If the Federal Reserve holds the money supply
                          e’                          at Sm, the interest rate rises from i (at point e)
                i’
Interest rate




                                                      to i ' (at point e').
                      e             e’’                       Alternatively, the Fed could hold the
                i
                                                              interest rate constant by increasing the
                                                    D’m       supply of money to S'm. The Fed may
                                               Dm             choose any point along the money
                                                              demand curve D'm.

                0    M         M’         Quantity of money



                                                                                                  35
The Fed pulled on the string
   big time beginning in
   1979—it was an anti-
  inflation strategy under
  Chairman Paul Volcker
   Modeling Contractionary Monetary Policy

Price Level
                           Potential
                           GDP       AS




                                       AD2

                                 AD1
   0             Y1                       Real GDP
20
     Rec es s i ons are s haded
18


16


14


12


10


8
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01

                           Federal Funds
                   Conventional 30 year
20
      Recessions are shaded
18

16

14

12

10

8

6
         80       82       84       86       88         90   92

                              Mortgage Interest Rates

     www.economagic.com
Monthly payments on a $110,000
30 year mortgage note
 Mortgage rate         Monthly
                      Payment1
         8%            $807.14

      10%              $965.33

      12%             $1,131.47

      14%             $1,303.36

      16%             $1,479.23

1 Does not include prorated insurance or
property taxes.
 2400                                  Data in thousands of units
          R ecessions are shaded

 2000


 1600


 1200


   800


   400
              80      82       84        86       88        90      92

                                   Monthly Housing Starts
www.economagic.gov
  More recently, the
Fed raised the federal
 funds rate six times
 between May 1999
and May 2000—from
   4.75% to 6.5 %.
      Evidently
 unemployment was
  getting “too low.”
 The FOMC reversed course
  in July 2000 and cut the
funds rate 17 times, to a low
of 1.00 percent in July 2003.
Beginning in 2004, and until
 summer of 2007, the FED
  was mainly concerned
      about inflation.

				
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posted:10/21/2012
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