Monetary Policy

The Roles of a Central Bank

1. The Central Bank is the lender to banks.

2. serves as the bank for the government that handles its payrolls for various government branches.

3. implements exchange rate policy by buying and selling foreign currencies.

4. controls money supply and implements monetary policy.

5. The Federal Reserve System was crated in 1913. The Fed is owned by the member banks. The owners get only small divides, but do not control its operation. Federal Reserve Board of Governors is appointed by the president. However, it is almost impossible for the present to influence the policies of the Fed.


How the Fed Changes Money Supply

The Fed has 3 major methods by which to control the money supply.


Open Market Operations

This involves buying and selling of government bonds by the Fed. This is the most important: (i) it can be implemented quickly and cheaply. The fed calls an agent who buys and sells bonds.

(ii) it can be done quietly when desired. Sometimes the Fed does not want to announce it publicly. (iii) The Fed can choose the quantity, small or large.

Suppose the reserve requirement is 10%. When the Fed buys a $1 million bond, initially deposit in a commercial bank increases by the same amount. However, since the reserve requirement is 10%, the entire banking system can lend $9 million, which results in a $9 million deposit. Thus, the money supply can increase up to $10 million.

Reserve Requirement

This tool is not frequently used, but is potentially powerful. If the required reserve ratio is raised to 15%, the sale of $1 million bond can increase money supply by $1 million/.15 = $6.7 million only. Thus, a change in the reserve requirement can significantly affect the money supply.

Frequent changes in RR make it difficult for banks to plan. It is like using a sledgehammer to kill a mosquito. In the 1970s, RR was changed twice, each time less than 1%.

If the Fed buys a bond for $1 billion, and RR = 10%, the potential money supply increase by $10 billion. If RR =12%, this amount reduces to $1/.12 = $8.3 billion. Thus, a small change in RR causes a big change in the potential money supply.

For this reason, RR changes are not used frequently.

Discount Rate

Banks that have trouble meeting their reserve requirement can borrow funds directly from the Fed at its discout window. Discount rate is the interest rate that the Fed charges to banks.

If the Fed wants to expand money supply, it lowers the discount rate. Sometimes the discount rate is changed several times a year.

The discount window is not used often, except in emergencies by the banks. In the stock market crash of 2008, the Fed provided loans to many financial institutions.

When banks needd short term loans, they tend to use the Federal Funds Market.


Difficulties in Controlling the Money Supply
It is difficult for the Fed to control the exact amount of money supply for two reasons.
unpredictability of deposit

The more people put cash in the banks, the more excess reserves the banking system has. As a result, more money is lent and more deposits are created.

During a financial crisis, people are worried about the health of the system and withdraw money. The more money they withdraw from the banking system, the less money is created.

loans When banks keep excess reserves they lend less to the public. The banks create less loan and money than the Fed desires. Accordingly, the Fed has less control.

Coordination of Fiscal and Monetary Policies

(i) Congress and the President make fiscal policy decisions.

(ii) The Fed makes monetary policy decisions.

The chairman of the Fed often participates in meetings with the President's staff. Through this process they try to reach a consensus. Some argue that this is dangerous and that the Fed should be completely independent of the executive branch, because the monetary policy might be used by the executive branch to reelect the incumbent.

Timing of monetary and fiscal policies

Initially, the economy has unemployment at point A. Even without any policy intervention, the economy will eventually reach point B. However, sometimes impatient policy makers want a quick fix and employ an expansionary fiscal or monetary policy, thereby overshooting the desired goal. AD curve shifts to AD", which causes inflation. As producers raise prices, AS shifts upward, and the economy eventually reach point F. The long run consequence is inflation and budget deficit, without any long term effects on output.


Money Market

Real Money supply Ms/P = speculative + transactions + precautionary demand.
Money supply is determined by the monetary authorities.

Real money balances (M/P) measure the purchasing power of a given money stock. A nation's nominal GDP is written as PY. If money is needed to faciliate economic transactions, money demand needed is proportional to nominal GDP, i.e.,

Md= kPY,

where k is a positive constant. If the money market is in equilibrium, money demand must be equal to money supply M. Thus, the above relation can be written as

M(1/k) = PY or


MV = PY,

where V is velocity of money.

If we assume that the velocity of money is constant, then the quantity equation becomes a useful theory, the Quantity Theory of Money.

Constant Velocity of Money

Velocity changes when consumer habits of spending money changes. When credit cards were invented, people no longer needed to carry large amounts of cash in person, and money demand declined and its velocity change declined as well.

Velocity of money is fixed, but can be changed in response to technological changes of handling money.

Hat Calculus (Percentage Changes)


Z = XY

Let the new value of Z be denoted by Z'. Then

Z' = (XΔX)(YΔY) = (1 + ^X)X(1 + ^Y)Y = (1 + ^X + ^Y + ^X^Y)XY

^Z = ^X + ^Y + ^X ^Y.


When the percentage changes are small,

Z = XY => ^Z = ^X + ^Y.

Z = 1/X => ^Z = - ^X. ( ^(1/X) + ^X = ^(1) = 0)

Z = X/Y => ^Z = ^X - ^Y.

MV = PY ≡ ^M + ^V = ^P + ^Y.

If velocity is constant, we have

^M = ^P + ^Y.


Growth rate of Money Supply = inflation rate + growth rate of real output.

That is, when money supply increases, either price or output must increase by the same proportion. In the Keynsian economy with substantial unemployment, price is fixed. Thus, an increase in money supply will raise real output proportionately. On the other hand, in a full employment economy, no output can be changed. Thus, a 10% increase in money supply will increase the price level by the same proportion. However, consumers may hold money for other purposes.

Inflation Rate = growth rate of money supply - growth rate of real GDP.

(i) If ^M > ^Y, then there will be inflation.
(ii) If ^M < ^Y, there will be deflation.
(iii) If ^M = ^Y, the price level will be stable.


Economists thought that velocity of money was constant. Velocity of money has been stable over a long period of time, when M2 definition is used.

Velocity of money is not constant, and often varies in a predictable way when new financial instruments are introduced (such as credit cards).

Why do countries allow the money supply to outpace real output? Due to war and political instability, a country's spending may exceed the amount of tax it collects. In this case, the government often print more money to pay bills. The more money they print, the higher infaltion they experience.


When there is rapid inflation, it is called hyperinflation. A famous exmaple is the hyperinflation in Germany. Inflation rate rose to roughly 300% per month. German government incurred a huget debt (war reparation payment) after WWI. Firms had to pay workers several times a week. Stores changed prices in the middle of the day. In this case, money stops being efficient in its role as the medium of exchange. Barter exchange flourishes instead.

German Hyperinflation

          Foward markets do not operate during periods of hyperinflation. Because inflation rates accelerate at an unknown rate, even speculators stay away from such currencies. Inflation rates differ amont countries due to differences in monetary and fiscal policies. Single currency in Europe means member countries cannot conduct their own monetary policies, i.e., they cannot increase money supply independently because it is the European Central Bank that controls the money supply. However, freedom is useful only when discretion is exercised. Just look at what happened to Germany after World War I.

(World War I, or the Great War, ended on November 11, 1918. The Versailles Treaty was signed on January 12, 1919 and Germany promised to pay war reparation payment of £6.6 billion.) The value of money can be totally undermined when the government prints so many pieces of paper currency. High inflation rate causes a capital flight. When the inflation rate was 6000% per year, it caused a dramatic capital flight. Workers converted their money into other stable currencies. As a result, stores refused to sell goods, and citizens looted many stores.

The infamous post-World War I inflation in Germany is a good example. In December 1919 there were about 50 billion marks in circulation in Germany. Exactly four years later, this figure expanded to 497 quintillion (497,000,000,000,000,000,000) marks. That is, the money supply increased 10 billion times.

          From August 1922 to November 1923, inflation averaged 322 percent per month. Prices at the end of that German hyperinflation (i.e., particularly high inflation) were 10 billion times the original level. (Someone who lived through hyperinflation defined it as follows: hyperinflation is when it is cheaper to pay for your lunch before you start eating it than after you finish).

This sample of German banknotes during this period is from Trinity Doubline College, Ireland.

          In October 1923, the prices increased 100 times. In October 15, 1923, a monetary reform was announced, a new unit of currency called Rentenmark replaced the old currency Reichsmark. One unit of the new currency was set equal to 1 trillion units of the old currency. A new bank was established to take over the function of note issue.

Excerpt from a book (lost the source).

          It was Germany, 1923, and times were hard. Inflation over the past 3 years had driven prices to very high levels. Ferdinand Porsche, the carmaker, needed cash.

          Porsche had received three luxury cars as partial compensation when he left Austro- Daimler. The three cars, called City Coaches, were elaborate creations. In front they offered open seats for the chauffeurs and passengers. Behind these were two more open seats with a movable cover in case of rain, and at the rear was a closed compartment for passengers for use in case of severe weather. The manufacturer boasted that the city Coach combined the best features of an open car, a convertible, and a limousine. Porsche approached a friend in Stuttgart, business executive Alfred Neubauer. He found a buyer in Backnang for one of these cars. He recalled later that Mr. Porsche was delighted with the price, which was in the millions of marks.

          The car was delivered to the buyer. One week later the money reached Stuttgart. During that week, however, the pace of inflation had accelerated. Porsche had sold one of the grandest vehicles in the worldžbut by the time he got the money, it was just enough to pay for six rides on the local streetcar line.

Difficulty of Controling Money Supply

The Role of Commercial Banks

One problem with the monetary policy is that it must be carried out through the commercial banks. The central bank can only change the environement in which commercial banks live, but it is the banks that must extend loans and create money. As the saying goes, you can lead a horse to water but you can't make it drink!

When the Fed wants to contract money supply, it has no trouble forcing the banks to comply. Why?

The banks must meet reserve requirements. If the Fed raises RR, then banks must sell bonds and other securities to increase its deposits with the Fed. In the process, the banks decrease loans and money supply.

When the Fed wants to increase money supply, it can decrease RR, which means the banks have excess reserves. They can increase loans, but they may not. During boom periods, the banks want to convert the excess reserves into other assets by making loans. However, in a recession, banks may be reluctant to extend loans. During the Great Depression, banks did not loan out these excess reserves.

In 1935, when discussing the Banking Act of 1935,

Congressman Thomas Goldsborough: You mean you cannot push a string.

Governor (of the Fed) Marriner Eccles: That is a good way to put it, one cannot push a string.

Nonbank Institutions Pension funds and insurance companies make loans, but are not subject to RR. They can alter the impact of Fed's policy.
Coordination Problem Fiscal policies are made by the executive branch, while monetary policy is made by the Fed. They may have conflicting goals, and may not agree on policy goals. The government may argue that unemployment is the urgent problem, while the Fed may be more concerned with inflation.



John Maynard Keynes argued that there are three components in the demand for money.

(i) Transactions Demand


Money is required to facilitate economic transactions, i.e., to pay bills. Other securities are not readily accepted. Transactions demand increases with the volume of economic transactions or output. Individuals and firms may hold money for transactions purposes, but this transactions balance may depend on the interest rate. Firms may try to economize the transactions balance, but Keynes thought that the tranasctions balance would be insensitive to changes in the interest rate.

(ii) Precautionary Demand

Individuals need cash to meet emergencies – medical emergencies, unemployment or repairs. Precautionary demand for money increases with income. To simplify the analysis, we can treat precautionary demand for money as unexpected transactions demand for money, and assume that it is insensitive to changes in the interest rate.

(iii) Speculative Demand

Keynes argued that firms and individuals hold some money for speculative purposes, to take advantage of profitable investment opportunities.

He argued that given uncertainties, speculative balance is inversely related to the interest rate.


We use the modern approach and assume money demand has two components.

Transations demand for money is proportional to income, and hence can be expressed as k(Y+) = kPy. Transactions are always in current prices (Py). Precautionary demand for money is included in the transactions balance. Speculative demand is inversely related to interest rate, and denoted by L(r¯).

two components: (Nominal) Money demand = L(r¯) + kPy

(Real) Money demand = ℓ(r¯) + ky, k > 0.

Money market equilibrium requires:

Ms/P = ℓ(r¯) + ky


    Money Supply

Money supply is largely governed by the central bank, and the quantity is periodically adjusted. It is considered to be vertical, independent of the market interest rate.


Money Market Equilibrium
Control Money Supply or Interest Rate
Some economists argue that the Fed should control money supply, while others contend that interest rate should be controled. Obviously, the Fed cannot do both, given the negative slope of the money demand curve. Suppose income increases. If money supply is controlled, this would result in an increase in the interest rate. If the Fed desires to maintain a stable interest rate, it must increase money supply.


The problem with targeting money supply is that the demand for money fluctuates considerably in the short run. When money supply is targeted, random fluctuations in money demand caused large variations in the interest rates durig the 1970s and 80s. These erratic changes can seriously disput the economy.

Interest rate targeting also creates problems. When the economy grows, money demand also grows. In order to maintain stable interest rate, money supply has to increase. Expanding money supply during the boom period is inflationary. Likewise, conracting money supply during recession will make the recession even worse. However, since the 1980s, the Fed switched to the interest rate targeting policy.

Which interest rate?

The Fed targets the federal funds rate, which is the interest rate that banks charge each other for short term loans. A bank that is short of reserves may borrow from another that has excess reserves.



Classical economists assumed that economies would operate at full employment because prices and wages are flexible. If unemployment were present, wages and prices would fall until full employment was restored. The classical economists wrote in the 19th century. Empirical evidence shows that prices were indeed flexible during that period. Extreme upward and downward movements in prices took place regularly. This was due to the greater importance of agriculture in the 19th century. Agricultural prices were flexible in both directions.

An increase in the real interest lowers the speculative balance, which must be offset by an increase in the tranactions balance, and hence real income must increase. There is a positive relationship between interest rate r and real income y that must be maintained in order to clear the money market. This relationship is called the LM curve (Liquidity-Money)


When both IS and LM intersect each other, both markets are in equilibrium.
Changes in Money Supply

Δ Ms/P = ℓ(r¯) + ky

For given output, an increase in money supply must be matched by an increase in the speculative demand for money, and hence the interest rate must be lowered. Thus, an increase in money supply shifts the LM curve to the right.
In recent years, there has been inventions of money substitutes such as credit cards and automated teller machines (ATMs), which reduce the need for cash. These changes also shift the LM curve to the right.


The Effect of Fiscal Expansion

Consider an increase in government spending by $1 trillion, which shifts the IS curve to the right. What is its economic impact?
As government spending increases (&uArr), output increases but interest rate also rises, which discourages investment. Thus, fiscal expansion crowds out domstic investment.
Ineffective Monetary Policy

Effects of monetary and fiscal policies depend on the shapes and slopes of IS and LM curves. In some cases, the LM curve may have a flag segment. For instance, the interest rate has been zero for about five years during this decade. Any further increase in money supply cannot lower the interest rate beyond a certain level, if most consumers believe that the interest rate will rise soon. Keynes called this liquidity trap. Any further increase in money supply will be absorbed as savings without affecting the output level. (The speculative demand increases.) A monetary expansion only shifts the LM curve to LM' without affecting the interest rate and output.

Supply Shocks

A negative supply shock causes a stagflation; as the supply curve shifts upward, price level rises, but output level declines.

Political business cycles

A political business occurs if the central bank cooperates with the incumbent party and pursue an expansionary monetary policy before an election.

Short Run

Increased output

Reduced unemployment

Incumbent party wins

Long Run inflation

Some economists argue that the central banks should adopt rules such as maintaining a constant growth of 3-5%, to faciliate economic growth. If the desired economic growth rate is 3% per year, the monetary growth rate should also be 3%. In this case, the average inflation rate is zero. However, this goal is unrealistic, because in most countries the inflation rates are positive.

Inflation Targeting


Some economists argue that we should target the inflation rate. This means the central bank needs to regulate the inflation rate within a narrow band, say between 2 and 3 %. Such targeting stabilizes inflationary expectation.

Bank of England: 2%

Bank of Canada: 2%

Bank of Brazil: 4.5%

Chile: 2-4%.

Empirical evidence suggests that those countries with inflation targets tend to have stable inflation rates.


Other economists: the central bank needs flexibility. Paul Volker and Alan Greenspan argue that the Fed chair does not need any rules, yet they were able to maintain stable inflation rates. (If it ain't broke, don't fix it.) Why target inflatio rates only? Why not target interest rate or unemployment rate.


Why not target inflation rates at 0 percent?

It is difficult to hit the target all the time.

Zero inflation target could lead to deflation (falling prices) as in Japan in the 1990s. In Japan the interest rate has been zero for several years. In this situation, expansionary policy is difficult to implement (as the interest rate is zero already.)

The Fed needs flexibility to couter disorderly conditions. The Fed made huge loans to avoid a financial crisis after September 11, 2001.

The cost of zero inflation rate is too high. It risks deflation. A 1% reduction in the inflation rate may be 3-% loss in output.


Taylor Rule

Taylor Rule is a hybrid, part rule, part discretion proposed by John Taylor in 1993: That the nominal interest should rate should change in response to the divergences of actual inflation rate and GDP from the target levels.

i = π + r* + α(π - π*) + β(y - y*)

i = interest rate

&pi = inflation rate

y = real GDP

* = target


If real GDP rises by 1% above potential GDP the FFR (federal funds rate) by.5 percent above the current inflation rate (α = .5)
If inflation rate rises 1% above the target rate of 2% raise the FFR by .5 percent relative to the inflation rate. (β = .5)
When real GDP = potential GDP and inflation rate = 2% FFR should remain at 4%. This means real interest rate = 4% - 2% = 2%

John Taylor emphasized that if inflation rate were to rise by 1%, the proper response would be to raise the interest rate by 1.5% (that is, .5 % above the inflation rate). If GDP falls by 1% below the growth path, interest rate could be cut by .5%.

During the Greenspan period, the Fed's policy more or less followed this rule unknowingly.