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practice? Does the U.S. money supply consist of com-
methods explained in the next chapter.)
modity money, full-bodied paper money, or fiat money?
6. Excess reserves make a bank less vulnerable to runs.
3. What is fractional reserve banking, and why is it the key
Why, then, don™t bankers like to hold excess reserves?
to bank profits? (Hint: What opportunities to make prof-
What circumstances might persuade them that it would
its would banks lose if reserve requirements were 100 per-
be advisable to hold excess reserves?
cent?) Why does fractional reserve banking give bankers
discretion over how large the money supply will be? Why 7. If the government takes over a failed bank with liabili-
does it make banks potentially vulnerable to runs? ties (mostly deposits) of $2 billion, pays off the deposi-
tors, and sells the assets for $1.5 billion, where does the
4. During the 1980s and early 1990s, a rash of bank failures
missing $500 million come from? Why?
occurred in the United States. Explain why these failures
did not lead to runs on banks.


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Licensed to:




Managing Aggregate Demand:
Monetary Policy
Victorians heard with grave attention that the Bank Rate had been raised. They did
not know what it meant. But they knew that it was an act of extreme wisdom.
J O H N K E N N ETH GA L B R A I TH



A rmed with our understanding of the rudiments of banking, we are now ready to
bring money and interest rates into our model of income determination and the
price level. Up to now, we have taken investment (I) to be a fixed number. But this is a
Monetary policy refers to
poor assumption. Not only is investment highly variable but it also depends on inter-
actions that the Federal
est rates”which are, in turn, heavily influenced by monetary policy. The main task of
Reserve System takes to
this chapter is to explain how monetary policy affects interest rates, investment, and change interest rates and
aggregate demand. By the end of the chapter, we will have constructed a complete the money supply. It is
macroeconomic model, which we will use in subsequent chapters to investigate a vari- aimed at affecting the
ety of important policy issues. economy.




CONTENTS
The Market for Bank Reserves
ISSUE: JUST WHY IS BEN BERNANKE SO MONEY AND THE PRICE LEVEL IN THE
IMPORTANT? The Mechanics of an Open-Market Operation KEYNESIAN MODEL
Open-Market Operations, Bond Prices, Application: Why the Aggregate Demand Curve
MONEY AND INCOME: THE IMPORTANT
and Interest Rates Slopes Downward
DIFFERENCE
OTHER METHODS OF MONETARY CONTROL FROM MODELS TO POLICY DEBATES
AMERICA™S CENTRAL BANK: THE FEDERAL
Lending to Banks
RESERVE SYSTEM
Changing Reserve Requirements
Origins and Structure
Central Bank Independence HOW MONETARY POLICY WORKS
Investment and Interest Rates
IMPLEMENTING MONETARY POLICY:
Monetary Policy and Total Expenditure
OPEN-MARKET OPERATIONS




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Licensed to:
Part 3
262 Fiscal and Monetary Policy



ISSUE: JUST WHY IS BEN BERNANKE SO IMPORTANT?
The financial crisis of 2007“2008 had been simmering below the surface for a
while. But when it burst into the open in August 2007, every eye in the finan-
cial world, it seemed, turned to Ben Bernanke, who had been installed as
chairman of the Federal Reserve Board just 18 months earlier. Why? Because
many observers see the Federal Reserve chairman as the most powerful per-
son in the economic world.
Bernanke is a brilliant but unassuming economist who taught for many years at
Princeton University. But now when he speaks, people in financial markets around the
world dote on his remarks with an intensity that was once reserved for utterances from
behind the Kremlin walls. The reason for all the attention is that, in the view of many
economists, the Federal Reserve™s decisions on interest rates are the single most impor-
tant influence on aggregate demand”and hence on economic growth, unemployment,
and inflation. And the financial crisis made
people worried about the health of the
economy.
Bernanke heads America™s central
bank, the Federal Reserve System. The
SOURCE: © Harley Schwadron. Reproduction rights obtainable from www


“Fed,” as it is called, is a bank”but a very
special kind of bank. Its customers are
banks rather than individuals, and it per-
forms some of the same services for them
as your bank performs for you. Although
it makes enormous profits, profit is not its
goal. Instead, the Fed tries to manage in-
terest rates according to what it perceives
to be the national interest. This chapter
will teach you how the Fed does its job
.CartoonStock.com




and why its decisions affect our economy
so profoundly. In brief, it will teach
you why people listen so intently when-
ever Ben Bernanke speaks.


MONEY AND INCOME: THE IMPORTANT DIFFERENCE
But first we must get some terminology straight. The words money and income are used
almost interchangeably in common parlance. Here, however, we must be more precise.
Money is a snapshot concept. It answers questions such as “How much money do you
have right now?” or “How much money did you have at 3:32 P.M. on Friday, November 5?”
To answer these questions, you would add up the cash you are (or were) carrying and
whatever checkable balances you have (or had), and answer something like: “I have
$126.33,” or “On Friday, November 5, at 3:32 P.M., I had $31.43.”
Income, by contrast, is more like a motion picture; it comes to you over a period of time. If
you are asked, “What is your income?”, you must respond by saying “$1,000 per week,” or
“$4,000 per month,” or “$50,000 per year,” or something like that. Notice that a unit of time is
attached to each of these responses. If you just answer, “My income is $45,000,” without indi-
cating whether it is per week, per month, or per year, no one will understand what you mean.
That the two concepts are very different is easy to see. A typical American family has
an income of about $45,000 per year, but its money holdings at any point in time (using the
M1 definition) may be less than $2,000. Similarly, at the national level, nominal GDP at the
end of 2007 was around $14 trillion, while the money stock (M1) was under $1.4 trillion.
Although money and income are different, they are certainly related. This chapter
focuses on that relationship. Specifically, we will look at how interest rates and the stock
of money in existence at any moment of time influences the rate at which people earn
income”that is, how monetary policy affects GDP.


Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 13 263
Managing Aggregate Demand: Monetary Policy



AMERICA™S CENTRAL BANK: THE FEDERAL RESERVE SYSTEM
When Congress established the Federal Reserve System in 1914, the United States joined the
company of most other advanced industrial nations. Until then, the United States, dis-
trustful of centralized economic power, was almost the only important nation without a
central bank. The Bank of England, for example, dates back to 1694. A central bank is a bank
for banks. The United
States™ central bank is the
Origins and Structure Federal Reserve System.

It was painful experiences with economic reality, not the power of economic logic, that
provided the impetus to establish a central bank for the United States. Four severe bank-
ing panics between 1873 and 1907, in which many banks failed, convinced legislators and
bankers alike that a central bank that would regulate credit conditions was not a luxury
but a necessity. The 1907 crisis led Congress to study the shortcomings of the banking sys-
tem and, eventually, to establish the Federal Reserve System.
Although the basic ideas of central banking came from
Europe, the United States made some changes when it im-
ported the idea, making the Federal Reserve System a


SOURCE: © The New Yorker Collection 1998, Peter Steiner from cartoonbank.com. All Rights Reserved.
uniquely American institution.1 Because of the vastness of
our country, the extraordinarily large number of commercial
banks, and our tradition of shared state-federal responsibili-
ties, Congress decided that the United States should have not
one central bank but twelve.
Technically, each Federal Reserve Bank is a corporation; its
stockholders are its member banks. But your bank, if it is a
member of the system, does not enjoy the privileges normally
accorded to stockholders: It receives only a token share of the
Federal Reserve™s immense profits (the bulk is turned over to
the U.S. Treasury), and it has virtually no say in corporate
decisions. In fact, the private banks are more like customers
of the Fed than owners.
Who, then, controls the Fed? Most of the power resides in
the seven-member Board of Governors of the Federal Reserve
System in Washington, and especially in its chairman. The
governors are appointed by the President of the United States,
with the advice and consent of the Senate, for fourteen-year
terms. The president also designates one of the members to
serve a four-year term as chairman of the board and thus to be
“I™m sorry, sir, but I don™t believe you know us well enough
the most powerful central banker in the world.
to call us the Fed.”
The Federal Reserve is independent of the rest of the gov-
ernment. As long as it stays within the authority granted to
it by Congress, it alone has responsibility for determining the nation™s monetary policy.
The power of appointment, however, gives the president some long-run influence over
Federal Reserve policy. For example, it was President George W. Bush in 2006 who se-
lected Ben Bernanke, a former adviser, to be the Fed™s next chairman.
Closely allied with the Board of Governors is the powerful Federal Open Market Com-
mittee (FOMC), which meets eight times a year in Washington. For reasons to be ex-
plained shortly, FOMC decisions largely determine short-term interest rates and the size
of the U.S. money supply. This twelve-member committee consists of the seven governors
of the Federal Reserve System, the president of the Federal Reserve Bank of New York,
and, on a rotating basis, four of the other eleven district bank presidents.2


Ironically, when the European Central Bank was established in 1999, its structure was patterned on that of the
1

Federal Reserve.
Alan Blinder was the vice chairman of the Federal Reserve Board, and thus a member of the Federal Open
2

Market Committee, from 1994 to 1996.


Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 3
264 Fiscal and Monetary Policy




A Meeting of the Federal Open Market Committee
Meetings of the Federal Open Market Committee are serious and secretary to call the roll. Only the 12 voting members answer,
formal affairs. All 19 members”7 governors and 12 reserve bank saying yes or no. Negative votes are rare, for the FOMC tries
presidents”sit around a mammoth table in the Fed™s cavernous but to operate by consensus and a dissent is considered a loud
austere board room. A limited number of top Fed staffers join them objection.
at and around the table, for access to FOMC meetings is strictly The meeting adjourns, and at precisely 2:15 P.M. a Fed spokesman
controlled. announces the decision to the public. Within minutes, financial
At precisely 9 A.M.”for punctuality is a high virtue at the Fed” markets around the world react.
the doors are closed and the chairman calls the meeting to order.
No press is allowed and, unlike most important Washington meet-
ings, nothing said there will leak. Secrecy is another high virtue at
the Fed.
After hearing a few routine staff reports, the chairman calls on
each of the members in turn to give their views of the current eco-
nomic situation. District bank presidents offer insights into their
local economies, and all members comment on the outlook for the




SOURCE: Courtesy of the Federal Reserve Board
national economy. Committee members also offer their views on
what changes in monetary policy, if any, are appropriate. Disagree-
ments are raised, but voices are not, for politeness is another
virtue. Strikingly, in this most political of cities, politics is almost
never mentioned.
Once he has heard from all the others, the chairman summa-
rizes the discussion, offers his own views of the economic situa-
tion and of the policy options, and recommends a course of
action. Most members normally agree with the chairman, though
some note differences of opinion. Then the chairman asks the




Central Bank Independence
For decades a debate raged, both in the United States and in other countries, over the pros
and cons of central bank independence.
Central bank
independence refers to Proponents of central bank independence argued that it enables the central bank to
the central bank™s ability to take the long view and to make monetary policy decisions on objective, technical

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