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The procedures followed when the FOMC wants to raise interest rates are just the op-
posite of those we have just explained. In brief, it sells government securities in the open
market. This takes reserves away from banks, because banks pay for the securities by
drawing down their deposits at the Fed. A multiple contraction of the banking system
ensues. The principles are exactly the same”and so are the uncertainties.


Open-Market Operations, Bond Prices, and Interest Rates
The expansionary monetary policy action we have been using as an example began when the
Fed bought more Treasury bills. When it goes into the open market to purchase more of
these bills, the Federal Reserve naturally drives up their prices. This process is illustrated
by Figure 3, which shows an inward shift of the (vertical) supply curve of T-bills available to
private investors”from S0S0 to S1S1”indicating that the Fed™s action has taken some of the
bills off the private market. With an unchanged (private) demand curve, DD, the price of
T-bills rises from P0 to P1 as equilibrium in the market shifts from point A to point B.
Rising prices for Treasury bills”or for any other type of
bond”translate directly into falling interest rates. Why? The
reason is simple arithmetic. Bonds pay a fixed number of dol-
S1 S0
lars of interest per year. For concreteness, consider a bond that
D
pays $60 each year. If the bond sells for $1,000, bondholders
earn a 6 percent return on their investment (the $60 interest
payment is 6 percent of $1,000). We therefore say that the inter-
Price of a Treasury Bill




est rate on the bond is 6 percent. Now suppose that the price of the
bond rises to $1,200. The annual interest payment is still $60, so
B
P1 bondholders now earn just 5 percent on their money ($60 is
5 percent of $1,200). The effective interest rate on the bond has fallen
A
P0
to 5 percent. This relationship between bond prices and interest
rates is completely general:
When bond prices rise, interest rates fall because the purchaser
of a bond spends more money than before to earn a given
D
number of dollars of interest per year. Similarly, when bond
S1 S0
prices fall, interest rates rise.
Quantity of Treasury Bills
In fact, the relationship amounts to nothing more than two
ways of saying the same thing. Higher interest rates mean lower
F I GU R E 3
bond prices; lower interest rates mean higher bond prices.6 Thus Figure 3 is another way to
Open-Market
look at the fact that Federal Reserve open-market operations influence interest rates.
Purchases and Treasury
Specifically:
Bill Prices

An open-market purchase of Treasury bills by the Fed not only raises the money supply
but also drives up T-bill prices and pushes interest rates down. Conversely, an open-
market sale of bills, which reduces the money supply, lowers T-bill prices and raises
interest rates.




OTHER METHODS OF MONETARY CONTROL
When the Federal Reserve System was first established, its founders did not intend it to
pursue an active monetary policy to stabilize the economy. Indeed, the basic ideas of sta-
bilization policy were unknown at the time. Instead, the Fed™s founders viewed it as a
means of preventing the supplies of money and credit from drying up during banking
panics, as had happened so often in the pre-1914 period.



For further discussion and examples, see Test Yourself Question 4 at the end of the chapter.
6




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Licensed to:

Chapter 13 269
Managing Aggregate Demand: Monetary Policy




You Now Belong to a Distinctive Minority Group
When the financial panic hit in 2007, more and more investors be-




SOURCE: © Sidney Harris, www.sciencecartoonsplus.com
came attracted to U.S. government bonds as a safe place to park
funds. But an amazing number of investors do not understand even
the elementary facts about bond investing”including the relation-
ship between bond prices and interest rates.
The Wall Street Journal reported back in November 2001 that
“One of the bond basics about which many investors are clueless,
for instance, is the fundamental seesaw relationship between
interest rates and bond prices. Only 31% of 750 investors partici-
pating in the American Century [a mutual fund company] tele-
phone survey knew that when interest rates rise, bond prices
generally fall.” * Imagine how many fewer, then, could explain
why this is so.

“When interest rates go up, bond prices go down. When interest
* Karen Damato, “Investors Love Their Bond Funds”Too Much?,” The Wall Street
rates go down, bond prices go up. But please don™t ask me why.”
Journal, November 9, 2001, p. C1.




Lending to Banks
One of the principal ways in which Congress intended the Fed to provide such insurance
against financial panics was to act as a “lender of last resort.” When risky business prospects
made commercial banks hesitant to extend new loans, or when banks were in trouble, the Fed
would step in by lending money to the banks, thus inducing them to lend more to their cus-
tomers. If that sounds familiar, it should, since it is exactly what the Fed and other central banks
did beginning in the summer and fall of 2007, when the financial crisis made banks wary of
lending. Mammoth amounts of central bank lending to commercial banks help keep the finan-
cial system functioning and eased the panic for a while. Later, in 2008, the Fed actually began a
new program of lending to securities firms”something it had not done since the 1930s.
The mechanics of Federal Reserve lending are illustrated in Table 2. When the Fed
makes a loan to a bank in need of reserves, that bank receives a credit in its deposit
account at the Fed”$5 million in the example. That $5 million represents newly created
reserves. So it expands the supply of reserves just as was shown in Figure 2. Furthermore,
because bank deposits, and hence required reserves, have not yet increased, this addition
to the supply of bank reserves creates excess reserves, which should lead to an expansion of
the money supply.

TA BL E 2
Balance Sheet Changes for Borrowing from the Fed

Banks Federal Reserve System
Assets Liabilities Assets Liabilities
Reserves 1 $5 million Loan from Loan to Bank
Fed 1 $5 million bank 1 $5 million reserves 1 $5 million

Bank borrows $5 million
Addendum: Changes
and
in Reserves
Actual the proceeds are credited
reserves 1 $5 million to its reserve account
Required
reserves No Change
Excess
reserves 1 $5 million




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Licensed to:
Part 3
270 Fiscal and Monetary Policy



The discount rate is the Federal Reserve officials can try to influence the amount banks borrow by manipulat-
interest rate the Fed ing the rate of interest charged on these loans, which is known as the discount rate. If the Fed
charges on loans that it wants banks to have more reserves, it can reduce the interest rate that it charges on loans,
makes to banks.
thereby tempting banks to borrow more”which is exactly what it did repeatedly in 2007
and 2008. Alternatively, it can soak up reserves by raising its rate and persuading the
banks to reduce their borrowings.
But when it changes its discount rate, the Fed cannot know for sure how banks will re-
act. Sometimes they may respond vigorously to a cut in the rate, borrowing a great deal
from the Fed and lending a correspondingly large amount to their customers. At other
times they may essentially ignore the change in the discount rate. In fact, when it first cut
the discount rate in 2007, the Fed was disappointed in the banks™ meager response be-
cause it wanted to add reserves to the system. This episode illustrates a general point: that
the link between the discount rate and the volume of bank reserves may be a loose one.
Some foreign central banks use their versions of the discount rate actively as the center-
piece of monetary policy. But in the United States, the Fed normally lends infrequently
and in very small amounts. It relies instead on open-market operations to conduct mone-
tary policy. The Fed typically adjusts its discount rate passively, to keep it in line with mar-
ket interest rates. But in a crisis, the Fed does use the discount window to supplement and
support open-market operations. It did so massively in 2007 and 2008.


Changing Reserve Requirements
In principle, the Federal Reserve has a third way to conduct monetary policy: varying the
minimum required reserve ratio. To see how this works, imagine that banks hold reserves
that just match their required minimums. In other words, excess reserves are zero. If the
Fed decides that lower interest rates are warranted, it can reduce the required reserve ra-
tio, thereby transforming some previously required reserves into excess reserves. No new
reserves are created directly by this action. But we know from the previous chapter that
such a change will set in motion a multiple expansion of the banking system. Looked at in
terms of the market for bank reserves (Figure 1 on page 265), a reduction in reserve
requirements shifts the demand curve inward (because banks no longer need as many
reserves), thereby lowering interest rates. Similarly, raising the required reserve ratio will
raise interest rates and set off a multiple contraction of the banking system.
In point of fact, however, the Fed has not used the reserve ratio as a weapon of mone-
tary control for years. Current law and regulations provide for required reserves equal to
10 percent of transaction deposits”a figure that has not changed since 1992.



HOW MONETARY POLICY WORKS
Remembering that monetary policy actions by the Fed are almost always open-market opera-
tions, the two panels of Figure 4 illustrate the effects of expansionary monetary policy (an open-
market purchase) and contractionary monetary policy (an open-market sale). Panel (a) looks
just like Figure 2 on page 266. So expansionary monetary policy actions lower interest rates
and contractionary monetary policy actions raise interest rates. But then what happens?
To find out, let™s go back to the analysis of earlier chapters, where we learned that
aggregate demand is the sum of consumption spending (C), investment spending (I), gov-
ernment purchases of goods and services (G), and net exports (X 2 IM). We know that
fiscal policy controls G directly and influences both C and I through the tax laws. We now
want to understand how monetary policy affects total spending.
Most economists agree that, of the four components of aggregate demand, investment
and net exports are the most sensitive to monetary policy. We will study the effects of
monetary and fiscal policy on net exports in Chapter 19, after we have learned about in-
ternational exchange rates. For now, we will assume that net exports are fixed and focus
on monetary policy™s influence on investment.



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

Chapter 13 271
Managing Aggregate Demand: Monetary Policy



Investment and Interest S2
S0 S1 S0
D D
Rates
Given recent events in the housing
market, it is important to remember B




Interest Rate




Interest Rate
that the I in C 1 I 1 G 1 (X 2 IM) in- E
E
cludes both business investment in A
new factories and machinery and in-
vestment in housing. Because the inter-
est cost of a home mortgage is the
major component of the total cost of D D
S0 S1 S2 S0
owning a house, fewer families will
want to purchase new homes as in- Bank Reserves Bank Reserves
terest rates rise. Thus, higher interest (a) (b)
rates will reduce expenditures on Expansionary Monetary Policy Contractionary Monetary Policy
housing. Business investment is also
sensitive to interest rates, for reasons F I GU R E 4
explained in earlier chapters.7 Because the rate of interest that must be paid on borrowings The Effects of
is part of the cost of an investment, business executives will find investment prospects less Monetary Policy on
attractive as interest rates rise. Therefore, they will spend less. We conclude that Interest Rates

Higher interest rates lead to lower investment spending. But investment (I) is a compo-
nent of total spending, C 1 I 1 G 1 (X 2 IM). Therefore, when interest rates rise, total
spending falls. In terms of the 45° line diagram of previous chapters, a higher interest
rate leads to a lower expenditure schedule. Conversely, a lower interest rate leads to a
higher expenditure schedule.
Figure 5 depicts this situation graphically.

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