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CHAPTER 13

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267

TABLE 1

Effects of an Open-Market Purchase of Securities on the Balance Sheets of Banks and the Fed

Banks

Federal Reserve System

Assets

Liabilities

Assets

Liabilities

Reser ves

$100 million

U.S. government

Bank

U.S. government

securities 1 $100 million

reser ves

$100 million

securities 2

$100 million

Addendum: Changes

Banks get reser ves

in Reserves

Actual

Fed gets securities

reser ves

$100 million

Required

reser ves

No Change

Excess

reserves

$100 million

trades its IOUs for an existing asset (a T-bill). But unlike other IOUs, the Fed’s IOUs constitute bank reserves and thus can support a multiple expansion of the money supply just as cash does. Let’s see how this works.

It is clear from Table 1 that bank deposits have not increased at all—yet. So required reserves are unchanged by the open-market operation. But actual reserves are increased by $100 million. So, if the banks held only their required reserves initially, they now have $100 million in excess reserves. As banks rid themselves of these excess reserves by making more loans, a multiple expansion of the banking system is set in motion—as described in the previous chapter. It is not difficult for the Fed to estimate the ultimate increase in the money supply that will result from its actions. As we learned in the previous chapter, each dollar of newly created bank reserves can support up to 1/m dollars of checking deposits, if m is the required reserve ratio. In the example in the last chapter, m 5 0.20; hence, $100 million in new reserves would support $100 million 4 0.2 5 $500 million in new money.

But estimating the ultimate monetary expansion is a far cry from knowing it with certainty. We know from the previous chapter that the oversimplified money multiplier formula is predicated on two assumptions: that people will want to hold no more cash, and that banks will want to hold no more excess reserves, as the monetary expansion proceeds. In practice, these assumptions are unlikely to be literally true. So to predict the eventual effect of its action on the money supply, the Fed must estimate both the amount that firms and individuals will add to their currency holdings and the amount that banks will add to their excess reserves. Neither of these can be estimated with utter precision. In summary:

When the Federal Reserve wants lower interest rates, it purchases U.S. government securities in the open market. It pays for these securities by creating new bank reserves, which lead to a multiple expansion of the money supply. Because of fluctuations in people’s desires to hold cash and banks’ desires to hold excess reserves, the Fed cannot predict the consequences of these actions for the money supply with perfect accuracy. But the Fed can always put the federal funds rate where it wants by buying just the right volume of securities.5

For this reason, in this and subsequent chapters, we will simply proceed as if the Fed controls the federal funds rate directly.

5 Why? Because the federal funds rate is observable in the market every minute and hence need not be estimated. If interest rates do not fall as much as the Fed wants, it can simply purchase more securities. If interest rates fall too much, the Fed can purchase less. And these adjustments can be made very quickly.

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The procedures followed when the FOMC wants to raise interest rates are just the opposite 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-

lars of interest per year. For concreteness, consider a bond that

pays $60 each year. If the bond sells for $1,000, bondholders

earn a 6 percent return on their investment (the $60 interest

Bill

payment is 6 percent of $1,000). We therefore say that the inter-

est rate on the bond is 6 percent. Now suppose that the price of the

Treasurya

bond rises to $1,200. The annual interest payment is still $60, so

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

to 5 percent. This relationship between bond prices and interest

Price

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

number of dollars of interest per year. Similarly, when bond

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

FIGURE 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

Bill Prices

Specifically:

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 openmarket 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 stabilization 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.

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

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Managing Aggregate Demand: Monetary Policy

269

You Now Belong to a Distinctive Minority Group

When the financial panic hit in 2007, more and more investors became 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 relationship 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 participating in the American Century [a mutual fund company] telephone survey knew that when interest rates rise, bond prices generally fall.” * Imagine how many fewer, then, could explain why this is so.

SOURCE: © Sidney Harris, www.sciencecartoonsplus.com

* Karen Damato, “Investors Love Their Bond Funds—Too Much?,” The Wall Street Journal, November 9, 2001, p. C1.

“When interest rates go up, bond prices go down. When interest rates go down, bond prices go up. But please don’t ask me why.”

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 customers. 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 financial 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.

TABLE 2

Balance Sheet Changes for Borrowing from the Fed

Banks

Federal Reserve System

Assets

Liabilities

Assets

Liabilities

Reser ves

$5 million

Loan from

Loan to

Bank

Fed

$5 million

bank 1

$5 million

reser ves

$5 million

Addendum: Changes

Bank borrows $5 million

in Reserves

and

Actual

the proceeds are credited

reser ves

$5 million

to its reser ve account

Required

reser ves

No Change

Excess

reserves

$5 million

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The discount rate is the interest rate the Fed charges on loans that it makes to banks.

Federal Reserve officials can try to influence the amount banks borrow by manipulating the rate of interest charged on these loans, which is known as the discount rate. If the Fed wants banks to have more reserves, it can reduce the interest rate that it charges on loans, 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 react. 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 because 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 centerpiece 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 monetary policy. The Fed typically adjusts its discount rate passively, to keep it in line with market 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 ratio, 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 monetary 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 operations, the two panels of Figure 4 illustrate the effects of expansionary monetary policy (an openmarket 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), government 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 international exchange rates. For now, we will assume that net exports are fixed and focus on monetary policy’s influence on investment.

FIGURE 5

The Effect of Interest Rates on Total Expenditure

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CHAPTER 13 Managing Aggregate Demand: Monetary Policy 271

Investment and Interest

S0 S1

S2 S0

Rates

Given recent events in the housing

market, it is important to remember

Rate

that the I in C 1 I 1 G 1 (X 2 IM) in-

cludes both business investment in

Interest

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

owning a house, fewer families will

S0 S1

S2 S0

want to purchase new homes as in-

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

FIGURE 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 component 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.

Monetary Policy and Total Expenditure

The effect of interest rates on spending provides the chief mechanism by which monetary policy affects the macroeconomy. We know from our analysis of the market for bank reserves (repeated in Figure 4) that monetary policy can move interest rates up or down. Let us, therefore, trace the impacts of monetary policy, starting there.

Suppose the Federal Reserve, worried that the
Suppose the Federal Reserve, worried that the
economy might slip into a recession, increases the
supply of bank reserves. It would normally do so		45°
by purchasing government securities in the open
market, thereby shifting the supply schedule for			C + I + G + (X – IM)
reserves outward—as indicated by the shift from			C + I + G + (X – IM)
reserves outward—as indicated by the shift from			(lower interest rate)
the black line S0S0 to the brick-colored line S1S1	Expenditure		C + I + G + (X – IM)
in Figure 4(a). This is essentially what the Fed did			C + I + G + (X – IM)
in Figure 4(a). This is essentially what the Fed did
in 2007 and 2008.			C + I + G + (X – IM)
With the demand schedule for bank reserves,			C + I + G + (X – IM)
With the demand schedule for bank reserves,			(higher interest rate)
DD, temporarily fixed, such a shift in the supply			(higher interest rate)

	Real

curve has the effect that an increase in supply al-
curve has the effect that an increase in supply al-
ways has in a free market: It lowers the price, as
ways has in a free market: It lowers the price, as
Figure 4(a) shows. In this case, the relevant price is
the rate of interest that must be paid for borrowing
reserves, r (the federal funds rate). So r falls.
Next, for reasons we have just outlined, invest-
ment spending on housing and business equipment		Real GDP
(I) rises in response to the lower interest rates. But,		Real GDP
(I) rises in response to the lower interest rates. But,

7 See, for example, Chapter 7, pages 138–139.

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as we learned in Chapter 9, such an autonomous rise in investment kicks off a multiplier chain of increases in output and employment.

This sequence of events summarizes the linkages from the supply of bank reserves to the level of aggregate demand. In brief, monetary policy works as follows:

Expansionary monetary policy leads to lower interest rates (R), and these lower interest rates encourage investment (I), which has multiplier effects on aggregate demand.

This process operates equally well in reverse. By contracting bank reserves and the money supply, the central bank can push interest rates up, which is precisely what the Fed did between mid-2004 and August 2006. Higher rates will cause investment spending to fall and pull down aggregate demand via the multiplier mechanism.

This, in outline form, is how monetary policy influences the economy in the Keynesian model. Because the chain of causation is fairly long, the following schematic diagram may help clarify it:

	1	2	3	4
Federal Reserve	M and R	I	C + I + G + ( X – I M )	GDP
Policy	M and R	I	C + I + G + ( X – I M )	GDP
Policy

Real Expenditure

5,500

FIGURE 6

The Effect of

Expansionary Monetary Policy on Total Expenditure

In this causal chain, Link 1 indicates that the Federal Reserve’s open-market operations affect both interest rates and the money supply. Link 2 stands for the effect of interest rates on investment. Link 3 simply notes that investment is one component of total spending. Link 4 is the multiplier, relating an autonomous change in investment to the ultimate change in aggregate demand. To see what econo-

mists must study if they are to estimate the effects of

monetary policy, let us briefly review what we know

45°

about each of these four links.

C +

+ (

– I

M )

Link 1 is the subject of this chapter. It was de-

C +

+ (

– I

M )

picted in Figure 4(a), which shows how injections of

bank reserves by the Federal Reserve push the inter-

est rate down. Thus, the first thing an economist

must know is how sensitive interest rates are to

changes in the supply of bank reserves.

Link 2 translates the lower interest rate into

higher investment spending. To estimate this effect

in practice, economists must study the sensitivity of

investment to interest rates—a topic we first took up

in Chapter 7.

Link 3 instructs us to enter the rise in I as an au-

tonomous upward shift of the C 1 I 1 G 1 (X 2 IM)

6,000

6,500

7,000

Real

GDP

schedule in a 45° line diagram. Figure 6 carries out

this next step. The expenditure schedule rises from

NOTE: Figures are in billions of dollars per year.

C 1 I0 1 G 1 (X 2 IM) to C 1 I1 1 G 1 (X 2 IM).

Finally, Link 4 applies multiplier analysis to this

vertical shift in the expenditure schedule to obtain the eventual increase in real GDP demanded. This change is shown in Figure 6 as a shift in equilibrium from E0 to E1, which raises real GDP by $500 billion in the example. Of course, the size of the multiplier itself must also be estimated. To summarize:

The effect of monetary policy on aggregate demand depends on the sensitivity of interest rates to open-market operations, on the responsiveness of investment spending to the rate of interest, and on the size of the basic expenditure multiplier.

MONEY AND THE PRICE LEVEL IN THE KEYNESIAN MODEL

Our analysis up to now leaves one important question unanswered: What happens to the price level? To find the answer, we must recall that aggregate demand and aggregate supply jointly determine prices and output. Our analysis of monetary policy so far has shown

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273

us how expansionary monetary policy boosts total spending: It increases the aggregate

FIGURE 7

quantity demanded at any given price level. But to learn what happens to the price level and

The Inflationary Effects

to real output, we must consider aggregate supply as well.

of Expansionary

Specifically, when considering shifts in aggregate de-

Monetary Policy

mand caused by fiscal policy in Chapter 11, we noted that an

upsurge in total spending normally induces firms to in-

crease output somewhat and to raise prices somewhat. This

is precisely what an upward-sloping aggregate supply

curve shows. Whether the responses come more in the form

500 billion

of real output or more in the form of price depends on the

slope of the aggregate supply curve (see Figure 7). Exactly

Level

103

the same analysis of output and price responses applies to

monetary policy or, for that matter, to anything that raises

Price

the aggregate demand curve. So we conclude that

100

Expansionary monetary policy causes some inflation

under normal circumstances. But exactly how much in-

flation it causes depends on the slope of the aggregate

supply curve.

The effect of expansionary monetary policy on the price

6,000

6,400

level is shown graphically on an aggregate supply and

Real GDP

demand diagram in Figure 7. In the example depicted in

Figure 6, the Fed’s actions lowered interest rates enough to

NOTE: GDP figures are in billions of dollars per year.

increase aggregate demand (through the multiplier) by

$500 billion. We enter this increase as a $500 billion horizontal shift of the aggregate de-

mand curve in Figure 7, from D0D0 to D1D1. The diagram shows that this expansionary

monetary policy pushes the economy’s equilibrium from point E to point B—the price

level therefore rises from 100 to 103, or 3 percent. The diagram also shows that real GDP

rises by only $400 billion, which is less than the $500 billion stimulus to aggregate de-

mand. The reason, as we know from earlier chapters, is that rising prices stifle real aggre-

gate demand.

By taking account of the effect of an increase in the money supply on the price level, we

have completed our story about the role of monetary policy in the Keynesian model. We

can thus expand our schematic diagram of monetary policy as follows:

	1	2	3	4
Federal Reserve	M and R	I	C + I + G + (X – IM)	Y and P
Policy	M and R	I	C + I + G + (X – IM)	Y and P
Policy

The last link now recognizes that both output and prices normally are affected by changes in interest rates and the money supply.

Application: Why the Aggregate Demand Curve

Slopes Downward8

This analysis of the effect of monetary policy on the price level puts us in a better position to understand why higher prices reduce aggregate quantity demanded—that is, why the aggregate demand curve slopes downward. In earlier chapters, we explained this phenomenon in two ways. First, we observed that rising prices reduce the purchasing power of certain assets held by consumers, especially money and government bonds, and that falling real wealth in turn retards consumption spending. Second, we noted that higher domestic prices depress exports and stimulate imports.

There is nothing wrong with this analysis; it is just incomplete. Higher prices have another important effect on aggregate demand, through a channel that we are now in a position to understand.

8 This section contains somewhat more difficult material, which can be skipped in shorter courses.

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D0	D1	S
		E1
Rate
Interest		E0	Effect of a
			Effect of a
			higher P
			higher P
	S	D0	D1
	Bank Reserves

Bank deposits are demanded primarily to conduct transactions. As we noted earlier in this chapter, an increase in the average money cost of each transaction—that is, a rise in the price level— will increase the quantity of deposits demanded, and hence increase the demand for bank reserves. Thus, when spending rises for any reason, the price level will also rise, and more reserves will therefore be demanded at any given interest rate—that is, the demand curve for bank reserves will shift outward to the right, as shown in Figure 8.

If the Fed does not increase the supply of reserves, this outward shift of the demand curve will force the cost of borrowing reserves—the federal funds rate—to rise, as Figure 8 makes clear. As we know, increases in interest rates reduce investment and, hence, reduce aggregate demand. This is the main reason why the economy’s aggregate demand curve has a negative slope, meaning that aggregate quantity demanded is lower when prices are higher. In sum:

FIGURE 8

The Effect of a Higher Price Level on the Market for Bank Reserves

At higher price levels, the quantity of bank reserves demanded is greater. If the Fed holds the supply schedule fixed, a higher price level must therefore lead to higher interest rates. Because higher interest rates discourage investment, aggregate quantity demanded is lower when the price level is higher—that is, the aggregate demand curve has a negative slope.

FROM MODELS TO POLICY DEBATES

You will no doubt be relieved to hear that we have now provided just about all the technical apparatus we need to analyze stabilization policy. To be sure, you will encounter many graphs in the next few chapters. Most of them, however, repeat diagrams with which you are already familiar. Our attention now turns from building a theory to using that theory to address several important policy issues.

The next three chapters take up a trio of controversial policy debates that surface regularly in the media: the debate over the conduct of stabilization policy (Chapter 14), the continuing debate over budget deficits and the effects of fiscal and monetary policy on growth (Chapter 15), and the controversy over the trade-off between inflation and unemployment (Chapter 16).

| SUMMARY |

1.A central bank is bank for banks.

2.The Federal Reserve System is America’s central bank. There are 12 Federal Reserve banks, but most of the power is held by the Board of Governors in Washington and by the Federal Open Market Committee.

3.The Federal Reserve acts independently of the rest of the government. Over the past 20 to 25 years, many countries have decided that central bank independence is a good idea and have moved in this direction.

4.The Fed has three major monetary policy weapons: open-market operations, reserve requirements, and its

lending policy to banks. But only open-market operations are used frequently.

5.The Fed increases the supply of bank reserves by purchasing government securities in the open market. When it pays banks for such purchases by creating new reserves, the Fed lowers interest rates and induces a multiple expansion of the money supply. Conversely, open-market sales of securities take reserves from banks, raise interest rates, and lead to a contraction of the money supply.

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6.When the Fed buys bonds, bond prices rise and interest rates fall. When the Fed sells bonds, bond prices fall and interest rates rise.

7.The Fed can also pursue a more expansionary monetary policy by allowing banks to borrow more reserves, perhaps by reducing the interest rate it charges on such loans

(the discount rate) or by reducing reserve requirements.

8.None of these weapons, however, gives the Fed perfect control over the money supply in the short run, because it cannot predict perfectly how far the process of deposit creation or destruction will go. The Fed can, however, control the interest rate paid to borrow bank reserves, which is called the federal funds rate, much more tightly.

9.Investment spending (I), including business investment and investment in new homes, is sensitive to interest rates (r). Specifically, I is lower when r is higher.

10.Monetary policy works in the following way in the Keynesian model: Raising the supply of bank reserves leads to lower interest rates; the lower interest rates stimulate investment spending; and this investment stimulus, via the multiplier, then raises aggregate demand.

11.Prices are likely to rise as output rises. The amount of inflation caused by expansionary monetary policy depends on the slope of the aggregate supply curve. Much inflation will occur if the supply curve is steep, but little inflation if it is flat.

12.The main reason why the aggregate demand curve slopes downward is that higher prices increase the demand for bank deposits, and hence for bank reserves. Given a fixed supply of reserves, this higher demand pushes interest rates up, which, in turn, discourages investment.

Monetary policy 261 Central bank 263

Federal Reserve System 263

Federal Open Market Committee (FOMC) 264

Central bank independence 264

\| KEY TERMS	\|
Open-market operations	265	Federal Reserve lending to
Equilibrium in the market for bank		banks 269
Equilibrium in the market for bank
reserves 265		Discount rate 270
Federal funds rate 266		Reserve requirements 270
Bond prices and interest		Why the aggregate demand curve
rates 268		slopes downward 273

| TEST YOURSELF |

1.Suppose there is $120 billion of cash and that half of this cash is held in bank vaults as required reserves (that is, banks hold no excess reserves). How large will the money supply be if the required reserve ratio is 10 percent? 12 1⁄2 percent? 16 2⁄3 percent?

2.Show the balance sheet changes that would take place if the Federal Reserve Bank of New York purchased an office building from Citigroup for a price of $100 million. Compare this effect to the effect of an open-market purchase of securities shown in Table 1. What do you conclude?

3.Suppose the Fed purchases $5 billion worth of government bonds from Bill Gates, who banks at the Bank of America in San Francisco. Show the effects on the balance sheets of the Fed, the Bank of America, and Gates. (Hint: Where will the Fed get the $5 billion to pay Gates?) Does it make any difference if the Fed buys bonds from a bank or an individual?

4.Treasury bills have a fixed face value (say, $1,000) and pay interest by selling at a discount. For example, if a one-year bill with a $1,000 face value sells today for $950, it will pay $1,000 2 $950 5 $50 in interest over its life. The interest rate on the bill is therefore $50/$950 5 0.0526, or 5.26 percent.

a.Suppose the price of the Treasury bill falls to $925. What happens to the interest rate?

b.Suppose, instead, that the price rises to $975. What is the interest rate now?

c.(More difficult) Now generalize this example. Let P be the price of the bill and r be the interest rate. Develop an algebraic formula expressing r in terms of P. (Hint: The interest earned is $1,000 2 P. What is the percentage interest rate?) Show that this formula illustrates the point made in the text: Higher bond prices mean lower interest rates.

5.Explain what a $5 billion increase in bank reserves will do to real GDP under the following assumptions:

a.Each $1 billion increase in bank reserves reduces the rate of interest by 0.5 percentage point.

b.Each 1 percentage point decline in interest rates stimulates $30 billion worth of new investment.

c.The expenditure multiplier is 2.

d.The aggregate supply curve is so flat that prices do not rise noticeably when demand increases.

6.Explain how your answers to Test Yourself Question 5 would differ if each of the assumptions changed. Specifically, what sorts of changes in the assumptions would weaken the effects of monetary policy?

7.(More difficult) Consider an economy in which government purchases, taxes, and net exports are all zero, the consumption function is

C 5 300 1 0.75Y

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Fiscal and Monetary Policy

and investment spending (I) depends on the rate of interest (r) in the following way:

I 5 1,000 2 100r

Find the equilibrium GDP if the Fed makes the rate of interest (a) 2 percent (r = 0.02), (b) 5 percent, and (c) 10 percent.

| DISCUSSION QUESTIONS |

1.Why does a modern industrial economy need a central bank?

2.What are some reasons behind the worldwide trend toward greater central bank independence? Are there arguments on the other side?

3.Explain why the quantity of bank reserves supplied normally is higher and the quantity of bank reserves demanded normally is lower at higher interest rates.

4.From September 2007 through April 2008, the Fed believed that interest rates needed to fall and took steps to reduce them, eventually cutting the federal funds rate from

5.25 percent to 2.0 percent. How did the Fed reduce the federal funds rate? Illustrate your answer on a diagram.

5.Explain why both business investments and purchases of new homes rise when interest rates decline.

6.In the early years of this decade, the federal government’s budget deficit rose sharply because of tax cuts and increased spending. If the Federal Reserve wanted to maintain the same level of aggregate demand in the face of large increases in the budget deficit, what should it have done? What would you expect to happen to interest rates?

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