Chapter 26 Summary

A. Central Banking and the Federal Reserve System 1. The Federal Reserve System is a central bank, a bank for bankers. Its objectives are to allow sustainable economic growth, maintain a high level of employment, ensure orderly financial markets, and above all to preserve reasonable price stability. 2. The Federal Reserve System (or "Fed") was created in 1913 to control the nation's money and credit and to act as the "lender of last resort." It is run by the Board of Governors and the Federal Open Market Committee (FOMC). The Fed acts as an independent government agency and has great discretion in determining monetary policy. 3. The Fed has three major policy instruments: (a) open-market operations, (b) the discount rate on bank borrowing, and (c) legal reserve requirements on depository institutions. Using these instruments, the Fed affects intermediate targets, such as the level of bank reserves, market interest rates, and the money supply. All these operations aim to improve the economy's performance with respect to the ultimate objectives of monetary policy: achieving the best combination of low inflation, low unemployment, rapid GDP growth, and orderly financial markets. In addition, the Fed along with other federal agencies must backstop the domestic and international financial system in times of crisis. 4. The most important instrument of monetary policy is the Fed's open-market operations. Sales by the Fed of government securities in the open market reduce the Fed's assets and liabilities and thereby reduce the reserves of banks. The effect is a decrease in banks' reserve base for deposits. People end up with less M and more government bonds. Open-market purchases do the opposite, ultimately expanding M by increasing bank reserves. 5. Outflows of international reserves can reduce reserves and M unless offset by sterilization though open-market purchases of bonds. Inflows have the opposite effects unless offset. In recent years, the Fed has routinely sterilized international reserve movements. In open economies with fixed exchange rates, monetary policies must be closely aligned with those in other countries. B. The Effects of Money on Output and Prices 6. If the Fed desires to slow the growth of output, the five-step sequence goes thus: a. The Fed reduces bank reserves through open-market operations. b. Each dollar reduction of bank reserves produces a multiple contraction of bank money and the money supply. c. In the money market, a reduction in the money supply moves along an unchanged money demand schedule, raising interest rates, restricting the amount and terms of credit, and tightening money. d. Tight money reduces investment and other interest-sensitive items of spending like consumer durables or net exports. e. The reduction in investment and other spending reduces aggregate demand by the familiar multiplier mechanism. The lower level of aggregate demand lowers output and the price level or inflation. The sequence is summarized by R down M down i up I, C, X down AD down real GDP down and inflation down 7. Although the monetary mechanism is often explained in terms of money affecting "investment," in fact the monetary mechanism is an extremely rich and complex process whereby changes in interest rates and asset prices influence a wide variety of elements of spending. These sectors include housing, affected by changing mortgage interest rates and housing prices; business investment, affected by changing interest rates and stock prices; spending on consumer durables, influenced by interest rates and credit availability; state and local capital spending, affected by interest rates; and net exports, determined by the effects of interest rates upon foreign exchange rates. 8. In an open economy, the international-trade linkage reinforces the domestic impacts of monetary policy. In a regime of flexible exchange rates, changes in monetary policy affect the exchange rate and net exports, adding yet another facet to the monetary mechanism. The trade link tends to reinforce the impact of monetary policy, operating in the same direction on net exports as it does on domestic investment. 9. Monetary policy may have different effects in the short run and the long run. In the short run, with a relatively flat AS curve, most of the change in AD will affect output and only a small part will affect prices. In the longer run, as the AS curve becomes more nearly vertical, monetary shifts lead predominantly to changes in the price level and much less to output changes. In the polar case where money-supply changes affect only nominal variables and have no effects on real variables, we say money is neutral. Most real-world monetary shifts have left real economic effects in their wake.