Monetary policy

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Monetary policy:
Monetary policy involves altering base interest rates, which ultimately determine all other
interest rates in the economy, or altering the quantity of money in the economy. Many
economists argue that altering exchange rates is a form of monetary policy, given that interest
rates and exchange rates are closely related.

Chapter Summary:

In summary of monetary policy chapter, the fed has three tools of monetary policy, the
one that use in market operations.

The other tools are used on very rare occasions.

The role of the fed in the banking system and in our economy is very important.

They formulate and execute monetary policy, supervise depository institutions, provide
an elastic currency, assist the federal government finance operations, serve as the banker
of the United State Government.

They do most of this by using open market operations which is the tool that work at
fastest.

It will remain the most important tool until a more efficient way one is discovered.

Background:
The goal of monetary policy is to influence the level of economic activity and stability of the
price level through actions that influence the rate of interest; and given this, influence those
components of aggregate demand that are sensitive to the rate of interest. The operative feature
of monetary policy is the supply of money.
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The interest rate transmission mechanism:

Interest rates transmit their way to aggregate demand in the following ways:
1. Household demand is affected because changes in interest rates affect savings, which
indirectly affect spending.
2. For households or firms with existing debt, such as a mortgage, a change in rates affects
repayments, and hence individuals have more (or less) cash after servicing their debts.
Changes in rates affect the cash-flow of firms and households.
3. In the case of new debt to fund spending, borrowing is also encouraged (or discouraged)
following interest rate changes.
4. Interest rates also affect consumer and business confidence, which in turn affects
spending.
5. Asset values are also affected by interest rates. A fall in rates will tend to increase the
profitability of firms and they may pay higher dividends to shareholders. This can trigger
an increase in household spending. Similarly, a rate fall makes savings less attractive and
property more attractive, increasing the value of property and household wealth.
6. Finally, interest rates may affect the exchange rate, which can also influence export
demand. For example, a rise in interest rates may raise the exchange rate, pushing up
export prices and reducing overseas demand. Changes in the exchange rate also affect the
price of imports, which also affect the inflation rate.

Summary of the transmission mechanism of monetary policy:

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Liquidity Preference:
Assume that the available financial assets are limited to money and bonds. Bonds stand for all
financial assets, including stock, bonds, CDs, or any form of debt or ownership that is less liquid
than money, i.e., cannot be directly exchanged for goods or services; but, provides its owner with
a stream of income over time. At any given time the amounts of money and bonds are fixed.
Taken together, the roster of bonds and money held by an individual is called their portfolio.
Equilibrium in the market for the components of portfolio, i.e., a circumstance such that all are
content with the particular portfolios being held, is dictated by the rate of interest (of course there
are really many rates of interest varying with respect to risk and the terms of bonds or other types
of financial instruments, e.g., bonds with longer maturities usually have higher yields).
An individuals decision about the mix of financial assets to hold must resolve the trade-off
between illiquid assets (bonds) that provide income and cash or checking account balances that
can be exchanged for goods and services. The rate of interest stands for the opportunity cost of
holding wealth in money form, i.e., the sacrifice in income made for the convenience of liquidity.
Given this, the demand for money (called Liquidity Preference) would be inversely related to
the rate of interest, e.g., the demand for money would fall and (consequently) the demand for
bonds would increase as the rate of interest (the yield on bonds) is high. At any given time the
supply of money and bonds is fixed. If individuals are not content with the particular mixture of
bonds and money being held, it is the interest rate that changes to bring the market into
equilibrium. If, say, people feel that they are holding too much money and too few bonds, then in
the effort to acquire bonds the price of bonds is bid up and thus (the dual) rate of interest is bid
down. The process continues until the rate of interest is sufficiently bid down to bring the market
into equilibrium for the amounts of bonds and money being held. By the same reasoning, if
people tried to sell bonds to make portfolios more liquid the price of bonds would be bid down
and the rate of interest is bid to higher levels. Accordingly, changes in the supply of money will
result in a change in the rate of interest as depicted in the graphic below.

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There are basically four policies that could be pursued that would change the supply of money.
These are (say, to increase the supply of money):

Policy #1: Reduce the reserve requirement.

Policy #2: Buy bonds in the open market.
Policy #3: Reduce interest rates in general by reducing the federal funds rate.
Policy #4: Encourage banks to extend credit.
The converse policies would tend to decrease the supply of money. In the graphic(s) above and
below the before case shows equilibrium before the implementation of a monetary policy and
the after case shows the change in equilibrium due to the monetary policy.

Investment Demand:
In general, investment is current production not consumed. In particular, in addition to being just
that, i.e., an increase in producer inventories, such refers to the purchase of new houses by the
private sector and the purchase of plant and equipment by business. Taking plant and equipment
as the largest component, it is important to realize that such commodities do not satisfy the wants
and needs of consumers. Instead, these commodities will be utilized in the production process to
produce commodities that do satisfy consumer wants in future time periods. Accordingly, the
value of such commodities is found in their contribution to future producer income. As with
financial assets, the current value of such a commodity is equal to the present value (i.e., as
discounted from future time periods) of the future income received by its owner. Generally, the
higher the rate of interest (used to discount the income received in the future) the lower the
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present value. Accordingly, as interest rates are high there are fewer investment opportunities
that are worth it in terms of their present value. Accordingly, as depicted in the graphic below,
the demand for investment is lower as interest rates are high, and conversely. The relationship
between the demand for investment goods and the rate of interest is sometimes called the
marginal efficiency of investment.
Simply said, if monetary policies are pursued that increase the supply of money, and
consequently reduce the rate of interest, the investment component of aggregate demand will
increase. Consumer expenditures of durable commodities (even though houses are the only
consumer item officially counted in reported investment) would also be similarly interest rate
sensitive (reinforcing the effect of interest rate changes on aggregate demand). In any case, given
a change in the rate of interest (decrease per the graphics here) there is a corresponding change in
aggregate demand via the multiplier. The analysis now proceeds exactly as in the case of changes
in government expenditure and taxation as spelled out in the graphics below.

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References:
https://www.google.com/search?
q=summary+of+monetary+policy&biw=1366&bih=657&source=lnms&tbm=i
sch&sa=X&ved=0ahUKEwieg6z2wqfMAhUFiRoKHf0ICEsQ_AUICCgD#im
grc=l1j7KaIUwG4PCM%3A
http://astro.temple.edu/~gmlady/web359/Graph_Policy.htm

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