Reading

100. i. Read the text and answer the questions.

1. Why is monetary policy a more subtle and more politically conservative measure than fiscal policy?
2. How can changes in banking practices reduce the Fed’s control of the money supply?
3. What are the effects of tight and easy money policies?
4. When does the velocity of money decline?
5. How can the Fed obtain the market interest rates it desires?

Effectiveness of Monetary Policy

100. R.
     McConnell, S. L. Bme

Strengths of Monetary Policy

Most economists regard monetary policy as an essential component of U.S. national stabilization policy, especially in view of the following features and evidence.

Speed and Flexibility. Compared with fiscal policy, monetary policy can be quickly altered. Recall that the application of fiscal policy may be delayed by congressional deliberations. In contrast, the Open Market Committee of the Federal Reserve System can buy or sell securities on a daily basis and thus affect the money supply and interest rates almost immediately.

Isolation from Political Pressure. Since members of the Fed’s Board of Covernors are appointed for 14-year terms, they are not often subject to lobbying and need not concern themselves with their popularity with voters. Thus the Board, more easily than Congress, can engage in politically unpopular policies which might be necessary for the long-term health of the economy. And, monetary policy itself is a more subtle and more politically conservative measure than fiscal policy. Changes in government spending directly affect the allocation of resources, and changes in taxes can have extensive political ramifications. By contrast, monetary policy works more subtly and therefore is more politically palatable.

Shortcomings and Problems

Despite its recent successes, monetary policy has certain limitations and it encounters real-world complications.

Less Control? Some commentators suggest that changes in banking practices may reduce, or make less predictable, the Fed’s control of the money supply. People can now move near-monies quickly from mutual funds and other financial investments to checking accounts, and vice versa. A particular monetary policy aimed at changing bank reserves might then be rendered less effective by movements of funds within the financial system.

For example, people might respond to a tight money policy by quickly converting near-monies in their mutual fund accounts or other liquid financial investments to money in their checking accounts. Bank reserves would then not fall as intended by the Fed, the interest rate would not rise, and aggregate demand might not change. Also, banking and finance are increasingly global. Flows of funds to or from the United States might undermine or render inappropriate a particular domestic monetary policy. Finally, the prospects of E-cash and smart cards might complicate the measurement of money and make its issuance more difficult to control.

Flow legitimate are these concerns? These financial developments could make the Fed’s task of monetary policy more difficult. But recent studies and Fed experience confirm that the traditional central bank tools of monetary policy remain effective in changing the money supply and interest rates.

Cyclical Asymmetry. If pursued vigorously, tight money can deplete commercial banking reserves to the point where banks are forced to reduce the volume of loans. This means a contraction of the money supply. But an easy money policy suffers from a “You can lead a horse to water, but you can’t make it drink” problem. An easy money policy can ensure only that commercial banks have the excess reserves needed to make loans. It cannot guarantee that the banks will actually make the loans and thus that the supply of money will increase.

In short, a potential cyclical asymmetry is at work. Monetary policy may be highly effective in slowing expansions and controlling inflation but largely ineffective in moving the economy from a recession or depression toward its full-employment output. This potential cyclical asymmetry, however, has not created major difficulties for monetary policy in recent eras. Since the Great Depression, higher excess reserves have generally translated into added lending and therefore into an increase in the money supply.

Changes in Velocity. Total expenditures may be regarded as the money supply multiplied by the velocity of money — the number of times per year the average dollar is spent on goods and services. If the money supply is $ 150 billion, total spending will be $ 600 billion if velocity is 4 but only $ 450 billion if velocity is 3.

Some economists feel that velocity changes in the opposite direction from the money supply, offsetting or frustrating policy-related changes in the money supply. During inflation, when the money supply is restrained by policy, velocity may increase. Conversely, when measures are taken to increase the money supply during recession, velocity may fall.

Velocity might behave this way because of the asset demand for money. An easy money policy, for example, means an increase in the supply of money relative to the demand for it and therefore a reduction in the interest rate. But when the interest rate — the opportunity cost of holding money as an asset — is lower, the public will hold larger money balances. This means dollars will move from hand to hand — from households to businesses and back again — less rapidly.

Interest as Income. Monetary policy is based on the idea that expenditures on capital goods and interest-sensitive consumer goods are inversely related to interest rates. We must now acknowledge that businesses and households are also recipients of interest income. The size of such income and the spending which flows from it vary directly with the level of interest rates.

Suppose inflation is intensifying and the Fed raises interest rates to increase the cost of capital goods, housing, and automobiles. The complication is that higher interest rates on a wide range of financial instruments (for example, bonds, certificates of deposits, checking accounts) will increase the incomes and spending of the households and businesses that own them. Such added spending is obviously at odds with the Fed’s effort to restrict aggregate demand.

The point is this: For those who pay interest as an expense, a rise in the interest rate reduces spending, while a decline in the interest rate increases spending. But for those who view interest as income, a rise in the interest rate increases spending, while a decline in the interest rate reduces spending. The change in spending by interest-income receivers partly offsets and weakens the change in spending by purchasers of capital goods, homes, and autos.

Recent Focus: The Federal Funds Rate

In the past few years, the Fed has communicated its changes in monetary policy by announcing changes in its targets for the federal funds rate. (Recall that this rate is the interest rate which banks charge one another on overnight loans.) Statements by the Fed that it intends to increase the Federal funds rate suggest a “tighter” monetary policy is coming, while statements that it intends to reduce the Federal funds rate foretell an “easier” monetary policy. Interest rates, in general, rise and fall with the Federal funds rate.

The Fed does not set either the Federal funds rate or the prime rate; each is established by the interaction of lenders and borrowers. But because the Fed can change the supply of excess reserves in the banking system and then the money supply, it normally can obtain the market interest rates it desires. To increase the Federal funds interest rate, the Fed sells bonds in the open market. Such open-market operations reduce excess reserves in the banking system, lessening the excess reserves available for overnight loans in the Federal funds market. The decreased supply of excess reserves in that market increases the Federal funds interest rate. In addition, reduced excess reserves decrease the amount of bank lending and hence the amount of deposit money. We know that declines in the supply of money lead to increases in interest rates in general, including the prime interest rate.

In contrast, when the Fed wants to reduce the Federal funds rate, it buys bonds from banks and the public. As a result, the supply of reserves in the Federal funds market increases and the Federal funds rate declines.

The money supply rises because the increased supply of excess reserves leads to greater lending and creation of deposit money. As a result, interest rates in general fall, including the prime interest rate.

100. 2. Decide whether these statements are True (T) or False (F).

1. According to recent studies the money supply and interest rates can be effectively changed by the traditional central bank tools.
2. Monetary policy is an instrument for moving the economy from a recession.
3. During inflation velocity may fall when the money supply is restrained.
4. Expenditures on capital goods and interest rates are mutually dependent.
5. The Fed sets the prime rate.