Fundamental Questions

1. What does the Federal Reserve do?

2. How is monetary policy set?

3. What are the tools of monetary policy?

4. What role do central banks play in the foreign exchange market?

5. What are the determinants of the demand for money?

6. How does monetary policy affect the equilibrium level of real GDP?

Teaching Objectives

The primary purpose of this chapter is to describe the principles of monetary policy, which is the second major tool of macroeconomic policy.

The unique feature of this chapter is the presentation of a money supply and demand model. Through this model, and the aggregate supply and demand model that was presented earlier, the chapter shows how changes in the money supply (which are carried out by the Fed) cause changes in equilibrium income. The chapter also discusses the institutional features of the Federal Reserve System, as well as the process by which monetary policy is set. The chapter then moves on to discuss the tools of monetary policy for the domestic economy and how the Fed can influence the exchange rate.

Two areas require special attention in this chapter: The relationship between bond prices and interest rates deserves some added attention, and many students will require a concrete exercise that demonstrates the money expansion process. The material in this chapter will be used later in Chapters 15 and 16 on macroeconomic policy and the various perspectives on macro policy.

Key Term Review

Federal Open Market Committee (FOMC)
intermediate target
equation of exchange
velocity of money
quantity theory of money
FOMC directive
legal reserves
federal funds rate
discount rate
open market operations
foreign exchange market intervention
sterilization
transactions demand for money
precautionary demand for money
speculative demand for money

Lecture Outline and Teaching Strategies

1. The Federal Reserve System

1.a. Structure of the Fed

1.a.1. Board of Governors

1.a.2. District banks

1.a.3. The Federal Open Market Committee

Teaching Strategy: Point out that 6 of the 13 voting members of the FOMC (the regional Fed presidents) are not subject to government approval.

1.b. Functions of the Fed

1.b.1. Banking services and supervision

1.b.2. Controlling the money supply

2. Implementing Monetary Policy

2.a. Policy goals: The ultimate goal of monetary policy is economic growth with stable prices.

Teaching Strategy: The goals of monetary policy are often in conflict and you may wish to point this out to your students. For example, as we will see in Chapter 15, low unemployment often comes at the cost of less price stability.

2.a.1. Intermediate targets: Because the Fed cannot directly control gross domestic product and prices, it must target variables that it can control and that are linked to its ultimate goals.

2.b. Operating procedures

2.b.1. Tools of monetary policy: The Fed can use the reserve requirement, the discount rate, and open market operations to change reserves and thereby control the money supply.

Teaching Strategy: Point out that because it has such a powerful effect on the multiplier, the reserve requirement is seldom used as a policy tool.

2.b.2. FOMC directives: The tools, targets, and goals of monetary policy create a feedback loop in which policy is gradually adjusted to affect targets, which subsequently affects goals.

Teaching Strategy: Point out that the Fed must frequently adjust its tools to its operating target in response to changes in the position of the target and aggregate supply and demand shocks.

2.c. Foreign exchange market intervention

2.c.1. Mechanics of intervention: Foreign exchange market intervention is the buying and selling of foreign exchange by a central bank in order to move exchange rates up or down.

2.c.2. Effects of intervention: If the Federal Reserve is concerned about the domestic impact of its foreign exchange market intervention, it can sterilize the intervention with an open market purchase or sale of bonds.

3. Monetary Policy and Equilibrium Income

To understand the workings of monetary policy we use the money supply and demand framework.

3.a. Money demand: There are three broad categories of demand for money-transactions demand for money, precautionary demand for money, and speculative demand for money.

3.a.1. The money demand function: Changes in the interest rate cause changes in the quantity of money demanded. Changes in nominal income cause shifts in the money demand function.

3.a.2. The money supply function: The position of the money supply function is determined by the Federal Reserve.

3.a.3. Equilibrium in the money market: This equilibrium is determined by an interest rate that equates the quantity of money demanded and the quantity of money supplied.

3.b. Money and equilibrium income: Monetary policy affects both investment and consumption spending, thus affecting equilibrium income.

Teaching Strategy: Note the large number of links between a change in the money supply and a change in equilibrium income. It is little wonder that many Keynesian economists questioned the effectiveness of monetary policy.