Introduction:

Thinking Like an Economist 1

2
CHAPTER30
CHAPTER

Monetary Policy

There have been three great inventions since the

beginning of time: fire, the wheel and central
banking.

— Will Rogers

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Goals

 Explain how monetary policy works in the AS/AD

model in both the traditional and structural
stagnation models

 Discuss how monetary policy works in practice

 Discuss the tools of conventional monetary policy

 Discuss the complex nature of monetary policy

and the importance of central bank credibility

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Monetary Policy
 Monetary policy is a policy of influencing the economy
through changes in the banking system’s reserves that
influence the money supply, credit availability, and interest
rates in the economy
• Fiscal policy is controlled by the government directly
• Monetary policy is controlled by the U.S. central
bank, the Federal Reserve Bank (the Fed)
• Monetary policy works through its influence on credit
conditions and the interest rate in the economy

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How Monetary Policy Works in the Models

Monetary policy affects both real output
Price level (production) and the price level (inflation
level)
Class discussion: How?
Expansionary monetary
SAS policy shifts the
AD curve to the right
P1
P0 AD1
Contractionary monetary
P2 policy shifts the
AD0 AD curve to the left

AD2
Real output
Y2 Y0 Y1

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How Monetary Policy Works in the Models

Price level If the economy is at or above

LAS potential, expansionary monetary
policy will cause input costs to rise
SAS1
Rising input costs will eventually
shift the SAS curve up so that
P1
SAS0 real output remains unchanged

AD1 The only long-run effect of

P0 expansionary monetary policy when
the economy is above potential is to
AD0 increase the price level

YP Real output

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How Monetary Policy Works in the Models

 Expansionary monetary policy is a policy that increases
the money supply and decreases the interest rate and it
tends to increase both investment and output

M i I Y

 Contractionary monetary policy is a policy that decreases

the money supply and increases the interest rate, and it
tends to decrease both investment and output

M i I Y

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Monetary Policy and the Fed

 A central bank is a type of banker’s bank whose financial obligations
underlie an economy’s money supply
• The central bank in the U.S is the Fed
• If commercial banks need to borrow money, they go to the central
bank
• If there’s a financial panic and a run on banks, the central bank is
there to make loans or ‘Bailout’ or ‘Dana Talangan’
• BLBI case in1998: IDR 147.7 T for 48 Banks where this given
economic loss to a country around IDR 138 T
• Century Bank case in 2008: The cost of bailout was about IDR 2.2 T
then increased to be IDR 6.7 T where IDR 3.1 T was corrupted and
eventually sold IDR 4.4 T to J Trust Investor Japan
Class Discussion: Why is it necessary?
 The ability to create money gives the central bank the power to control
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Structure of the Fed

Board of Governors Regional Reserve Banks

7 members appointed by the Oversees and Branches
president and confirmed by 12 regional Federal Reserve
the senate banks and 25 branches

Federal Open Market

Committee (FOMC)
Board of Governors plus 5 Federal
Reserve bank presidents

Open Market Operations Provides Services

FINANCIAL SECTOR GOVERNMENT

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Duties of the Fed

 Conducts monetary policy (influencing the supply of

money and credit in the economy)
 Supervises and regulates financial institutions
 Lender of last resort to financial institutions
 Provides banking services to the U.S. government
 Issues coin and currency
 Provides financial services to commercial banks, savings
and loan associations, savings banks, and credit unions

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Funding the budget deficit in Indonesian

case due to against Covid 19 crisis
• Long tradition of fiscal discipline. Balanced
budgets and Bank Indonesia independence
• Alternative sources are limited.
• BI has bought bonds in the past in the secondary
market to restrain yields.
• Now it has also agreed to buy bonds at tender
(‘standby’) through non- competitive bidding.
• And it will buy some bonds directly from the
government at yields which provide ‘burden-
sharing’.

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The Tools of Conventional Monetary Policy

 The Fed influences the amount of money in the economy

by controlling the monetary base
• Monetary base is vault cash, deposits of the Fed,
and currency in circulation
 Monetary policy affects the amount of reserves in the
banking system
• Reserves are vault cash or deposits at the Fed
• Reserves and interest rates are inversely related

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Monetary Policy: 1.Open Market Operations

 Open market operations are the primary way in which the

Fed changes the amount of reserves in the system
• Open market operations are the Fed’s buying and
selling of Treasury bills and Treasury bonds (from
the secondary market or over the counter)
• To expand the money supply, the Fed buys bonds
(supply money to the market)
• To contract the money supply, the Fed sells bonds
(Absorb money from the market)

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Open Market Operations

 An open market purchase is expansionary monetary policy

that tends to reduce interest rates and increase income
• When the Fed buys bonds, it deposits money in its
accounts at a bank
• Bank reserves are increased, and when banks loan
out the excess reserves, the money supply
increases

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Open Market Operations

 An open market sale is a contractionary monetary policy

that tends to raise interest rates and lower income
• When the Fed sells bonds, it receives checks
drawn against banks
• The bank’s reserves are reduced and the money
supply decreases

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10-year Government Bond Yields
Indonesia and comparators
9.00
8.00
7.00
10-year Bond Yield (%)

6.00
5.00
4.00
3.00
2.00
1.00
0.00
Jan-20 Feb-20 Mar-20 Apr-20 May- Jun-20 Jul-20 Aug-20
20 Period

Indonesia India China Philippines

Thailand Source: tradingeconomics.com
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Monetary policy: 2.The Reserve Requirement
and the Money Supply
 The reserve requirement or ‘Giro Wajib Minimum’ (GWM) is the
percentage the Fed sets as the minimum amount of reserves a bank
must have

 There are other ways the Fed can impact the banks’ reserves

• The Fed can directly add to the banks’ reserves

• The Fed can change the interest rate it pays banks’ on their
reserves or Commercial banks save their money into the central
bank to gain interest.

• The Fed can change the Fed funds rate, the rate of interest at
which banks borrow the excess reserves of other banks or
‘overnight rate’ Commercial banks can borrow the money to each
other. JIBOR in Indonesia: Jakarta Interbank Offered Rate (around
3-4%). The World uses LIBOR rate.
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Borrowing from the Fed and the Discount
Rate
 In case of a shortage of reserves, a bank can borrow
reserves directly from the Fed
 The discount rate is the interest rate the Fed charges for
those loans it makes to banks
• An increase in the discount rate makes it more
expensive to borrow from the Fed and may decrease
the money supply
• A decrease in the discount rate makes it less expensive
to borrow from the Fed and may increase the money
supply

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The Fed Funds Market

 Banks with surplus reserves loan these reserves to banks
with a shortage in reserves
• Fed funds are loans of excess reserves banks make
to each other
• Fed funds rate is the interest rate banks charge each
other for Fed funds
 By selling bonds, the Fed decreases commercial banks’
reserves, causing the Fed funds rate to increase
 By buying bonds, the Fed increases commercial banks’
reserves, causing the Fed funds rate to decrease

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Global financial market during Pandemic

Financial pressure has subsided but sentiment remains fickle

Global financial market volatility Capital flows back into the Emerging
eased Market
200 100 170 (Bloomberg EM Capital Flow Proxy Index)
MOVE Index
160
150
150
100 50 140
50 130
120
0 0
110
Jan-19

Apr-19

Jan-20

Apr-20
Jul-19

Jul-20
Oct-19

100
Jan-19 Apr-19 Jul-19 Oct-19 Jan-20 Apr-20 Jul-20
The global stock market is rising (MSCI Index, 100 = Jan Real money
2019) flows
130.0
120.0
110.0
100.0
90.0
80.0 Emerging Market Advanced Economies
70.0
Jan-19 Apr-19 Jul-19 Oct-19 Jan- Apr-20 Jul-20
20
Source:
6
Bloomberg

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The Fed Funds Rate
and the Discount Rate since 1990
The Federal Reserve Bank follows expansionary
9% or contractionary monetary policy by targeting a
8% lower or higher Fed funds rate
7%
Fed funds rate
6%
5%
4%
3% Discount rate
2%
1%
0%
1990 1994 1998 2002 2006 2010 2014

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Offensive and Defensive Actions

 Defensive actions are designed to maintain the current
monetary policy
• The Fed buys bonds during emergencies or
‘extraordinary’ directly from the primary market: the
MoF’s bonds. UU No.2/2020 due to Covid19.
• Reserves would otherwise decrease because
individuals and businesses don’t get to the bank
with their cash
 Offensive actions are designed to have expansionary or
contractionary effects on the economy

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The Fed Funds Rate as an Operating Target

 Monetary policy affects interest rates
 The Fed looks at the Federal funds rate and other
targets to determine whether monetary policy is tight
or loose
 If the Fed funds rate is above the Fed’s target range,
it buys bonds to increase reserves and lower the
Fed funds rate
 If the Fed funds rate is below the Fed’s target range,
it sells bonds to decrease reserves and raise the
Fed funds rate

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The Complex Nature of Monetary Policy

While the Fed focuses on the Fed funds rate as its operating
target, it also has its eye on its ultimate targets: stable prices,
acceptable employment, sustainable growth, and moderate
long-term interest rates

Fed tools Operating target Intermediate targets Ultimate targets

Open market Stable prices

Consumer confidence
operations, Sustainable growth
Stock prices
Discount rate, Fed funds rate Acceptable
Interest rate spreads
and Reserve employment
Housing starts
requirement Moderate i rates

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The Taylor Rule

 The Taylor rule is a useful approximation for predicting
Fed policy

 Formally the Taylor rule is:

Fed funds rate = 2% + Current inflation

+ 0.5 x (actual inflation less desired inflation)
+ 0.5 x (percent deviation of aggregate
output from potential)

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Limits to the Fed’s Control of the Interest
Rate
 The Fed may not be able to shift the entire yield curve
up or down, but may make it steeper, flatter or inverted
 A yield curve is a curve that shows the relationship
between interest rates and bonds’ time to maturity

 An inverted yield curve is one in which the short-term

rate is higher than the long-term rate

 As financial markets become more liquid, and

technological changes occur, the Fed’s ability to control
the long-term rate through conventional monetary policy
lessens

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The Yield Curve

8 8
7 7
Yield (interest rate)

Yield (interest rate)

6 6
5 5
4 4
3 3
2 2
1 1
1 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr. 1 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr.
Time to maturity Time to maturity
Yield Curve Inverted Yield Curve

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Maintaining Policy Credibility

 Policy makers are very concerned about establishing
policy credibility because they believe that it is necessary
to prevent inflationary expectations from becoming built
into the economy
 Nominal interest rates are the rates you actually see
and pay
 Real interest rates are nominal interest rates adjusted
for expected inflation
 Real interest rate = Nominal interest rate
- Expected inflation

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Maintaining Policy Credibility

 The real interest rate cannot be observed since it
depends on expected inflation, which cannot be directly
observed
 Making a distinction between nominal and real rates
adds another uncertainty to the effect of monetary policy
 If expansionary policy leads to expectations of increased
inflation, nominal rates will increase and leave real rates
unchanged

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Monetary Regimes
 Most economists believe that a monetary regime, not a monetary
policy, is the best approach to policy
 A monetary regime is a predetermined statement of the policy
that will be followed in various situations
 A monetary policy is a response to events chosen without a
predetermined framework
 Monetary regimes are now favored because rules can help generate
market expectations
 An explicit monetary regime has problems because special
circumstances arise where it makes sense to deviate from the regime

Class Discussion: Do you think monetary policy in Indonesia is effectively

worked to affect the economy rather than the Fiscal policy?

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Chapter Summary
 Monetary policy is the policy of influencing the economy
through changes in the banking system’s reserves that
affect the money supply
 In the AS/AD model, expansionary monetary policy works
as follows:
↑M → i↓ → ↑I → ↑Y
 Contractionary monetary policy works as follows:
↓ M → ↑i → ↓I → ↓Y
 In the structural stagnation model, expansionary monetary
policy lowers interest rates and raises asset prices

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Chapter Summary
 The Federal Open Market Committee (FOMC) makes
the actual decisions about monetary policy
 The Fed is a central bank; it conducts monetary policy
for the U.S. and regulates financial institutions
 The Fed changes the money supply through open
market operations
 The Federal funds rate is the rate at which one bank
lends reserves to another bank
 The Fed’s direct control is on short-term interest rates

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Chapter Summary
 A change in reserves changes the money supply by the
change in reserves times the money multiplier
 The Taylor rule is a feedback rule that states: Set the
Fed funds rate at 2 plus current inflation plus one-half
the difference between actual and desired inflation plus
one-half the percent difference between actual and
potential output
 Nominal interest rates are the interest rates we see and
pay. Real interest rates are nominal interest rates
adjusted for expected inflation: Real interest rate =
Nominal interest rate – Expected inflation.

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