CHAPTER SUMMARY
1. Three groups help determine the money supply: the central bank, private-sector banks, and the general public. The central bank sets the monetary base, which is the quantity of central bank liabilities that can be used as money.
The monetary base equals the sum of bank reserves (deposits by banks at the central bank plus currency in the vaults of banks) and currency held by the nonbank public.2. The central bank can affect the size of the monetary base and thus the money supply through open-market operations. An open-market sale (in which central bank assets are sold for currency or bank reserves) reduces the monetary base. An open-market purchase (in which the central bank uses money to buy assets, such as government securities, from the public) increases the monetary base.
3. The central bank of the United States is called the Federal Reserve System, or the Fed. The leadership of the Fed is the Board of Governors, which in turn is headed by the chairman of the Federal Reserve. The Federal Open Market Committee (FOMC) meets about eight times each year to set monetary policy.
4. The Fed affects the U.S. money supply through openmarket operations, discount window lending, changes in the interest rate on reserves, and changes in reserve requirements. To deal with the zero lower bound in the financial crisis of 2008, the Fed developed new tools, including forward guidance and quantitative easing.
5. The Fed uses intermediate targets such as the money supply or short-term interest rates (primarily the fed funds rate) to guide monetary policy. Stabilizing interest rates is a useful strategy when fluctuations in money supply or demand would otherwise cause the LM curve to shift randomly back and forth.
6. The Federal Reserve and many other central banks choose to target interest rates in setting policy. This method can be analyzed either in the traditional IS-LM model, or in a modified model with a horizontal LR curve replacing the LM curve.
7. In a monetary-policy regime with abundant reserves, the Fed primarily changes the federal funds rate by changing the interest rate on reserves.
8. Setting monetary policy is difficult because of uncertainty about the state of the economy, about the structure of the economy, and about how people's expectations will respond to economic shocks or policy actions.
9. In the Great Recession that accompanied the financial crisis of 2008, the Fed found itself in a liquidity trap, having hit the zero lower bound on short-term interest rates. In response, the Fed used new policies, including forward guidance and quantitative easing.
10. Monetary policy may be conducted either by rules or by discretion. Under rules, the central bank is required to follow a simple predetermined rule for monetary policy, such as a requirement for constant money growth. Under discretion, the central bank is expected to monitor the economy and use monetary policy actively to maintain full employment and to keep inflation low. Discretion for monetary policy is usually favored by Keynesians, who argue that it gives the Fed maximum flexibility to stabilize the economy.
11. Monetarists, led by Milton Friedman, argue that, because of information problems and lags between the implementation of policy changes and their effects, the scope for using monetary policy to stabilize the economy is small. Furthermore, they argue, the Fed cannot be relied on to use active monetary policy wisely and in the public interest. Monetarists advocate a constant-growth-rate rule for the money supply to discipline the Fed and keep monetary fluctuations from destabilizing the economy.
12. An additional argument for rules is that they increase central bank credibility. Supporters of rules claim that the use of ironclad rules will cause the public to believe the central bank if it says (for example) that money supply growth will be reduced, with the implication that inflation can be reduced without a large increase in unemployment.
13. The Taylor rule suggests that a central bank targets interest rates based on the deviation of inflation from its target and the deviation of output from its fullemployment level.
14. Inflation targeting has been adopted by a number of countries. This approach allows the central bank some discretion in the short run but commits the bank to achieving a preannounced target for inflation in the longer run.
15. Possible ways to enhance a central bank's credibility are to appoint a central banker who is “tough" on inflation and to increase the central bank's independence from other parts of the government.
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