6. Monetary Policy Effects
When the interest rate reaction function---equation 30---is included in the model, monetary policy is endogenous. In other words, there is no exogenous monetary policy variable to change. One can, of course, drop equation 30 and examine the effects of exogenous monetary policy changes, and this is what is done in this chapter. The most straightforward experiment is to change the short term interest rate RS, and this is done first.

Experiment 6.1: Increase in the Short Term Interest Rate RS

  • Take RS to be exogenous and change it by 1.0 in each quarter of the forecast period. Solve the model.
  1. Answer the questions posed at the end of Experiment 5.1. (Experiment 6.1 is another key experiment that you should have a good understanding of.)
  2. What did M1 do in response to the increase in RS? What about nonborrowed reserves BR - BO? Why?
  3. Remember that -AG is the amount of government securities outstanding. This is the open market operations variable of the Fed. Note that -AG increased in the experiment. Why?
  4. What was the effect on government interest payments INTG? How did this affect SGP?

Instead of changing RS and observing how M1 and the other variables change, you can change M1 and observe how RS and the other variables change. In fact, if you take M1 to be exogenous and change it by the same amount that it changed in Experiment 6.1, you will get the same answers (aside from rounding error). Experiment 6.2 does this.

Experiment 6.2: Decrease in the Money Supply M1

  • Change M1 in the first four quarters of the forecast period by the amounts that it was changed in Experiment 6.1. Solve the model for the first four quarters of the forecast period. (Only the first four quarters are used here to save you from entering so many numbers.)
  1. Observe that the results for this experiment are the same as those for Experiment 6.1.
  2. Now that you have done this experiment, you may want to do other ones where M1 is changed by different amounts.

Instead of changing either RS or M1, you can change nonborrowed reserves (UBR = BR - BO.) Again, if you change UBR by the same amount that it changed in Experiments 6.1 and 6.2, you will get the same answers. This is done in Experiment 6.3.

Experiment 6.3: Decrease in Nonborrowed Reserves UBR

  • Change UBR the first four quarters of the forecast period by the amounts that it was changed in Experiment 6.1. Solve the model for the first four quarters of the forecast period.
  1. Observe that the results for this experiment are the same as those for Experiments 6.1 and 6.2.
  2. Now that you have done this experiment, you may want to do other ones where UBR is changed by different amounts.

Instead of changing RS, M1, or UBR, you can change the amount of government securities outstanding, AG. (Remember that -AG is actually the amount of government securities outstanding.) Again, if you change AG by the same amount that it changed in Experiments 6.1, 6.2, and 6.3, you will get the same answers. This is done in Experiment 6.4.

Experiment 6.4: Increase in the Amount of Government Securities Outstanding (-AG)

  • Change AG in the first four quarters of the forecast period by the amounts that it was changed in Experiment 6.1. Solve the model for the first four quarters of the forecast period.
  1. Observe that the results for this experiment are the same as those for Experiments 6.1, 6.2, and 6.3.
  2. Now that you have done this experiment, you may want to do other ones where AG is changed by different amounts.

WARNING: Be careful when choosing values for AG . It is easy to pick values of AG for which the model has no solution. Note also that even though AG is the main tool of the Fed, it is not an interesting target variable. The Fed is more interested in intermediate targets like RS and M1 and final targets like real GNP, the unemployment rate, and the rate of inflation than it is in AG itself.

When AG is taken to be exogenous, you can also change the two other tools of monetary policy, RD and G1. As discussed in Section 2.5, these tools are not used very often, and so they are of limited interest. It is instructive, however, to see what happens when RD and G1 are changed, and the next two experiments do this.

Experiment 6.5: Increase in the Discount Rate RD

  • Take AG to be exogenous. Change RD by 1 in each quarter of the forecast period. Solve the model.
  1. What did bank borrowing BO do and why?
  2. Why did RS initially increase? Explain carefully.
  3. Why did RS decrease after a while? Was a small cycle created?
  4. Note that in general the effects are fairly small, which may be one of the reasons that RD is not a major policy tool.

In the next experiment G1 is changed. Say that you wanted to increase G1 so that required reserves increase by about $1 billion. How much should G1 be increased? Requiredy reserves are -G1*MB. MB in 2008:3 was -$344.1 billion, and $1 billion is .25 percent of this. Therefore, G1 should be raised by about .0025, which is what the following experiment does.

Experiment 6.6: Increase in the Required Reserve Ratio G1

  • Take AG to be exogenous. Change G1 by .0025 in each quarter of the forecast period. Solve the model.
  1. Why did RS increase initially?
  2. What did bank borrowing BO do and why? What about total reserves BR?
  3. What happened to RS over time and why?