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ECON 1 – Section 20

ECON 1 – Section 20. Stabilizing Aggregate Demand: The Role of the Fed. Contact Details. GSI: Ramon Estopina Office Hours: Thursday 1:45-3:45 PM Office: Evans 508-7 Email: estopina@haas.berkeley.edu

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ECON 1 – Section 20

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  1. ECON 1 – Section 20 Stabilizing Aggregate Demand:The Role of the Fed ECON 1 – Section 20 – Page 1

  2. Contact Details • GSI: Ramon Estopina • Office Hours: Thursday 1:45-3:45 PM • Office: Evans 508-7 • Email: estopina@haas.berkeley.edu • Handouts (only sections 104 & 133) after class in: http://www.ocf.berkeley.edu/~jaychen/econ1/ • Please read: Read before downloading!. ECON 1 – Section 20 – Page 2

  3. Section 20 Agenda • Administrative Stuff (10 min) • Recap Quiz (10 min) • Example 26.4 (10 min) • Problem 26.8 (10 min) • Problem 26.9 (10 min) • Re-cap (2 min) ECON 1 – Section 20 – Page 3

  4. Administrative Stuff • PS #4 due today !!! Leave them on the table. • Remember, no class next Monday!! -Midterm. • Review session probably Friday, check Econ-1 website. ECON 1 – Section 20 – Page 4

  5. Review of Last Lecture - 11/6th • Chapter 23 & 26: • Federal Reserve (Fed) • Federal Funds Rate (Federal Open Market Committee) • Discount Rate • Buying/Selling Bonds (Open Market Operations) • Relationship between Price of Bonds and Interest rate • Money D& S (equilibrium, shifts, stabilization by FED) • Keynesian Model • Keynesian cross, AD as function of r • FED fights inflation, FED fights recession • Taylor Rule ECON 1 – Section 20 – Page 5

  6. Recap Quiz - 1 • The interest rate that commercial banks charge each other for very short-term loans is called: • discount rate. • reserve rate. • real interest rate. • federal funds rate. • prime rate. ECON 1 – Section 20 – Page 6

  7. Recap Quiz - 2 • When the real interest rate rises, which of the following is true? • C and Ip spending rise. • C and Ip spending fall. • C rises while Ip spending falls. • C falls while Ip spending rises. • C falls while Ip spending is unchanged. ECON 1 – Section 20 – Page 7

  8. Recap Quiz - 3 • To fight a recession, the Fed should do which of the following? • Raise the real interest rate. • Lower the real interest rate. • Keep the real interest rate constant. • Allow the real interest rate to fluctuate with the market. • Raise the nominal interest rate. ECON 1 – Section 20 – Page 8

  9. Recap Quiz - 4 • The Taylor rule is a(n) • rule the Fed is required to follow regarding monetary policy. • example of a policy reaction function. • rule that helps Congress coordinate fiscal policy with monetary policy. • guideline for individuals in making their portfolio allocation decisions. • "rule of thumb" for solving the basic Keynesian model. ECON 1 – Section 20 – Page 9

  10. Recap Quiz - 5 • An increase in the interest rate by the Fed, made with the intention of reducing an expansionary gap, is called • expansionary monetary policy. • monetary loosening. • contractionary fiscal policy. • expansionary fiscal policy. • contractionary monetary policy. ECON 1 – Section 20 – Page 10

  11. Review Question • You hear a news report that employment growth is lower than expected. • How do you expect that report to affect market interest rates? ECON 1 – Section 20 – Page 11

  12. Review Answer • Slow employment growth is indicative of a possible recessionary output gap. • Typically the Fed responds to a slowing of the economy by lowering the nominal interest rate. • A weaker economy also reduces the demand for money, which reduces the nominal interest rate. ECON 1 – Section 20 – Page 12

  13. Another Review Question • The Fed faces a recessionary gap. How would you expect it to respond? • How its policy change is likely to affect the economy? ECON 1 – Section 20 – Page 13

  14. Another Review Answer • The Fed is likely to respond to a recessionary gap with an expansionary monetary policy intended to stimulate aggregate demand. • The first step is an open-market purchase of government bonds, which puts additional money into circulation and lowers the nominal interest rate. • The lower interest rate stimulates aggregate demand (consumption and investment spending). • An increase in aggregate demand in turn raises short-run equilibrium output, as firms produce enough to meet the extra demand. ECON 1 – Section 20 – Page 14

  15. Important to remember: • Equations of the day: • The real interest affects consumption ad planned investment. • Where a, b >0 and measure the strength of the interest rate effect. ECON 1 – Section 20 – Page 15

  16. Important to remember (2) • Combined with the equations we know: • Composed of: • Autonomous AD, effect of r & Induced AD ECON 1 – Section 20 – Page 16

  17. Important to remember (3) • In equilibrium Y = AD, so: • Vary scary, isn’t it? ECON 1 – Section 20 – Page 17

  18. Example 26.4 (F&B page 707) • In a certain economy, we have: • Where r is set by the Fed = 5% • Solve for the short-run equilibrium. ECON 1 – Section 20 – Page 18

  19. Example 26.4 (Conclusion) • We know the definition of Aggregate Demand is: AD = C + Ip + G + NX • Substituting the components: AD = [640 + 0.8(Y-250)-400(0.05)] + [250-600(0.05)] +300+20 • And finally: AD = 960 + 0.8Y • In addition, from the short term equilibrium: Y=AD • So the previous equation will be: Y = 960 + 0.8Y • Solving for Y: Y = 960 / 0.2 = 4,800 ECON 1 – Section 20 – Page 19

  20. Problem 26.8 (F&B page 719) • For the following economy, find at what rate should the Fed set the real interest rate to eliminate any output gap. ECON 1 – Section 20 – Page 20

  21. Problem 26.8 (cont’d) • A) The relationship between aggregate demand and output is given by: • Autonomous aggregate demand equals 23,600 the part of aggregate demand that does not depend on output nor on r. ECON 1 – Section 20 – Page 21

  22. Problem 26.8 (cont’d) • To find short-run equilibrium output, use the equation Y=AD and solve for Y: • Potential output Y*=40,000. To find the real interest rate consistent with no output gap, we set Y=40,000 in the equation for short-run equilibrium output and solve for r. ECON 1 – Section 20 – Page 22

  23. Problem 26.8 (cont’d) • So we have: • So the real interest rate that eliminates any output gap is 6%. ECON 1 – Section 20 – Page 23

  24. Problem 26.8 (cont’d) • With Y*=Y as found before, now G increases to 7,600. • What happens to the SR equilibrium if the Fed leaves r unchanged? • What should the Fed do to keep the economy at full employment? ECON 1 – Section 20 – Page 24

  25. Problem 26.8 (cont’d) • Let’s solve for the new value of short-run equilibrium output. • Recall for this economy: • Now there is an increase in government purchases from 7000 to 7600 so autonomous AD raises by 600, from 23,600 to 24,200. ECON 1 – Section 20 – Page 25

  26. Problem 26.8 (cont’d) • And r = 6%, consequently: • Solving for output: ECON 1 – Section 20 – Page 26

  27. Problem 26.8 (cont’d) • So if the Fed keeps the interest rate at 6%, the increase in government purchases raises output above potential (an expansionary gap, remember Y*=40,000). • To keep the economy at full employment (and reduce inflation), the Fed has to offset the increase in government purchases with a higher real interest rate. ECON 1 – Section 20 – Page 27

  28. Problem 26.8 (cont’d) • Remember the process for contractionary monetary policy: • Fed Increases interest rates by reducing money supply (selling bonds)… • This will reduce C and I… • Then AD Decreases… • …and Decrease GDP and employment. ECON 1 – Section 20 – Page 28

  29. Problem 26.8 (cont’d) • To see how much the real interest rate must rise, note that after the increase in government purchases aggregate demand is given by: • Solving for output: ECON 1 – Section 20 – Page 29

  30. Problem 26.8 (cont’d) • We want to know the value of r that sets Y at its full-employment level of 40,000. To find that rate, we set Y=40,000 in the previous equation and solve for r: ECON 1 – Section 20 – Page 30

  31. Problem 26.8 (cont’d) • So to keep the economy at full employment when government purchases increase, the Fed should raise the real interest rate from 6% to 7%. • The increase in r is consistent with the effects of an increased government deficit in the market for saving and investment (Chapter 22). ECON 1 – Section 20 – Page 31

  32. Problem 26.8 (Conclusion) • In other words, Expenditure line (r=6%) Expenditure line (r=7%) 41,200 40,000 ECON 1 – Section 20 – Page 32

  33. Problem 26.9 (F&B page 720) • Supposing the Fed follows the Taylor rule, find the real int. rate (r) and the nominal int. rate (i) that the Fed will set in each of the following situations: • A) Inflation or 4% and a expansionary gap equal to 1% of potential output. ECON 1 – Section 20 – Page 33

  34. Problem 26.9 (cont’d) • Remember Taylor rule: • Fed sets r, so it decreases as relative income gap grows, and increases as inflation increases. • Fed’s goals: • Y = Y* • Low (inflation rate) ECON 1 – Section 20 – Page 34

  35. Problem 26.9 (cont’d) • Taylor rule is an example of a Policy reaction function. • It describes how the action a policymaker takes depends on the state of the economy • Ideally policymakers should try to react in such a way as to optimize economic performance ECON 1 – Section 20 – Page 35

  36. Problem 26.9 (cont’d) • A) Inflation of 4% and a expansionary gap equal to 1% of potential output. ECON 1 – Section 20 – Page 36

  37. Problem 26.9 (cont’d) • B) Inflation of 2% and a recessionary gap equal to 2% of potential output. ECON 1 – Section 20 – Page 37

  38. Problem 26.9 (cont’d) • C) Inflation of 6% and no output gap. ECON 1 – Section 20 – Page 38

  39. Problem 26.9 (Conclusion) • D) Inflation of 2% and a recessionary gap equal to 5% of potential output. • Can the Fed set a negative real interest rate? • It’s possible for the Fed to set a negative r, by setting the nominal rate below . ECON 1 – Section 20 – Page 39

  40. Problems for next sections !!! • For next section: • Chapter 27: Problems 2, 4, 6 & 8. • Remember: This is not mandatory. • It won’t be graded. Only for those of you that need improvement in Exam grades. ECON 1 – Section 20 – Page 40

  41. Next class • Next Class: • Section 21 – Wednesday, Nov 20th • No class next Monday. Midterm Exam. • Due PS#4 !!!! • If you want more practice, work on Next Sections Problems (although you probably have enough). • Read ch. 27. • You can download handouts this afternoon. • Thank you for coming on time !!! • Enjoy the long weekend & C-U Wednesday !!. ECON 1 – Section 20 – Page 41

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