Monetary Policy

1. Monetary Policy Learning Objectives By driving down interest rates, the Fed succeeded in heading off what some economists had predicted would be a prolonged and severe recession.

2. What we learned in our last class: Fractional reserve banking system, bank run, bank panic Organization of the Fed. How the Federal Reserve Manages the Money Supply: Monetary policy and monetary policy tools Open market operations Discount policy Reserve requirements The Fed cannot completely control the money supply: the nonbank public and banks.

3. What we learned in our last class: The Quantity Theory of Money A theory of the connection between money and prices that assumes that the velocity of money is constant. M × V = P × Y Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output If the velocity is constant: Inflation rate = Growth rate of the money supply − Growth rate of real output In the long run, inflation results from the money supply growing at a faster rate than real GDP. Hyperinflation and how it comes.

4. Learning Objective 14.1 What Is Monetary Policy? Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives. The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy: 1 Price stability 2 High employment 3 Economic growth 4 Stability of financial markets and institutions

5. Learning Objective 14.1 What Is Monetary Policy? The Goals of Monetary Policy Price Stability FIGURE 14.1 The Inflation Rate, 1952–2006

6. Learning Objective 14.1 What Is Monetary Policy? The Goals of Monetary Policy High Employment The goal of high employment extends beyond the Fed to other branches of the federal government. Economic Growth Policymakers aim to encourage stable economic growth because stable growth allows households and firms to plan accurately and encourages the long-run investment that is needed to sustain growth.

7. Learning Objective 14.1 What Is Monetary Policy? The Goals of Monetary Policy Stability of Financial Markets and Institutions When financial markets and institutions are not efficient in matching savers and borrowers, resources are lost.

8. Learning Objective 14.2 The Money Market and the Fed’s Choice of Monetary Policy Targets Monetary Policy Targets The Fed tries to keep both the unemployment and inflation rates low, but it can’t affect either of these economic variables directly. The Fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level. Two main targets are: the money supply and the interest rate.

9. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets The Demand for Money FIGURE 14.2 The Demand for Money

10. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets Shifts in the Money Demand Curve FIGURE 14.3 Shifts in the Money Demand Curve

11. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets How the Fed Manages the Money Supply: A Quick Review Equilibrium in the Money Market FIGURE 14.4 The Impact on the Interest Rate When the Fed Increases the Money Supply

12. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets Equilibrium in the Money Market FIGURE 14.5 The Impact on the Interest Rate When the Fed Increases the Money Supply

13. Learning Objective 14.4 A Closer Look at the Fed’s Settingof Monetary Policy Targets Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? FIGURE 14.11 The Fed Can’t Target Both the Money Supply and the Interest Rate

14. Learning Objective 14.2 Solved Problem The Relationship between Treasury Bill Prices and Their Interest Rates What is the interest rate of a Treasury bill that pays $1,000 in one year, if its price is $962? What is the interest rate of the Treasury bill if its price is $29?

15. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets A Tale of Two Interest Rates Why do we need two models of the interest rate? The answer is that the loanable funds model is concerned with the long-term real rate of interest, and the money-market model is concerned with the short-term nominal rate of interest. Choosing a Monetary Policy Target There are many different interest rates in the economy. For purposes of monetary policy, the Fed has targeted the interest rate known as the federal funds rate.

16. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets The Importance of the Federal Funds Rate Federal funds rate The interest rate banks charge each other for overnight loans.

17. Learning Objective 14.2 The Money Market and the Fed’s Choiceof Monetary Policy Targets The Importance of the Federal Funds Rate FIGURE 14.6 Federal Funds Rate Targeting, January 1997–May 2007

18. Learning Objective 14.3 Monetary Policy and Economic Activity How Interest Rates Affect Aggregate Demand Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: • Consumption • Investment • Net exports

19. Learning Objective 14.3 MakingtheConnection The Inflation and Deflation of the Housing Market “Bubble”

20. What we learned in last class: Monetary policy Definition Four economic objectives: Price stability, High employment, Economic growth, Statility of financial markets Two targets: interest rate and the money supply. (thinking about three main tools, don't get confused !!) Money supply and money demand model

21. What we learned in last class: Monetary policy The relationship between Treasury bill prices and their interest rates. Two interest rates: Short-run vs. long-run, norminal vs. real, loanable funds market vs. money market The Fed targets the federal funds rate. How Interest Rates Affect Aggregate Demand: Consumption, Investment, Net exports.

22. Learning Objective 14.3 Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look Expansionary monetary policy The Federal Reserve’s increasing the money supply and decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation.

23. Learning Objective 14.3 Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP andthe Price Level: An Initial Look FIGURE 14.7 Monetary Policy

24. Learning Objective 14.3 Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level: A More Complete Account FIGURE 14.8 An Expansionary Monetary Policy

25. Learning Objective 14.3 MakingtheConnection The Fed Responds to the Terrorist Attacks of September 11, 2001 The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

26. Learning Objective 14.3 Monetary Policy and Economic Activity Can the Fed Eliminate Recessions? Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do.

27. Learning Objective 14.3 Monetary Policy and Economic Activity Using Monetary Policy to Fight Inflation FIGURE 14.9 A Contractionary Monetary Policy in 2000

28. Learning Objective 14.3 14-3 Solved Problem The Effects of Monetary Policy The hypothetical information in the table shows what the values for real GDP and the price level will be in 2011 if the Fed does not use monetary policy.

29. Learning Objective 14.3 14-3 Solved Problem The Effects of Monetary Policy (continued)

30. Learning Objective 14.3 Monetary Policy and Economic Activity A Summary of How Monetary Policy Works Table 14-1 Expansionary and Contractionary Monetary Policies

31. Learning Objective 14.3 MakingtheConnection Why Does Wall Street Care about Monetary Policy? The stock market reacts when the Fed either raises or lowers interest rates.

32. Learning Objective 14.3 Monetary Policy and Economic Activity Can the Fed Get the Timing Right? FIGURE 14.10 The Effect of a Poorly Timed Monetary Policy on the Economy Don’t Let This Happen to YOU!Remember That with Monetary Policy, It’s the Interest Rates—Not the Money—That Counts

33. Learning Objective 14.4 A Closer Look at the Fed’s Settingof Monetary Policy Targets Should the Fed Target Inflation? Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

34. Learning Objective 14.3 MakingtheConnection How Does the Fed Measure Inflation? In 2000, the Fed announced that it would rely more on the PCE than on the CPI in tracking inflation. The Fed noted three advantages that the PCE has over the CPI: 1 The PCE is a so-called chain-type price index, as opposed to the market-basket approach used in constructing the CPI. As we saw in Chapter 20, because consumers shift the mix of products they buy each year, the market-basket approach makes the CPI overstate actual inflation. A chain-type price index allows the mix of products to change each year. 2 The PCE includes the prices of more goods and services than the CPI, so it is a broader measure of inflation. 3 Past values of the PCE can be recalculated as better ways of computing price indexes are developed and as new data become available. This allows the Fed to better track historical trends in the inflation rate.

35. Learning Objective 14.3 MakingtheConnection How Does the Fed Measure Inflation?

36. Learning Objective 14.5 Is the Independence of theFederal Reserve a Good Idea? The Case for Fed Independence FIGURE 14.12 The More Independent the Central Bank, the Lower the Inflation Rate

37. Learning Objective 14.5 Is the Independence of theFederal Reserve a Good Idea? The Case against Fed Independence In democracies, elected representatives usually decide important policy matters. In the United States, however, monetary policy is not decided by elected officials. Instead, it is decided by the unelected FOMC. Because those deciding monetary policy do not have to run for election, they are not accountable for their actions to the ultimate authorities in a democracy: the voters.