Transcript Stabilizing Aggregate Demand

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Stabilizing Aggregate Demand:
The Role of the Fed
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Usefulness of
Monetary Policy
Monetary policy
Can be changed quickly
Is more flexible and responsive than fiscal
policy
Therefore, monetary policy is used more
actively than fiscal policy to stabilize the
economy
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Money Supply and
Interest Rates
Changing the money supply
Changes interest rates
Nominal interest rate is the “price” of money
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Forms of Money
Money
Refers to a set of assets
Cash and checking accounts
Is a type of financial asset
Is a way of holding wealth
Cash, government bonds, rare stamps, etc.
Portfolio allocation decision
The decision about the forms in which to hold
one’s wealth
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Demand for Money
Demand for money
The amount of wealth an individual chooses
to hold in the form of money
Businesses must also must decide how much
money to hold
Businesses hold more than half of the total money stock
Cost-benefit criterion tells us that an individual
should increase money holdings if the benefit of
doing so exceeds the cost
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Benefits of Holding Money
Benefits of holding money
Usefulness in making transactions
Factors that affect the demand for
money (note that credit cards have
decreased the demand for money)
Income
Technological and financial innovation
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Costs of Holding Money
Costs of holding money
Opportunity costs
The interest that could have been earned
by holding interest-bearing assets
Bonds and stocks pay a positive nominal
return
Most forms of money pay little or no interest
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Macroeconomic Factors
Affecting Money Demand
Nominal interest rate
Affects the cost of holding money
Real output
Affects the benefits of money
Price level
Affects the benefits of money
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Nominal Interest Rate
A nominal interest rate (i)
Determines the opportunity cost of holding money
The higher the nominal interest rate
The greater the opportunity cost of holding money and
the less money demanded
The nominal interest rate
Some average measure of interest rates
Thousands of different assets each with their own rate of
return, or interest rate
Rates tend to rise and fall together
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Real Income or Output Y
Real income or Output (Y)
An increase in real income raises the
quantity of goods and services that people
and businesses want to buy and sell
Higher transactions require more money
to be held, increasing the demand for
money
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Price Level (P)
The higher the prices of goods and
services, the more dollars that are
needed to make a given set of
transactions
Higher transactions require more
money to be held, thereby increasing
the demand for money
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Money Demand Curve
Money demand curve
Relates the aggregate quantity of money
demanded M to the nominal interest rate i
Because an increase in the nominal
interest rate increases the opportunity cost
of holding money, the money demand
curve slopes downward
Reducing the quantity of money demanded
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 14.1
The Money Demand Curve
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Fig. 14.2
A Shift in the Money Demand
Curve
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Equilibrium in the
Money Market
Federal Reserve System controls the
U.S. money supply
Quantity of money (M) is set by the Fed
Equilibrium
Occurs at the intersection of supply and
demand
Price is the nominal interest rate (i)
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 14.3
Equilibrium in the Market for Money
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Reaching Equilibrium
Recall the inverse relationship between
interest rates and bond prices
If the nominal interest rates were too low
The public’s quantity demanded for money is
greater than the quantity supplied
The public wants to hold more money
So, they sell some of the interest-bearing assets
Which depresses the price of bonds
Which increases interest rates (i)
As interest rates rise the quantity demanded of
money falls and equilibrium results
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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How the Fed Controls the
Nominal Interest Rate
When the Fed changes the money supply
The equilibrium nominal interest rate changes
The Fed’s primary tool
Open-market operations
Buying bonds in order to increase the money supply
Selling bonds in order to decrease the money supply
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Fig. 14.4
The Fed Lowers the
Nominal Interest Rate
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Fig. 14.5
The Fed Stabilizes the Interest
Rate After
an Increase in Money Demand
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Can the Fed Control the
Real Interest Rate?
By controlling the money supply
The Fed controls the nominal interest rate
However, important economic decisions
depend on the real interest rate
Decisions to save and invest
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Controlling the
Real Interest Rate
Most economists believe the Fed can
control the real interest rate
Definition of the real interest rate:
r=i–p
The Fed can control the nominal
interest rate (i) quite precisely
Inflation (p) changes relatively slowly
after policy changes
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Controlling the Real
Interest Rate in the LR
Because inflation changes slowly
Changing nominal interest rates causes
real interest rates to change by the same
amount
However, in the long-run the real
interest rate is determined by
Balance of saving and investment
Several years or more
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 14.6
The Federal Funds Rate, 1970-2000
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Federal Funds Rate
The Fed targets the federal funds rate
Interest rates tend to move together
This causes other interest rates to
change in the same direction
There is not an exact relationship
The Fed’s control of other interest rates is
somewhat less precise than its control of
the federal funds rate
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Monetary Policy on the
Economy
Aggregate demand depends on the real
interest rate
A lower real interest rate encourages
higher spending
As the Fed changes the real interest rate it
changes aggregate demand in the desired
direction, thereby changing aggregate
output and employment
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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AD and the
Real Interest Rate
Higher real interest rate
Increases the reward for saving
Increases in saving S
Decreases consumption spending C
Increases the cost of borrowing
Decreases consumption spending C
Cars cost more
Decreases investment I
Buying new machinery and homes cost more
Lower real interest rates have the opposite
effect
Decreasing financing costs
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fed Fights a Recession
Facing a recessionary gap
Fed reduces real interest rates
Stimulating C and I
Increasing AD
Increasing output and employment
Expansionary monetary policy or monetary
easing
A reduction in interest rates by the Fed, made
with the intention of reducing a recessionary gap
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 14.7
The Fed Fights a Recession
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Fed Fights Inflation
Facing an expansionary gap
Fed increases real interest rates
Reducing C and I
Decreasing AD
Decreasing output and employment
Contractionary monetary policy or monetary
tightening
An increase in interest rates by the Fed, made
with the intention of reducing an expansionary
gap
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 14.8
The Fed Fights Inflation
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Fed’s Policy
Reaction Function
Policy reaction function 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
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Fig. 14.9
An Example of a Fed
Policy Reaction Function
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Art or Science?
Manipulating the models overstates the
precision of monetary policy
The real world is complex and our knowledge of
the economy is imperfect
Fed policymakers only have an approximate
idea of the effect of a given change in the real
interest rate on AD, output, and employment
The Fed proceeds cautiously avoiding large
changes at any one time
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.