Transcript O`Sullivan, Sheffrin, Perez: Economics: Principles, Applications, and

Monetary Policy
PREPARED BY:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
chapter
17.1
THE MONEY MARKET
• money market
The market for money in which the
amount supplied and the amount
demanded meet to determine the
nominal interest rate.
The Demand for Money
INTEREST RATES AFFECT MONEY DEMAND
• transaction demand for money
The demand for money based on
the desire to facilitate transactions.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
17.1
THE MONEY MARKET
The Demand for Money
INTEREST RATES AFFECT MONEY DEMAND
 FIGURE 17.1
Demand for Money
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chapter
17.1
THE MONEY MARKET
The Demand for Money
THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND
 FIGURE 17.2
Shifting the
Demand for Money
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chapter
17.1
THE MONEY MARKET
The Demand for Money
OTHER COMPONENTS OF MONEY DEMAND
• illiquid
Not easily transferable to money.
• liquidity demand for money
The demand for money that represents
the needs and desires individuals and
firms have to make transactions on short
notice without incurring excessive costs.
• speculative demand for money
The demand for money that arises
because holding money over short
periods is less risky than holding
stocks or bonds.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
17.2
HOW THE FEDERAL RESERVE CAN
CHANGE THE MONEY SUPPLY
Open Market Operations
• open market operations
The purchase or sale of U.S.
government securities by the Fed.
• open market purchases
The Fed’s purchase of government
bonds from the private sector.
• open market sales
The Fed’s sale of government
bonds to the private sector.
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chapter
17.2
HOW THE FEDERAL RESERVE CAN
CHANGE THE MONEY SUPPLY
Other Tools of the Fed
CHANGING RESERVE REQUIREMENTS
CHANGING THE DISCOUNT RATE
• discount rate
The interest rate at which banks
can borrow from the Fed.
• federal funds market
The market in which banks borrow
and lend reserves to and from one
another.
• federal funds rate
The interest rate on reserves
that banks lend each other.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
17.3
HOW INTEREST RATES ARE DETERMINED:
COMBINING THE DEMAND AND SUPPLY OF MONEY
 FIGURE 17.3
Equilibrium in the
Money Market
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chapter
17.3
HOW INTEREST RATES ARE DETERMINED:
COMBINING THE DEMAND AND SUPPLY OF MONEY
 FIGURE 17.4
Federal Reserve and Interest Rates
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chapter
RISING INTEREST RATES DURING AN ECONOMIC RECOVERY
APPLYING THE CONCEPTS #1: What happens to interest rates when the economy recovers
from a recession?
Economists have often noticed that interest rates start to rise:
• As an economy recovers from a recession.
• As the economy grows quickly.
Why should a recovery be associated with higher interest rates?
• The extra income being generated by firms and individuals during the recovery will
increase the demand for money.
• Because the demand for money increases while the supply of money remains
fixed, interest rates rise.
• The Federal Reserve itself may want to raise interest rates as the economy grows
rapidly to avoid overheating the economy.
• The Fed cuts back on the supply of money to raise interest rates.
The public should expect rising interest rates during a period of economic recovery and
rapid GDP growth.
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chapter
Extra Application 4
GETTING THE PRICE RIGHT
All the markets have the inflation jitters largely due to Ben Bernanke’s control of the Fed.
Investors have yet to determine Bernanke’s likely reaction to economic news and are
concerned over how the Fed might react to personal income and spending data soon to be
released. If inflation appears imminent, the Fed will likely raise rates.
• The Fed receives economic data ahead of the general public and many Fed watchers
believe that core personal consumption expenditure (PCE) data play a bigger role in
the Fed’s decision-making than the CPI or PPI.
• The PCE data is considered to be more responsive to economic changes and thus a
better measure of inflation.
It is difficult to separate the different inflation measures. The PCE is compiled by the
Commerce Department and uses both CPI and PPI data (compiled by the Labor
Department) to adjust for inflation. The government also monitors import prices and
compiles an Import Price Index that indicated import prices increased by 1.6% in May.
So, what does the Fed look at?
The Fed probably considers all of this information when making interest rate
determinations. However, how much weight each factor carries is indeterminate since we
are on the outside looking in.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
17.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
 FIGURE 17.5
The Money Market and Investment Spending
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chapter
17.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
 FIGURE 17.6
Monetary Policy and Interest Rates
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chapter
17.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
 FIGURE 17.7
Money Supply and Aggregate Demand
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chapter
17.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
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chapter
17.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
Monetary Policy and International Trade
• exchange rate
The rate at which currencies
trade for one another in the
market.
• depreciation of a currency
A decrease in the value of a
currency.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
17.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
Monetary Policy and International Trade
• appreciation of a currency
An increase in the value of a
currency.
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THE EFFECTIVENESS OF COMMITTEES
APPLYING THE CONCEPTS #2: Is it better for decisions about monetary policy to be made by a
single individual or by a committee?
Professor Alan Blinder was convinced that committees were not effective for making
decisions about monetary policy.
Blinder developed an experiment to see whether individuals or groups make better decisions
and who makes them more rapidly. The experiment was designed to explore how quickly
individuals and groups could distinguish changes in underlying trends from random events.
Example:
• If unemployment were to rise in one month, such a rise could be• a temporary aberration.
• the beginning of a recession.
Problems:
• Changing monetary policy would be a mistake if the rise were temporary.
• Waiting too long to change policy would be costly if the change were permanent.
Who is better at making these sorts of determinations?
• Committees make decisions as quickly and are more accurate than individuals making
decisions by themselves.
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chapter
17.5
MONETARY POLICY CHALLENGES FOR THE FED
Lags in Monetary Policy
Expectations of Inflation
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