Transcript Economics R. Glenn Hubbard, Anthony Patrick O`Brien, 2e.

Monetary Policy
Learning Objectives
Define monetary policy and
describe the Federal Reserve’s
monetary policy goals.
Describe the Federal Reserve’s
monetary policy targets and
explain how expansionary and
contractionary monetary policies
affect the interest rate.
Use aggregate demand and
aggregate supply graphs to show
the effects of monetary policy on
real GDP and the price level.
By driving down interest rates,
the Fed succeeded in heading
off what some economists had
predicted would be a prolonged
and severe recession.
Assess the arguments for and
against the independence of the
Federal Reserve.
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What we learned in our last class:
Fractional reserve banking system, bank run, bank panic
Organization of the Fed.
Chapter 14: Monetary Policy
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.
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What we learned in our last class:
The Quantity Theory of Money
Chapter 14: Monetary Policy
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.
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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.
Chapter 14: Monetary Policy
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
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Learning Objective 14.1
What Is Monetary Policy?
The Goals of Monetary Policy
Price Stability
FIGURE 14.1
Chapter 14: Monetary Policy
The Inflation Rate, 1952–2006
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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.
Chapter 14: Monetary Policy
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.
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Learning Objective 14.1
What Is Monetary Policy?
The Goals of Monetary Policy
Stability of Financial Markets and Institutions
Chapter 14: Monetary Policy
When financial markets and institutions
are not efficient in matching savers and
borrowers, resources are lost.
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
Monetary Policy Targets
Chapter 14: Monetary Policy
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.
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
The Demand for Money
FIGURE 14.2
Chapter 14: Monetary Policy
The Demand for Money
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
Shifts in the Money Demand Curve
FIGURE 14.3
Chapter 14: Monetary Policy
Shifts in the Money
Demand Curve
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
How the Fed Manages the Money Supply: A Quick Review
Equilibrium in the Money Market
FIGURE 14.4
Chapter 14: Monetary Policy
The Impact on the Interest Rate When
the Fed Increases the Money Supply
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
Equilibrium in the Money Market
FIGURE 14.5
Chapter 14: Monetary Policy
The Impact on the Interest Rate When
the Fed Increases the Money Supply
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Learning Objective 14.4
A Closer Look at the Fed’s Setting
of Monetary Policy Targets
Why Doesn’t the Fed Target Both the Money Supply
and the Interest Rate?
FIGURE 14.11
Chapter 14: Monetary Policy
The Fed Can’t Target
Both the Money Supply
and the Interest Rate
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Learning Objective 14.2
Solved Problem
The Relationship between Treasury Bill Prices and Their Interest Rates
Chapter 14: Monetary Policy
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?
 $1, 000  P 
Interest Rate  
 x 100
P


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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
A Tale of Two Interest Rates
Why do we need two models of the interest rate?
Chapter 14: Monetary Policy
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.
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
The Importance of the Federal Funds Rate
Chapter 14: Monetary Policy
Federal funds rate The interest
rate banks charge each other for
overnight loans.
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Learning Objective 14.2
The Money Market and the Fed’s Choice
of Monetary Policy Targets
The Importance of the Federal Funds Rate
FIGURE 14.6
Chapter 14: Monetary Policy
Federal Funds Rate Targeting,
January 1997–May 2007
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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:
Chapter 14: Monetary Policy
• Consumption
• Investment
• Net exports
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Learning Objective 14.3
Making
the
Chapter 14: Monetary Policy
Connection
The Inflation and Deflation of the
Housing Market “Bubble”
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What we learned in last class:
Monetary policy
Definition
Chapter 14: Monetary Policy
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
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What we learned in last class:
Monetary policy
The relationship between Treasury bill prices and their
interest rates.
Chapter 14: Monetary Policy
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.
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Learning Objective 14.3
Monetary Policy and Economic Activity
The Effects of Monetary Policy on Real GDP and
the Price Level: An Initial Look
Chapter 14: Monetary Policy
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.
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Learning Objective 14.3
Monetary Policy and Economic Activity
The Effects of Monetary Policy on Real GDP and
the Price Level: An Initial Look
FIGURE 14.7
Chapter 14: Monetary Policy
Monetary Policy
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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
Chapter 14: Monetary Policy
An Expansionary
Monetary Policy
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Learning Objective 14.3
Making
the
Chapter 14: Monetary Policy
Connection
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.
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Learning Objective 14.3
Monetary Policy and Economic Activity
Can the Fed Eliminate Recessions?
Chapter 14: Monetary Policy
Keeping recessions shorter and milder than
they would otherwise be is usually the best the
Fed can do.
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Learning Objective 14.3
Monetary Policy and Economic Activity
Using Monetary Policy to Fight Inflation
FIGURE 14.9
Chapter 14: Monetary Policy
A Contractionary
Monetary Policy in 2000
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Learning Objective 14.3
Solved Problem
14-3
The Effects of Monetary Policy
Chapter 14: 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.
YEAR
POTENTIAL REAL GDP
REAL GDP
PRICE LEVEL
2010
$13.3 trillion
$13.3 trillion
140
2011
$13.7 trillion
$13.6 trillion
142
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Learning Objective 14.3
Solved Problem
14-3
Chapter 14: Monetary Policy
The Effects of Monetary Policy (continued)
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Learning Objective 14.3
Monetary Policy and Economic Activity
A Summary of How Monetary Policy Works
Table 14-1
Chapter 14: Monetary Policy
Expansionary and Contractionary
Monetary Policies
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Learning Objective 14.3
Making
the
Chapter 14: Monetary Policy
Connection
Why Does Wall Street Care
about Monetary Policy?
The stock market reacts when
the Fed either raises or lowers
interest rates.
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Learning Objective 14.3
Monetary Policy and Economic Activity
Can the Fed Get the Timing Right?
FIGURE 14.10
Chapter 14: Monetary Policy
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
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Learning Objective 14.4
A Closer Look at the Fed’s Setting
of Monetary Policy Targets
Should the Fed Target Inflation?
Chapter 14: Monetary Policy
Inflation targeting Conducting
monetary policy so as to commit the
central bank to achieving a publicly
announced level of inflation.
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Learning Objective 14.3
Making
the
How Does the Fed Measure Inflation?
Connection
Chapter 14: Monetary Policy
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.
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Learning Objective 14.3
Making
the
How Does the Fed Measure Inflation?
Chapter 14: Monetary Policy
Connection
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Learning Objective 14.5
Is the Independence of the
Federal Reserve a Good Idea?
The Case for Fed Independence
FIGURE 14.12
Chapter 14: Monetary Policy
The More Independent the
Central Bank, the Lower the
Inflation Rate
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Learning Objective 14.5
Is the Independence of the
Federal Reserve a Good Idea?
The Case against Fed Independence
Chapter 14: Monetary Policy
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.
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