Transcript PPT

The Federal Reserve
and Monetary Policy
PREPARED BY:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez
chapter
1 What happens to interest rates when the economy recovers from a recession?
Rising Interest Rates During an Economic Recovery
2 Is it better for decisions about monetary policy to be made by a single
individual or by a committee?
The Effectiveness of Committees
3 What are the advantages and disadvantages of the Federal Reserve becoming
more transparent about its actions and decisions and disclosing more
information to the public?
Making the Federal Reserve More Transparent
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14.1
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.
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14.1
THE MONEY MARKET
The Demand for Money
INTEREST RATES AFFECT MONEY DEMAND
 FIGURE 14.1
Demand for Money
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14.1
THE MONEY MARKET
The Demand for Money
THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND
 FIGURE 14.2
Shifting the
Demand for Money
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14.1
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.
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14.2
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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14.2
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.
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14.3
HOW INTEREST RATES ARE DETERMINED:
COMBINING THE DEMAND AND SUPPLY OF MONEY
 FIGURE 14.3
Equilibrium in the
Money Market
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14.3
HOW INTEREST RATES ARE DETERMINED:
COMBINING THE DEMAND AND SUPPLY OF MONEY
 FIGURE 14.4
Federal Reserve and Interest Rates
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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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Extra Application 4
BERNANKE’S STEADY COURSE
Fed chief Ben Bernanke appears to be filling Greenspan’s shoes well. He generated
positive buzz for the recent decision to leave rates unchanged for the second time at the
Fed’s September 20 meeting. Many analysts feared the Fed might react to inflation
pressures by increasing rates again. However, it appears Bernanke may favor a softer
approach. The financial markets responded positively with the Dow Jones Industrial
Average moving up 72 points for the day.
• There are still fears among some economists that the Fed may not react fast enough
to a slowing economy.
• The general consensus is the cuts will begin to come late next year if the economy
continues to show signs of weakness.
The expectation that interest rates will soon fall usually
pushes stock prices higher. Lower interest rates decrease
the cost of doing business for firms and also push the
intrinsic value of stocks higher due to discounting expected
cash flows at a lower rate. Both of these factors cause
investors to reassess stock values and increase demand
for stocks resulting in pushing prices higher.
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Extra Application 5
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.
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14.3
HOW INTEREST RATES ARE DETERMINED:
COMBINING THE DEMAND AND SUPPLY OF MONEY
Interest Rates and Bond Prices
HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES
GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
 FIGURE 14.5
The Money Market and Investment Spending
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
 FIGURE 14.6
Monetary Policy and Interest Rates
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
 FIGURE 14.7
Money Supply and Aggregate Demand
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
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14.4
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.
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14.4
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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MAKING THE FEDERAL RESERVE MORE TRANSPARENT
APPLYING THE CONCEPTS #3: What are the advantages and
disadvantages of the Federal Reserve becoming more transparent about
its actions and decisions and disclosing more information to the public?
In recent years, the Fed has gradually become more open in its deliberations.
But should the Fed go further in describing its intended future policies?
• Some members of the FOMC believe that the financial markets need
more information so that they have a clearer idea of what future Fed
policy and short-term interest rates are likely to be.
• Other members feel that the financial markets understand the implicit
rules that the Fed follows and that issuing a more complex public
statement will just confuse matters.
Now the members of the FOMC participate in drafting statements. The Fed
clearly recognizes that its statements may be just as important as its actions.
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Extra Application 6
FED SUCCEEDS BY DOING NOTHING
Fed watchers believe the nation’s central bank will leave interest rates unchanged for now
but agree on very little else after that. Some believe the next move will be down, others
believe the next interest rate move will be up. The point of contention lies with the economy.
While the economy has slowed considerably, inflation is still higher than central bank
targets.
• The fear is that stagflation, slow growth and high inflation, similar to the late 1970s
may return.
• If the current growth and inflation trends continue, many believe the Fed will increase
rates at the next meeting to curb inflation.
• Others believe that even slower growth will force the Fed to lower interest rates to
stimulate the economy.
To date the Fed seems content to leave rates unchanged and attempt to influence the
markets through commentary, or “jawboning.” Look for the Fed to threaten raising rates
to curb inflation with the hopes that talking tough will keep the economy growing and
prices in check. Changing interest rates is likely a last resort in the current environment.
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14.5
MONETARY POLICY CHALLENGES FOR THE FED
Lags in Monetary Policy
Influencing Market Expectations: From the Federal
Funds Rate to Interest Rates on Long-Term Bonds
Looking Ahead: From the Short Run to The Long Run
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appreciation of a currency
liquidity demand for money
depreciation of a currency
money market
discount rate
open market operations
exchange rate
open market purchases
federal funds market
open market sales
federal funds rate
speculative demand for money
illiquid
transaction demand for money
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