Transcript Monetary Policy

Monetary Policy, Toll
Brothers, and
the Housing Market
The Sequel: Housing Bubble
Sub-prime mortgage crisis
Recession of 2008 - 09
By driving down interest rates,
the Fed succeeded in heading
off what some economists had
predicted would be a prolonged
and severe recession.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
1 of 39
What Is Monetary Policy?
Monetary policy How the Federal Reserve
manages the money supply and interest rates
to pursue its economic goals.
The Goals of Monetary Policy
Chapter 14: 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
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
2 of 38
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.
The federal funds rate is the Fed’s most important direct target variable
The federal funds rate affects the money supply.
Money supply growth affects inflation, unemployment, and growth.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
3 of 38
The Money Market and the Fed’s Choice
of Monetary Policy Targets
Chapter 14: Monetary Policy
The Demand for Money
(An increase in the
price of bonds)
Substitute away from bonds toward
money.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
4 of 38
Chapter 14: Monetary Policy
Shifts in the Money Demand Curve
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
5 of 38
Equilibrium in the Money Market
The Impact on the Interest Rate When
the Fed Increases the Money Supply
Chapter 14: Monetary Policy
People try to buy
bonds. Bond prices
fall.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
6 of 38
Federal funds rate The interest rate banks charge each
other for overnight loans of reserves (deposits held at the
Fed).
Chapter 14: Monetary Policy
Federal Funds Rate Targeting,
January 1997–May 2007
When Fed increases
supply of reserves by
buying something, fed
funds rate falls.
When Fed decreases
supply of reserves by
selling something, fed
funds rate rises.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
7 of 38
Monetary Policy and Economic Activity
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
Chapter 14: Monetary Policy
• Net exports
Expansionary monetary policy The Federal Reserve increasing the
money supply and decreasing interest rates to increase real GDP.
Contractionary monetary policy The Federal Reserve adjusting
the money supply to increase interest rates to reduce inflation.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
8 of 38
Making
the
Chapter 14: Monetary Policy
Connection
The Inflation and Deflation of the
Housing Market “Bubble”
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
9 of 38
Monetary Policy and Economic Activity
Chapter 14: Monetary Policy
The Effects of Monetary Policy on Real GDP and
the Price Level: An Initial Look
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
10 of 38
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.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
11 of 38
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
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
12 of 38
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
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
13 of 38
Monetary Policy and Economic Activity
Chapter 14: Monetary Policy
A Summary of How Monetary Policy Works
BEST: Buy Ease Sell Tighten
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
14 of 38
Some Issues Regarding the Conduct of Monetary Policy
1. Should the Fed Target the Money Supply?
Rather than use an interest rate as its monetary policy target, the Fed
should target the money supply.
Economists who make this argument belong to the Monetarist School.
Chapter 14: Monetary Policy
The leader of the monetarist school was Nobel laureate Milton Friedman.
Friedman and his followers favored replacing monetary policy with a
monetary growth rule.
Steady money growth  steady, predictable inflation
Steady money growth  automatic stabilizer.
Problem is, it’s hard to get the money supply where you want it.
The public’s changing split of its money holdings between currency
and demand deposits changes the money multiplier.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
15 of 38
2. Why Doesn’t the Fed Target Both the Money Supply
and the Interest Rate?
Chapter 14: Monetary Policy
The Fed Can’t Target
Both the Money Supply
and the Interest Rate
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
16 of 38
Monetary Policy and Economic Activity
3. Can the Fed Get Timing Right?
Chapter 14: Monetary Policy
The Effect of a Poorly
Timed Monetary Policy
on the Economy
Friedman’s complaint about discretionary monetary policy:
“Too much too late”
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
17 of 38
4. Should the Fed adhere to a simple rule … or exercise discretion?
Taylor rule A rule developed by John Taylor -- a Stanford
professor and advisor to Presidents Bush -- that links the Fed’s
target for the federal funds rate to economic variables.
Federal funds target rate = Current inflation rate
+ Real equilibrium federal funds rate
+ (1/2) x Inflation gap
Chapter 14: Monetary Policy
+ (1/2) x Output gap
According to Taylor rule, if inflation rises by one percentage point, the
Federal Funds rate should rise by 1 ½ percentage points.
The real federal funds rate then rises by ½ %, slowing inflation.
5. 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.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
18 of 38
6. Is the Independence of the
Federal Reserve a Good Idea?
The Case for Fed Independence
Chapter 14: Monetary Policy
The More Independent the
Central Bank, the Lower the
Inflation Rate
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
19 of 38
How Does the Fed Measure Inflation?
Chapter 14: Monetary Policy
Personal Consumption Expenditure Price Index:
A Chained Index
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
20 of 38
Key Terms
Contractionary monetary policy
Expansionary monetary policy
Federal funds rate
Inflation targeting
Monetary policy
Chapter 14: Monetary Policy
Taylor rule
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
21 of 38