Chapter 14

Which interest Rate does the Fed try to manipulate?

* The Federal Fund Rate - The interest rate banks charge each other for overnight loans. Other Options - Discount Rate: the interest rate rate the federal reserve changes on discount loans. - The Prime Rate: The interest rate that the largest and best customers pay.

Fed wants to increase Money Supply

- FOMC will call NY fed and have them buy government treasury bonds (open market purchase). In exchange for currency

Goals of Monetary Policy

1. Low inflation (price stability) 2. Low unemployment 3. Stable long run economic growth (of markets and institutions) 4. Financial Market Stability ( economic growth)

Targets of Monetary Policy (Federal Reserve)

1. The nominal money supply (M1) 2. Short term nominal interest rates (M2) The Fed has the pick just ONE

Tools of Monetary Policy (Federal Reserve)

1.Open Market Operations 2. Discount Window (Interest Rates) 3. Required Reserve Ratio

Taylor Rule

A rule developed by John Taylor that links the Fed's target to the federal funds rate to economic variables.

Explain the relationship between the two possible targets: the M1 or M2 and the S-T interest rate.

Assume all assets are into two groups: 1. Money (Currency) 2. Non-monetary assets (Bonds) The interest rate is the opportunity cost of holding money. (the trade of between liquidity of return)

How interest rates affect AD

Changes in interest rates will not affect government purchases but they will affect the other three components of AD in the following way: Consumption: DECREASE Interest = INCREASE C so INCREASE AD Investment: INCREASE Interest = DECAERSE I Net Exports: if USA interest >foreign interest, then NX DECREASE and AD DECREASE

Inflation Targeting

Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

Money Markets

Occurs where the money demand curve crisses the money supply curve

Shift Variables for Money Demand

Shift to the right.. 1. Y - (GDP or Wealth or Income) increase 2. General Price Level Increase

Monetary Policy Targets

The Fed uses variables that 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.

Targets short term nominal interest rate would slow down the economy

The Md curve is downward sloping because of a DECREASE in the interest rate. People hold fewer bonds and more cash so the Md INCREASES.

Expansionary Monetary Policy

The federal reserve's increasing the money supply and decreasing interest rates to increase real GDP. Money Supply (MS)= Interest decrease (if they want to stimulate the economy.) AD SHIFTS TO THE RIGHT

Contractionary Monetary Policy

The federal reserves adjusting the money supply to increase interest rates to reduce inflation. Cause AD to DECREASE LEFT SHIFT slow down economy

Shift Variable for Money Supply

The right.. - When the fed increases money supply the equilibrium interest rates falls. The left... - When the Fed decreases the money supply and the equilibrium interest rates rises.

Which Target does the Fed try to manipulate?

The short term nominal interest rate