Econ26

Monetary Policy Targets

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.

Contractionary monetary policy

The Federal Reserve's adjusting the money supply to increase interest rates to reduce inflation. In panel (b), the economy begins at point A, with real GDP at $14.2 trillion and the price level at 102. A contractionary monetary policy causes aggregate demand to shift to the left, from AD1 to AD2, decreasing real GDP from $14.2 trillion to $14.0 trillion and the price level from 102 to 100 (point B).With real GDP back at its potential level, the Fed can meet its goal of price stability.

A Contractionary Monetary Policyin 2006

The economy began 2005 in equilibrium at point A, with real GDP equal to potential GDP of $12.6 trillion and a price level of 100.0. From 2005 to 2006, potential GDP increased from $12.6 trillion to $13.0 trillion, as long-run aggregate supply increased from LRAS2005 to LRAS2006. The Fed raised interest rates because it believed the housing boom was causing aggregate demand to increase too rapidly. Without the increase in interest rates, aggregate demand would have shifted from AD2005 to AD2006(without policy), and the new short-run equilibrium would have occurred at point B. Real GDP would have been $13.2 trillion— $200 billion greater than potential GDP—and the price level would have been 104.5. The increase in interest rates resulted in aggregate demand increasing only to AD2006(with policy). Equilibrium occurred at point C, with real GDP equal to potential GDP of $13.0 trillion and the price level rising only to 103.3.

A Expansion Monetary Policy

The economy begins in equilibrium at point A, with real GDP of $14.0 trillion and a price level of 100. Without monetary policy, aggregate demand will shift from AD1 to AD2(without policy), which is not enough to keep the economy at full employment because long-run aggregate supply has shifted from LRAS1 to LRAS2. The economy will be in short-run equilibrium at point B, with real GDP of $14.3 trillion and a price level of 102. By lowering interest rates, the Fed increases investment, consumption, and net exports sufficiently to shift aggregate demand to AD2(with policy). The economy will be in equilibrium at point C, with real GDP of $14.4 trillion, which is its full employment level, and a price level of 103. The price level is higher than it would have been if the Fed had not acted to increase spending in the economy.

Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targetingMonetary policy Taylor rule

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The hypothetical information in the table shows what the values for real GDP and the price level will be in 2013 if the Fed does not use monetary policy.

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The Taylor Rule

A rule developed by John Taylor 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) + ((1/2) x Output gap).

The Changing Mortgage Market

By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors through Fannie Mae and Freddie Mac to banks and, ultimately, to individuals and families borrowing money to buy houses.

The Demand for Money

Changes in real GDP or the price level cause the money demand curve to shift. An increase in real GDP or an increase in the price level will cause the money demand curve to shift from MD1 to MD2. A decrease in real GDP or a decrease in the price level will cause the money demand curve to shift from MD1 to MD3.

Inflation targeting

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

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand :

Consumption Investment Net exports

The Wonderful World of Leverage

During the housing boom, many people purchased houses with down payments of 5 percent or less. In this sense, borrowers were highly leveraged, which means that their investment in their house was made mostly with borrowed money.

The Inflation Rate, January 1952-July 2009

For most of the 1950s and 1960s, the inflation rate in the United States was 4 percent or less. During the 1970s, the inflation rate increased, peaking during 1979-1981, when it averaged more than 10 percent. After 1992 the inflation rate was usually less than 4 percent, until increases in oil prices pushed it above 5 percent during summer 2008. The effects of the recession caused several months of deflation—a falling price level—during early 2009. Note: The inflation rate is measured as the percentage change in the consumer price index (CPI) from the same month in the previous year.

Responses to the Failure of Lehmann Brothers

In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock. Taking partial ownership positions in private commercial banks was an unprecedented action for the federal government. Clearly, the recession of 2007-2009, and the accompanying financial crisis, had led the Fed and the Treasury to implement new approaches to policy. Many of these new approaches were controversial because they involved partial government ownership of financial firms, implicit guarantees to large financial firms that they would not be allowed to go bankrupt, and unprecedented intervention in financial markets.

Can the Fed Eliminate Recessions?

Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do.

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.

The Goals of Monetary Policy The Fed has four main monetary policy goals that are intended to promote a well-functioning economy:

Price stability High employment Stability of financial markets and institutions Economic growth

The Housing Bubble

Sales of new homes in the United States went on a roller-coaster ride, rising by 60 percent between January 2000 and July 2005, before falling by 76 percent between July 2005 and January 2009.

Federal Funds Rate Targeting, January 1998-July 2009

The Fed does not set the federal funds rate, but its ability to increase or decrease bank reserves quickly through open market operations keeps the actual federal funds rate close to the Fed's target rate. The orange line is the Fed's target for the federal funds rate, and the jagged green line represents the actual value for the federal funds rate on a weekly basis.

The Fed Can't Target Both the Money Supply and the Interest Rate

The Fed is forced to choose between using either an interest rate or the money supply as its monetary policy target. In this figure, the Fed can set a target of $900 billion for the money supply or a target of 5 percent for the interest rate, but it can't hit both targets because only combinations of the interest rate and the money supply that represent equilibrium in the money market can be achieved.

Monetary policy

The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals.

Federal funds rate

The interest rate banks charge each other for overnight loans.

The Effect of a Poorly Timed Monetary Policy on the Economy

The upward-sloping straight line represents the long-run growth trend in real GDP. The curved red line represents the path real GDP takes because of the business cycle. If the Fed is too late in implementing a change in monetary policy, real GDP will follow the curved blue line. The Fed's expansionary monetary policy results in too great an increase in aggregate demand during the next expansion, which causes an increase in the inflation rate.

Stability of Financial Markets and Institutions

When financial markets and institutions are not efficient in matching savers and borrowers, resources are lost.

The Impact on Interest Rates When the Fed Decreases the Money Supply

When the Fed decreases the money supply, households and firms will initially hold less money than they want, relative to other financial assets. Households and firms will sell Treasury bills and other financial assets and withdraw money from interest-paying bank accounts. These actions will increase interest rates. Eventually, interest rates will rise to the point at which households and firms will be willing to hold the smaller amount of money that results from the Fed's actions. In the figure, a reduction in money supply from $900 billion to $850 billion causes the money supply curve to shift to the left, from MS1 to MS2, and causes the equilibrium interest rate to rise from 4 percent to 5 percent.

The Impact on the Interest Rate When the Fed Increases the Money Supply

When the Fed increases the money supply, households and firms will initially hold more money than they want, relative to other financial assets. Households and firms use the money they don't want to hold to buy Treasury bills and make deposits in interest-paying bank accounts. This increase in demand allows banks and sellers of Treasury bills and similar securities to offer lower interest rates. Eventually, interest rates will fall enough that households and firms will be willing to hold the additional money the Fed has created. In the figure, an increase in the money supply from $900 billion to $950 billion causes the money supply curve to shift to the right, from MS1 to MS2, and causes the equilibrium interest rate to fall from 4 percent to 3 percent.

A Tale of Two Interest Rates

Why do we need two models of the interest rate? 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.

The Role of Investment Banks

By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury.

Initial Fed and Treasury Actions

First, although the Fed traditionally made loans only to commercial banks, in March 2008 it announced the Primary Dealer Credit Facility, under which primary dealers—firms that participate in regular open market transactions with the Fed—are eligible for discount loans. Second, also in March, the Fed announced the Term Securities Lending Facility, under which the Fed will loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities. Third, once again in March, the Fed and the Treasury helped JPMorgan Chase acquire the investment bank Bear Stearns, which was on the edge of failing. Finally, in early September, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac.

High Employment

The goal of high employment extends beyond the Fed to other branches of the federal government.

Should the Fed Target the Money Supply?

Some economists have argued that rather than use an interest rate as its monetary policy target, the Fed should use the money supply. Many of the economists who make this argument belong to a school of thought known as monetarism. The leader of the monetarist school was Nobel Laureate Milton Friedman. Friedman and his followers favored replacing monetary policy with a monetary growth rule.

Expansionary monetary policy

The Federal Reserve's increasing the money supply and decreasing interest rates to increase real GDP. In panel (a), the economy begins in a recession at point A, with real GDP of $13.8 trillion and a price level of 98. An expansionary monetary policy causes aggregate demand to shift to the right, from AD1 to AD2, increasing real GDP from $13.8 trillion to $14.0 trillion and the price level from 98 to 100 (point B). With real GDP back at its potential level, the Fed can meet its goal of high employment.

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.