GS ECO 2301 CH 15 Monetary Policy

Choosing a Monetary Policy Target As we have seen, the Fed uses monetary policy targets to affect economic variables, such as real GDP or the price level, that are closely related to the Fed's policy goals. The Fed can use either the money supply or the interest rate as its monetary policy target.

As Figure 15.5 shows, the Fed is capable of affecting both. The Fed has generally focused on the interest rate rather than on the money supply. In 1980, Congress began allowing banks to pay interest on checking accounts.

Why are there so many estimates? Because GDP is such a comprehensive measure of output in the economy, collecting the necessary data is very time-consuming. To provide the advance estimate, the BEA relies on surveys conducted by the Commerce Department of retail sales and manufacturing shipments, as well as data from trade organizations, estimates of government spending, and so on.

As time passes, these organizations gather additional data, and the BEA is able to refine its estimates. Do these revisions to the GDP estimates matter? Sometimes they do, as the following example indicates. At the beginning of 2008, some economists believed that the U.S. economy might be in a recession. The effects of the continuing decline in housing prices were being felt in the financial system, and the unemployment rate was increasing. Members of the Fed's Open Market Committee remained cautiously optimistic, however, forecasting that real GDP would increase about 1.7 percent during the year. The BEA's advance estimate of the first quarter's GDP seemed to confirm that this forecast of slow growth might be accurate by showing an increase in real GDP of 0.6 percent at an annual rate.

Food and energy prices are much more volatile than are the prices of all the goods and services in the CPI taken together. Food can be volatile because weather-related problems such as too little or too much rain can lead to large fluctuations in supply. Energy prices can fluctuate when political unrest in the Middle East or other energy-producing regions disrupts supply, when the Organization of the Petroleum Exporting Countries (OPEC) oil cartel attempts to increase prices, or as shale oil production in the United States fluctuates.

Because the factors that cause volatility in food and energy prices tend not to persist for more than a few months, they don't have a long-lasting effect on the overall rate of inflation.

Shifts in the Money Demand Curve Similarly, the demand curve for money is drawn holding constant all variables, other than the interest rate, that affect the willingness of households and firms to hold money.

Changes in variables other than the interest rate cause the demand curve to shift. The three most important variables that cause the money demand curve to shift are • changes in real GDP, • the price level, and • technology.

The Fed's New Policy Tools Prior to the financial crisis of 2007-2009, the Fed increased the federal funds rate by selling Treasury securities to reduce bank reserves, thereby forcing up interest rates. Bank reserves prior to the crisis had only been about $6 billion.

During and after the crisis, bank reserves soared, reaching a high of $2.8 trillion and were still well above $2 trillion in late 2017. Because banks were swimming in excess reserves, the Fed's draining some of them through open market sales of Treasury securities would have had no effect on interest rates. Instead, the Fed was forced to rely on a more complicated mechanism. Beginning in 2008, the Fed began paying banks interest on their reserve holdings. The interest rate that the Fed pays on reserves sets a floor for the federal funds rate.

March 2008 Action Although the Fed traditionally made discount loans only to commercial banks, the Fed announced it would temporarily make discount loans to primary dealers—firms that participate in regular open market transactions with the Fed.

Goal: Provide short-term funds to these dealers, some of which are investment banks, so they would not have to raise funds by selling securities, which might further reduce the prices of these securities.

March 2008 Action The Fed and the Treasury helped JPMorgan Chase acquire the investment bank Bear Stearns, which was close to failing.

Goal: Avoid a financial panic that the Fed and the Treasury believed would result from Bear Stearns's failure. Its failure might have caused many investors and financial firms to stop making loans to other investment banks.

September 2008 Action The Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac. Although the federal government sponsored Fannie Mae and Freddie Mac, they were actually private businesses. The firms were placed under the supervision of the Federal Housing Finance Agency.

Goal: Avoid further devastating a weak housing market. The Treasury believed that the bankruptcy of Fannie Mae and Freddie Mac would have caused a collapse in confidence in mortgage-backed securities.

Housing prices and housing rents have generally increased at about the same rate, but between January 2000 and May 2006, housing prices nearly doubled, while rents increased by less than 25 percent. This large divergence between housing prices and rents is evidence of a bubble.

In addition, in some cities, there was an increase in the number of buyers who did not intend to live in the houses they purchased but were using them as investments. Like stock investors during a stock market bubble, these housing investors were expecting to make a profit by selling houses at higher prices than they had paid for them, and they were not concerned about whether the prices of the houses were above the value of the housing services provided.

Surveys show that many people in the United States are skeptical about whether changes in the consumer price index (CPI) are a good measure of inflation. The CPI measures the price level based on a market basket that contains 211 goods and services, including shoes, fresh fruit, refrigerators, textbooks, gasoline, and doctor visits. But many people think of inflation in terms of increases in the prices of the goods they buy most frequently—particularly food and gasoline.

Not only does the Fed not concentrate on changes in the prices of food and gasoline, it actually prefers to exclude food and gasoline prices when measuring inflation. Fed policymakers refer to these adjusted measures of inflation as "core" inflation. Why does the Fed ignore the prices that many people think are the most important? The key reason is that monetary policy affects the economy with a lag of many months. As a result, Fed policymakers don't want to react to every movement—up or down—in prices.

During 2006 and 2007, the air was rapidly escaping from the housing bubble. Panel (a) of Figure 15.12 shows new home sales for each month from January 2000 through June 2017. New home sales rose by 60 percent between January 2000 and July 2005 and then fell by 80 percent between July 2005 and May 2010. Sales then began to gradually increase but were still at low levels well into 2017.

Sales of existing homes followed a similar pattern. Panel (b) shows that prices of new and existing homes also began to decline beginning in 2006. Some homebuyers began having trouble making their loan payments. When lenders foreclosed on some of these loans, the lenders sold the homes, causing housing prices to decline further.

One final note on terminology: An expansionary monetary policy is sometimes called

a loose policy, or an easy policy. A contractionary monetary policy is sometimes called a tight policy.

In 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (the Fed). The main responsibility of the Fed was to

make discount loans to banks to prevent the bank panics we discussed in Chapter 14, Section 14.4. In response to the Great Depression of the 1930s, Congress amended the Federal Reserve Act to give the Federal Reserve's Board of Governors broader responsibility to act "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Monetary policy

refers to the actions the Fed takes to manage the money supply and interest rates to achieve its macroeconomic policy goals.

The price of a house should reflect the value of the housing services it provides. We can use the

rents charged for comparable houses in an area to measure the value of housing services. We would expect, then, that housing prices and rents would increase at roughly the same rate. If prices of single-family homes rise significantly relative to rents for single-family homes, it is likely that the housing market is experiencing a bubble.

Recall that we calculate the real interest rate by

subtracting the inflation rate from the nominal interest rate.

As we saw in Chapter 10, Section 10.3, the typical recession since 1950 has lasted less than one year, which increases the likelihood that

the Fed may accidentally engage in a procyclical policy. Making this mistake is, of course, less likely in a long and severe recession such as the recession of 2007-2009.

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

1. Price stability 2. High employment 3. Stability of financial markets and institutions 4. Economic growth

A Tale of Two Interest Rates In Chapter 10, Section 10.2, we discussed the loanable funds model of the interest rate. In that model, the equilibrium interest rate is determined by the demand and supply for loanable funds. So, we have two models of the interest rate: 1. The loanable funds model is concerned with the long-term real rate of interest, which is the interest rate that is most relevant when savers consider purchasing a long-term financial security such as a corporate bond. It is also the interest rate that is most relevant to firms that are borrowing to finance long-term investment projects such as new factories or office buildings, or to households that are taking out mortgage loans to buy new homes.

2. The money market model is concerned with the short-term nominal rate of interest. When analyzing monetary policy, economists focus on the short-term nominal interest rate because it is the interest rate most affected by Federal Reserve policy. Often—but not always—there is a close connection between movements in the short-term nominal interest rate and movements in the long-term real interest rate. So, when the Fed takes actions to increase the short-term nominal interest rate, usually the long-term real interest rate also increases. In other words, as we will discuss in the next section, when the interest rate on Treasury bills rises, the real interest rate on mortgage loans usually also rises, although sometimes only after a delay.

Shifts in the Money Demand Curve : Changes in GDP Figure 15.3 illustrates shifts in the money demand curve. An increase in real GDP means that the amount of buying and selling of goods and services will increase. This additional buying and selling increases the demand for money as a medium of exchange, so the quantity of money households and firms want to hold increases at each interest rate, shifting the money demand curve to the right.

A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. A higher price level increases the quantity of money required for a given amount of buying and selling.

Shifts in the Money Demand Curve : Changes in Price Level A higher price level increases the quantity of money required for a given amount of buying and selling. Eighty years ago, for example, when the price level was much lower and someone could purchase a new car for $500 and a salary of $30 per week was typical for someone in the middle class, the quantity of money demanded by households and firms was much lower than today, even adjusting for the effect of the lower real GDP and smaller population of those years. An increase in the price level increases the quantity of money demanded at each interest rate, shifting the money demand curve to the right.

A decrease in the price level decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left.

The Fed and other central banks around the world responded to the 2007-2009 recession by pushing overnight lending rates—such as the federal funds rate in the United States—to nearly zero. But these very low interest rates failed to result in rapid economic recovery. To lower the federal funds rate, the Fed buys Treasury bills through open market purchases, which increases bank reserves.

Banks then lend out these reserves to households and firms. As the following graph shows, however, in late 2008, many banks began piling up excess reserves rather than lending out the funds. Total bank reserves had been less than $50 billion in August 2008, but as the financial crisis became more severe, total reserves soared to more than $900 billion by May 2009. The increase was partly due to the Fed's starting in October 2008 to pay an interest rate of 0.25 percent on bank reserves held as deposits at the Fed. Primarily, though, the increase occurred because banks were reluctant to make loans at low interest rates to households and firms whose financial positions had been damaged by the recession. Some economists argued that the Fed was facing a situation known as a liquidity trap, in which short-term interest rates are pushed to zero, leaving the central bank unable to lower them further. Liquidity traps may also have occurred in the United States during the 1930s and in Japan during the 1990s.

Choosing a Monetary Policy Target (continued) At the same time, money market mutual funds were becoming more popular with small savers as a way to earn higher interest rates than banks offered. As a result of these developments, some economists argued that the Fed should focus less on M1 than on M2. They argued that the relationship between M2 and inflation and changes in GDP was more stable than the relationship between M1 and these variables.

But even the relationship between M2 and other key economic variables broke down in the early 1990s. In July 1993, then Fed Chairman Alan Greenspan informed the U.S. Congress that the Fed would cease using M1 or M2 targets to guide the conduct of monetary policy. The Fed has correspondingly increased its reliance on interest rate targets. 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.

The Inflation and Deflation of the Housing Market Bubble To understand the 2007-2009 recession and the financial crisis that accompanied it, we need to start by considering the housing market. The Fed lowered the target for the federal funds rate during the 2001 recession to stimulate demand for housing. The policy was successful, and most builders experienced several years of high demand.

By 2005, however, many economists argued that a "bubble" had formed in the housing market. As we discussed in Chapter 6, Section 6.2, the price of any asset reflects the returns the owner of the asset expects to receive. For example, the price of a share of stock reflects the profitability of the firm issuing the stock because the owner of a share of stock has a claim on the firm's profits.

In June 2017, Fed Chair Janet Yellen and the other members of the Federal Open Market Committee decided to raise the target for the federal funds rate to a range of 1.00 to 1.25 percent By raising the interest rate it pays on bank reserves to 1.25 percent, the Fed could be confident that banks would be unlikely to lend below that rate.

By raising the interest rate it pays on reverse repurchase agreements to 1.00 percent, the Fed could be confident that financial firms such as investment banks would be unlikely to lend elsewhere at a lower rate. Raising these two interest rates enabled the Fed to keep the federal funds rate in a target range of 1.00 percent to 1.25 percent. Although this procedure is more complex than the Fed's traditional means of raising the target for the federal funds rate, it is an effective way for the Fed to achieve that target at a time when banks are holding very high levels of excess reserves.

The Importance of the Federal Funds Rate Recall that every bank must keep 10 percent of its checking account deposits above a certain threshold amount as reserves, either as currency held in the bank or as deposits with the Fed (see Chapter 14, Section 14.3). The Fed pays banks a low interest rate on their reserve deposits, so banks normally have an incentive to invest reserves above the 10 percent minimum rather than leave those funds with the Fed.

During the financial crisis of 2007-2009, bank reserves soared as banks attempted to meet an increase in deposit withdrawals and as they became reluctant to lend to any borrowers except those with flawless credit histories. Banks continued to hold large reserve deposits for several years following the end of the financial crisis. These conditions were very unusual, however. In normal times, banks keep few excess reserves, and when they need additional reserves, they borrow in the federal funds market from banks that have reserves available.

To reassure investors, Congress used two government-sponsored enterprises (GSEs): the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). These two institutions stand between investors and banks that grant mortgages.

Fannie Mae and Freddie Mac sell bonds called mortgage-backed securities to investors and use the funds to purchase mortgages from banks. 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.

Taylor has proposed that the Fed adopt an explicit rule to guide its monetary policy actions. The Fed would not be constrained to mechanically following the exact Taylor rule given earlier, but whatever rule the Fed adopted, it would have to publicly justify deviating from the rule, if a majority of the FOMC came to believe that was necessary.

Fed Chair Janet Yellen and most current and past members of the FOMC are against the proposal because they believe it might limit the Fed's ability to pursue innovative policies in a financial crisis. They also note that the Taylor rule does not account for changes over time in the equilibrium real interest rate, or for changes the FOMC might want to make in the target inflation rate.

1 of 4 Goals of Monetary Policy : Price Stability Rising prices reduce the usefulness of money as a medium of exchange and a store of value. Especially after inflation rose dramatically and unexpectedly during the 1970s, policymakers in most industrial countries have had price stability as a key policy goal.

Figure 15.1 shows that from the early 1950s until 1968, the inflation rate in the United States remained below 4 percent per year. Inflation rose above 10 percent for several years in the late 1970s and early 1980s. Since 1992, the inflation rate has usually been below 4 percent. The 2007-2009 recession caused several months of deflation—a falling price level—during early 2009, and the slow pace of the recovery from the recession resulted in another three months of deflation during early 2015.

Using Monetary Policy to Fight Inflation In addition to using an expansionary monetary policy to reduce the severity of recessions, the Fed can use a contractionary monetary policy to keep aggregate demand from expanding so rapidly that the inflation rate begins to increase.

Figure 15.10 shows the situation during 2005 and 2006, when the Fed faced this possibility. During 2005, real GDP was equal to potential GDP, but Fed Chair Alan Greenspan and other members of the FOMC were concerned that the continuing boom in the housing market might lead aggregate demand to increase so rapidly that the inflation rate would begin to accelerate. The Fed had been gradually increasing the target for the federal funds rate since mid-2004. The figure shows that without the Fed's actions to increase interest rates, aggregate demand would have shifted farther to the right, and equilibrium would have occurred at a level of real GDP that was beyond the potential level. The price level would have risen from 92.0 in 2005 to 96.1 in 2006, meaning that the inflation rate would have been 4.5 percent. Because the Fed kept aggregate demand from increasing as much as it otherwise would have, short-run equilibrium occurred at potential GDP, and the price level in 2006 rose to only 94.8, keeping the inflation rate at 3.0 percent.

With inflation targeting, the Fed can still respond to periods of recession or other economic problems without following an inflexible rule. An inflation target allows monetary policy to focus on inflation and inflation forecasts except during times of severe recession. Arguments supporting the Fed's use of an explicit inflation target focus on the following points.

First, announcing explicit targets for inflation draws the public's attention to what the Fed can actually achieve in practice. Most economists believe that over the long run, monetary policy has a greater effect on inflation than on the growth of real GDP. Second, announcing an inflation target provides an anchor for inflationary expectations. If households, firms, and participants in financial markets believe that the Fed will hit an annual inflation target of 2 percent, then they will expect that if inflation is temporarily lower or higher, it will eventually return to the target rate. Third, inflation targets promote accountability for the Fed by providing a yardstick against which its performance can be measured.

Some economists and policymakers are critical of the Fed's decision to adopt an explicit inflation target. Opponents make several arguments.

First, rigid numerical targets for inflation diminish the flexibility of monetary policy to address other policy goals. Second, because monetary policy affects inflation with a lag, inflation targeting requires that the Fed use forecasts of future inflation, which may turn out to be inaccurate. Third, holding the Fed accountable only for a goal of low inflation may make it more difficult for elected officials to monitor the Fed's support for good economic policy overall. Finally, inflation targets may increase uncertainty over whether the Fed will take prompt action to return the economy to full employment following a recession.

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 Milton Friedman, who was skeptical that the Fed would be able to correctly time changes in monetary policy.

Friedman and his followers favored replacing monetary policy with a monetary growth rule. Ordinarily, we expect monetary policy to respond to changing economic conditions: When the economy is in recession, the Fed reduces interest rates, and when inflation is increasing, the Fed raises interest rates. A monetary growth rule, in contrast, is a plan for increasing the money supply at a constant rate that does not change in response to economic conditions.

Should the Fed Target the Money Supply? (continued) Friedman and his followers proposed a monetary growth rule of increasing the money supply every year at a rate equal to the long-run annual growth rate of real GDP, which has been about 3 percent since 1950 (although in recent years it has grown at the slower rate of about 2 percent per year). If the Fed adopted this monetary growth rule, it would stick to it through changing economic conditions. But what happens under a monetary growth rule if the economy moves into recession? Shouldn't the Fed abandon the rule to drive down interest rates?

Friedman argued that the Fed should stick to the rule even during recessions because he believed that active monetary policy destabilizes the economy by increasing the number of recessions and their severity. By keeping the money supply growing at a constant rate, Friedman argued, the Fed would greatly increase economic stability. During the 1970s, some economists and politicians urged the Federal Reserve to adopt a monetary growth rule. But the fairly close relationship between movements in the money supply and movements in real GDP and the price level that existed before 1980 has become much weaker. Since 1980, the growth rate of M1 has been unstable. In some years, M1 has grown more than 10 percent, while in other years, it has actually fallen. Yet despite these wide fluctuations in the growth of M1, growth in real GDP has been fairly stable, and inflation has remained low during most years. Consequently, support inside and outside the Fed for following a monetary growth rule has declined.

March 2008 Action The Fed announced that it would loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities.

Goal: Make it possible for primary dealers that owned mortgage-backed securities that were difficult or impossible to sell to have access to Treasury securities that they could use as collateral for short-term loans.

How the Fed Manages the Money Supply: A Quick Review Having discussed money demand, we now turn to money supply. In Chapter 14, Section 14.4, we saw how the Federal Reserve manages the money supply. Eight times per year, the Federal Open Market Committee (FOMC) meets in Washington, DC.

If the FOMC decides to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to purchase U.S. Treasury securities. The sellers of these Treasury securities deposit the funds they receive from the Fed in banks, which increases bank reserves. Typically, banks loan out most of these reserves, which creates new checking account deposits and expands the money supply. If the FOMC decides to decrease the money supply, it orders the trading desk to sell Treasury securities, which decreases bank reserves and contracts the money supply.

In the hypothetical situation shown in Figure 15.9, in the first year, equilibrium is at point A, with potential GDP of $17.0 trillion and a price level of 110. In the second year, LRAS increases to $17.4 trillion, but AD increases only to AD2(without policy), which is not enough to keep real GDP at potential GDP. (there's more supply than demand - which means prices will be lowered, (GDP) to get rid of excess inventory, shedding of jobs)

If the Fed does not intervene, the new short-run equilibrium will occur at $17.3 trillion (point B). The $100 billion gap between this level of real GDP and potential GDP at LRAS2 means that some firms are operating at less than their normal capacity. Incomes and profits will fall, firms will begin to lay off workers, and the unemployment rate will rise. (recession)

Can the Fed Eliminate Recessions? Panel (a) of Figure 15.7 shows a completely successful expansionary monetary policy that shifts the AD curve to bring real GDP back to potential GDP. In practice, this ideal is very difficult for the Fed to achieve, as the length and severity of the 2007-2009 recession illustrates. The best the Fed can realistically do is keep recessions shorter and milder than they would otherwise be.

If the Fed is to succeed in offsetting the effects of the business cycle, it needs to quickly recognize the need for a change in monetary policy. If the Fed is late in recognizing that a recession has begun or that the inflation rate is increasing, it may not be able to implement a new policy quickly enough to do much good. There is typically a lag, or delay, between a policy change and its effect on real GDP, employment, inflation, and other economic variables.

3 of 4 Goals of Monetary Policy : Stability of Financial Markets and Institutions (Continued) Just as commercial banks can experience a crisis if depositors begin to withdraw funds, investment banks and other financial firms can experience a crisis if investors stop providing them with short-term loans.

In 2008, the Fed took several steps to ease the liquidity problems of these financial firms because the Fed believed these problems were increasing the severity of the recession. In Section 15.6, we will discuss in more detail the new policies the Fed enacted to help deal with the financial crisis.

We now have an explanation for why the demand curve for money slopes downward: When interest rates on Treasury bills and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high; when interest rates are high, the opportunity cost of holding money will be high, so the quantity of money demanded will be low.

In Figure 15.2, a decrease in the interest rate from 4 percent to 3 percent causes the quantity of money demanded by households and firms to rise from $3.5 trillion to $3.6 trillion.

As Fed Chair Janet Yellen has put it, Fed policymakers "pay attention to core inflation and similar measures because, in light of the volatility of food and energy prices, core inflation has been a better forecaster of overall inflation."

In other words, to reach its goal of price stability, the Fed has to concentrate on the underlying inflation rate and avoid being distracted by temporary increases in food or energy prices—however painful the typical consumer may find those increases to be. If you want to know what the Fed thinks the current inflation rate is, look at data on the core PCE price index. The Bureau of Economic Analysis publishes these data monthly.

The Fed and the Treasury Department Respond Because the problems in financial markets resulting from the bursting of the housing bubble were so severe, the Fed entered into an unusual partnership with the U.S. Treasury Department to develop suitable policies. Fed Chairman Ben Bernanke and U.S. Treasury Secretaries Henry Paulson (in the Bush administration) and Timothy Geithner (in the Obama administration) responded to the crisis by intervening in financial markets in unprecedented ways.

Initial Fed and Treasury Actions The financial crisis significantly worsened following the bankruptcy of the investment bank Lehman Brothers on September 15, 2008. So, it is useful to look at the actions taken by the Fed and the Treasury before and after that date. Table 15.3 shows four key actions the Fed and Treasury took to deal with problems in the financial system before the bankruptcy of Lehman Brothers.

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 cannot tell firms how many people to employ or what prices to charge for their products.

Instead, the Fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables, such as real GDP, employment, and the price level, that are closely related to the Fed's policy goals. The two main monetary policy targets are the money supply and the interest rate. As we will see, the Fed typically uses the interest rate as its policy target.

To spur economic recovery, the Fed, the European Central Bank, the Bank of Japan, and other central banks turned to a policy of quantitative easing (QE), which involves buying securities beyond the short-term government securities that are usually involved in open market operations. The Fed began purchasing 10-year U.S. Treasury notes to push their interest rates lower.

Interest rates on home mortgage loans typically move closely with interest rates on 10-year Treasury notes. The Fed also purchased certain mortgage-backed securities. The Fed's objective was to keep interest rates on mortgages low and to keep funds flowing into the mortgage market to help stimulate demand for housing. The Fed's first round of QE began in November 2008. Because the U.S. economy recovered more slowly than expected, the Fed engaged in two additional rounds of QE before ending the program in October 2014. The use of QE by the Fed and other central banks, combined with very low inflation rates and the slow recovery from the 2007-2009 recession, led to historically low interest rates in most countries. The graph below shows interest rates on 10-year U.S. Treasury notes and on the corresponding German government bonds.

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. Many households finance purchases of consumer durables, such as automobiles and furniture, by borrowing. Lower interest payments on loans increase household spending on consumer durables. Higher interest rates reduce household spending on consumer durables. Lower interest rates also reduce the return to saving, leading households to save less and spend more. Higher interest rates increase the return to saving, leading households to save more and spend less.

Investment. Firms finance most of their spending on machinery, equipment, and factories out of their profits or by borrowing. Firms borrow either in financial markets by issuing corporate bonds or by obtaining loans from banks. Higher interest rates on corporate bonds or on bank loans make it more expensive for firms to borrow, so they will undertake fewer investment projects. Lower interest rates make it less expensive for firms to borrow, so they will undertake more investment projects. Lower interest rates can also have an effect on stock prices, which can increase firms' investment spending. As interest rates decline, stocks become a more attractive investment relative to bonds. The increase in demand for stocks raises their prices. By issuing additional shares of stock, firms can acquire the funds they need to buy new factories and equipment, so investment increases. Spending by households on new homes is also part of investment. When interest rates on mortgage loans rise, the cost of buying new homes rises, and fewer new homes will be purchased. When interest rates on mortgage loans fall, more new homes will be purchased.

1 of 4 Goals of Monetary Policy : Price Stability (continued) The inflation rates during the years 1979-1981 were the highest the United States has ever experienced during peacetime. When Paul Volcker became chairman of the Federal Reserve's Board of Governors in August 1979, he emphasized fighting inflation.

Later Fed chairs continued to focus on inflation, arguing that if inflation is low over the long run, the price system will do a better job of efficiently allocating resources, and the Fed will have the flexibility it needs to increase aggregate demand to fight recessions. Although the severity of the 2007-2009 recession led the Fed to adopt extraordinary policy measures that we will discuss later in this chapter, price stability remains a key policy goal of the Fed.

Finally, 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.

Many of the Treasury's and the Fed's new approaches to policy 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. Although the approaches were new, they were intended to achieve the traditional macroeconomic policy goals of high employment, price stability, and stability of financial markets. What remains to be seen is whether these new approaches represent a permanent increase in federal government involvement in U.S. financial markets or whether policy will eventually return to more traditional approaches.

But between December 2015 and mid-2017, the Fed raised its target for the federal funds rate four times. Businesspeople, policymakers, and economists were focused on predicting how many further rate increases Fed Chair Janet Yellen and her colleagues were planning. Does this focus indicate that the Fed chair is more important to the U.S. economy than the president of the United States?

Most economists would answer "yes." The president can take actions that affect the economy but needs the approval of Congress before enacting most polices. In contrast, the structure of the Fed gives the chair substantial control over monetary policy. As a result, the Fed chair can often have greater influence over the economy than the president.

Nobel Laureate Milton Friedman famously described the lags for monetary policy as "long and variable," which means that it can take months or years for changes in monetary policy to affect real GDP and inflation and that the lags vary based on economic circumstances.

Once the Fed reduces the target federal funds rate, it takes time for the interest rates that affect firm and household behavior to also decline. Then it takes time for firms to identify newly profitable investment projects, obtain loans from banks or arrange to sell bonds, and start spending the borrowed funds. Similarly, it takes time for families to respond to lower mortgage interest rates by buying houses and for homebuilders to begin building the houses. As a result, the full effect of a change in monetary policy is typically spread out over several years.

4 of 4 Goals of Monetary Policy : Economic Growth In Chapters 10 and 11, we discussed the importance of economic growth to raising living standards. Policymakers aim to encourage stable economic growth, which allows households and firms to plan accurately and encourages firms to engage in the investment that is needed to sustain growth.

Policy can spur economic growth by providing incentives for saving to ensure a large pool of investment funds, as well as by providing direct incentives for business investment. Congress and the president, however, may be better able to increase saving and investment than is the Fed. For example, Congress and the president can change the tax laws to increase the return to saving and investing. In fact, some economists question whether the Fed can play a role in promoting economic growth beyond attempting to meet its goals of price stability, high employment, and financial stability.

The Effects of Monetary Policy on Real GDP and the Price Level In Chapter 13, we developed the aggregate demand and aggregate supply model to explain fluctuations in real GDP and the price level. In the basic version of the model, we assume that there is no economic growth, so the long-run aggregate supply curve does not shift. In panel (a) of Figure 15.7, short-run equilibrium is at point A, where the aggregate demand (AD1) curve intersects the short-run aggregate supply (SRAS) curve.

Real GDP is below potential GDP, as shown by the LRAS curve, so the economy is in a recession, with some firms operating below normal capacity and some workers having been laid off. To reach its goal of high employment, the Fed carries out an expansionary monetary policy by increasing the money supply and decreasing interest rates. Lower interest rates cause an increase in consumption, investment, and net exports, which shifts the aggregate demand curve to the right, from AD1 to AD2. Real GDP increases from $16.8 trillion to potential GDP of $17.0 trillion, and the price level rises from 108 to 110 (point B). The policy successfully returns real GDP to its potential level. Rising production leads to increasing employment, allowing the Fed to achieve its goal of high employment.

Remember That with Monetary Policy, It's the Interest Rates—Not the Money—That Counts It is tempting to think of monetary policy as working like this: If the Fed wants more spending in the economy, it increases the money supply, and people spend more because they now have more money. If the Fed wants less spending in the economy, it decreases the money supply, and people spend less because they now have less money. In fact, that is not how monetary policy works.

Remember the important difference between money and income: The Fed increases the money supply by buying Treasury bills. The sellers of the Treasury bills have just exchanged one asset—Treasury bills—for another asset—a check from the Fed; the sellers have not increased their income. Even though the money supply is now larger, no one's income has increased, so no one's spending should be affected. It is only when monetary policy lowers interest rates that spending is affected. When interest rates are lower, households are more likely to buy new homes and automobiles, and businesses are more likely to buy new factories and warehouses. Lower interest rates also lead to a lower value of the dollar, which lowers the prices of exports and raises the prices of imports, thereby increasing net exports. It isn't the increase in the money supply that has brought about this additional spending, it's the lower interest rates.

Many economists believe, however, that sometimes a stock market bubble can form when the prices of stocks rise above levels that can be justified by the profitability of the firms issuing the stocks.

Stock market bubbles end when enough investors decide stocks are overvalued and begin to sell. Why would an investor be willing to pay more for stocks than would be justified by their underlying value? There are two main explanations: 1. The investor may be caught up in the enthusiasm of the moment and, by failing to gather sufficient information, may overestimate the true value of the stocks. 2. The investor may expect to profit from buying stocks at inflated prices if the investor can sell them at even higher prices before the bubble bursts.

Was the housing bubble the result of overly optimistic expectations by homebuyers and builders that new residential construction and housing prices would indefinitely continue to rise at rapid rates? While overly optimistic expectations may have played some role in the housing bubble, many economists believe that changes in the market for mortgages may have played a bigger role.

The Changing Mortgage Market Until the 1970s, the commercial banks and savings and loans that granted mortgages kept the loans until the borrowers paid them off. As we saw in Chapter 14, Section 14.4, a financial asset such as a mortgage is a security only if it can be resold in a secondary market. Many members of Congress believed that home ownership could be increased by creating a secondary market in mortgages. If banks and savings and loans could resell mortgages, individual investors would in effect be able to provide funds for mortgages. The process would work like this: If a bank or savings and loan granted a mortgage and then resold the mortgage to an investor, the bank could use the funds received from the investor to grant another mortgage. In this way, banks and savings and loans could grant more mortgage loans because they would no longer depend only on their deposits for the funds needed to make the loans. One barrier to creating a secondary market in mortgages was that most investors were unwilling to buy mortgages because they were afraid of losing money if the borrower stopped making payments, or defaulted, on the loan.

Chairman Ben Bernanke and other Fed officials were also concerned that they lacked the legal authority to make loans to Lehman Brothers. They believed that the Federal Reserve Act prohibited making loans to a firm that was insolvent, meaning that the value of the firm's assets—such as its holdings of mortgage securities—was less than the value of its liabilities—such as the loans it had received from other financial firms.

The Fed and the Treasury decided to allow Lehman Brothers to go bankrupt, which it did on September 15. The adverse reaction in financial markets was stronger than the Fed and the Treasury had expected, and just two days later, the Fed agreed to provide an $85 billion loan to the American International Group (AIG)—the largest insurance company in the United States—in exchange for the federal government receiving an 80 percent ownership stake, effectively giving the government control of the company. One important result of the failure of Lehman Brothers was the heavy losses suffered by Reserve Primary Fund, a money market mutual fund that had made short-term loans to Lehman Brothers. The problems at Reserve led many investors to withdraw their funds from it and other money market funds. These withdrawals reduced the ability of the money market funds to purchase commercial paper from corporations.

Why Doesn't the Fed Target Both the Money Supply and the Interest Rate? Most economists believe that the interest rate is the best monetary policy target. But as we have just seen, other economists believe the Fed should target the money supply. Why doesn't the Fed satisfy both groups by targeting both the money supply and the interest rate? The simple answer is that the Fed can't target both at the same time. To see why, look at Figure 15.11, which shows the money market.

The Fed is forced to choose between using either the interest rate or the money supply as its monetary policy target. In this figure, the Fed can set a target of $3.5 trillion for the money supply or a target of 5 percent for the interest rate, but the Fed can't hit both targets because it can achieve only combinations of the interest rate and the money supply that represent equilibrium in the money market. Source: Federal Reserve Bank of St. Louis. Remember that the Fed controls the money supply, but it does not control money demand. Money demand is determined by decisions of households and firms as they weigh the trade-off between the convenience of money and its low interest rate compared with other financial assets. Therefore, the Fed has to choose between targeting an interest rate and targeting the money supply. For most of the period since World War II, the Fed has chosen the federal funds rate as its target.

3 of 4 Goals of Monetary Policy : Stability of Financial Markets and Institutions Firms often need to borrow funds as they design, develop, produce, and market their products. Savers look to financial investments to increase the value of their savings as they prepare to buy homes, pay for the educations of their children, and provide for their retirement.

The Fed promotes the stability of financial markets and institutions so that an efficient flow of funds from savers to borrowers will occur. As we saw in Chapter 14, Section 14.4, the financial crisis of 2007-2009 brought the issue of stability in financial markets to the forefront.

The Fed's preferred measure of inflation is the core personal consumption expenditures (PCE) price index, which excludes food and energy prices.

The PCE price index is a measure of the price level that is similar to the GDP deflator, except it includes only the prices of goods from the consumption category of GDP. The PCE price index includes the prices of more goods and services than the CPI, so it is a broader measure of inflation.

The Taylor Rule (example) Consider an example in which the current inflation rate is 1 percent, and real GDP is 1 percent below potential GDP. Federal funds target rate = 1% + 2% + [(1/2) × −1%] + [(1/2) × −1%] =2%.

The Taylor rule accurately predicted changes in the federal funds target during the period of Alan Greenspan's leadership of the Federal Reserve from 1987 to 2006. For the period of the late 1970s and early 1980s, when Paul Volcker was chairman of the Federal Reserve, the Taylor rule predicts a federal funds rate target lower than the actual target the Fed used. In other words, Chairman Volcker kept the federal funds rate at an unusually high level to bring down the very high inflation rates of the late 1970s and early 1980s. In contrast, using data from the chairmanship of Arthur Burns from 1970 to 1978, the Taylor rule predicts a federal funds rate target higher than the actual target. Chairman Burns kept the federal funds rate at an unusually low level during these years, which helps to explain why the inflation rate grew worse.

Responses to the Failure of Lehman Brothers Some economists and policymakers criticized the decision by the Fed and the Treasury to help arrange the sale of Bear Stearns to JPMorgan Chase. Their main concern was with the moral hazard problem, which is the possibility that managers of financial firms such as Bear Stearns might make riskier investments if they believe that the federal government will save them from bankruptcy.

The Treasury and the Fed acted to save Bear Stearns because they believed that the failure of a large financial firm could have wider economic repercussions. As we discussed in Chapter 14, Section 14.4, when a financial firm sells off its holdings of bonds and other assets, it causes their prices to fall, which in turn can undermine the financial position of other firms that also own these assets. In September 2008, when the investment bank Lehman Brothers was near bankruptcy, the Fed and the Treasury had to weigh the moral hazard problem against the possibility that the failure of Lehman Brothers would lead to further declines in asset prices and endanger the financial positions of other firms.

Implementing a policy too late may actually destabilize the economy. To see why, consider Figure 15.8. The straight line represents the long-run growth trend in real GDP in the United States. Historically real GDP has grown about 3 percent per year, although in recent years annual growth in real GDP has been closer to 2 percent.

The actual path of real GDP differs from the underlying trend because of the business cycle, which is shown by the red curved line. As we saw in Chapter 10, Section 10.3, the actual business cycle is more irregular than the stylized cycle shown here. The increase in aggregate demand caused by the Fed's lowering interest rates is likely to push the economy beyond potential GDP and cause a significant acceleration in inflation. Real GDP ends up following the path indicated by the blue curved line. The Fed has inadvertently engaged in a procyclical policy, which increases the severity of the business cycle, as opposed to a countercyclical policy, which is meant to reduce the severity of the business cycle and which is what the Fed intends to use.

When these economists anticipate that aggregate demand is not growing fast enough to allow the economy to remain at full employment, they present their findings to the FOMC, which decides whether circumstances require a change in monetary policy. For example, suppose that the FOMC meets and considers a forecast from the staff indicating that during the following year, a gap of $100 billion will open between equilibrium real GDP and potential GDP. In other words, the macroeconomic equilibrium illustrated by point B in Figure 15.9 will occur. The FOMC may then decide to carry out an expansionary monetary policy to lower interest rates to stimulate aggregate demand.

The figure shows the results of a successful attempt to do this: AD has shifted to the right, and equilibrium occurs at potential GDP (point C). The Fed will have successfully headed off the falling incomes and rising unemployment that otherwise would have occurred. Bear in mind that we are illustrating a perfectly executed monetary policy that keeps the economy at potential GDP, which is difficult to achieve in practice for reasons discussed in the previous section. Notice in Figure 15.9 that the expansionary monetary policy caused the inflation rate to be higher than it would have been. Without the expansionary policy, the price level would have risen from 110 to 112, so the inflation rate for the year would have been 1.8 percent. By shifting the aggregate demand curve, the expansionary policy caused the price level to increase from 112 to 113, raising the inflation rate from 1.8 percent to 2.7 percent.

The Taylor Rule How does the Fed choose a target for the federal funds rate? The discussions at the meetings of the FOMC can be wide-ranging, and they take into account many economic variables. John Taylor of Stanford University has analyzed Fed decision making and developed the Taylor rule to explain federal funds rate targeting. The Taylor rule begins with an estimate of the value of the equilibrium real federal funds rate, which is the federal funds rate—adjusted for inflation—that would be consistent with real GDP being equal to potential GDP in the long run. Taylor believes this rate to be 2 percent. According to the Taylor rule, the Fed should set the target for the federal funds rate so that it is equal to the sum of the inflation rate, the equilibrium real federal funds rate, and two additional terms.

The first of these additional terms is the inflation gap—the difference between current inflation and a target rate; the second is the output gap—the percentage difference between real GDP and potential GDP. The inflation gap and output gap are each given "weights" that reflect their influence on the federal funds target rate. With weights of 1/2 for both gaps, we have the following Taylor rule: Federal funds target rate = Current inflation rate + Equilibrium real federal funds rate+ [(1/2) × Inflation gap] + [(1/2) × Output gap] The Taylor rule includes expressions for the inflation gap and the output gap because the Fed is concerned about both inflation and fluctuations in real GDP.

The Demand for Money The Fed's two monetary policy targets are related. To understand this relationship, we first need to examine the money market, which brings together the demand and supply for money. Figure 15.2 shows the demand curve for money.

The interest rate is on the vertical axis, and the quantity of money is on the horizontal axis. Here we are using the M1 definition of money, which equals currency plus checking account deposits. Notice that the demand curve for money is downward sloping.

The green line in the graph shows inflation calculated using the CPI, including prices for all 211 goods and services in the consumer market basket. The blue line shows inflation calculated using core CPI, which leaves out the prices of food and energy, such as gasoline and natural gas used in heating homes.

The red line shows inflation calculated using the core PCE, which also excludes prices for food and energy. As the graph shows, food and energy prices are much more volatile than are the prices of all the goods and services in the CPI taken together. For instance, during the recession of 2007-2009, the inflation rate measured by the CPI was negative—deflation occurred—during nine months. When changes in food and energy prices are excluded, by contrast, the inflation rate whether measured by core CPI or core PCE is positive in every month. This pattern repeated in early 2015, when falling energy prices caused the CPI to decline for several months.

This increase in demand for interest-paying bank accounts and short-term financial assets allows banks to offer lower interest rates on certificates of deposit, and it allows sellers of Treasury bills and similar assets to also offer lower interest rates. As the interest rates on certificates of deposit, Treasury bills, and other short-term assets fall, the opportunity cost of holding money falls.

The result is a movement down the money demand curve. Eventually the interest rate falls enough that households and firms are willing to hold the additional $100 billion worth of money the Fed has created, and the money market will be back in equilibrium. To summarize: When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money.

A Summary of How Monetary Policy Works Table 15.2 compares the steps involved in expansionary and contractionary monetary policies. We need to note an important qualification to this summary. At every point, we should add the phrase "relative to what would have happened without the policy."

The table isolates the effect of monetary policy, holding constant all other factors affecting the variables involved. In other words, we are invoking the ceteris paribus condition, discussed in Chapter 3, Section 3.1. This point is important because a contractionary monetary policy, for example, does not cause the price level to fall; instead, a contractionary monetary policy causes the price level to rise by less than it would have without the policy.

The Effects of Monetary Policy on Real GDP and the Price Level: A More Complete Account During certain periods, AD does not increase enough during the year to keep real GDP at potential GDP. This slow growth in aggregate demand may be due to households and firms becoming pessimistic about the future state of the economy, leading them to cut back their spending on consumer durables, houses, and factories.

There are other reasons aggregate demand might grow slowly: The federal government could decide to balance the budget by cutting back its purchases and raising taxes, or recessions in other countries might cause a decline in U.S. exports.

Let's briefly review the dynamic model. Recall that over time, the U.S. labor force and the U.S. capital stock will increase. Technological change will also occur. The result will be an increase in potential GDP, which we show by the long-run aggregate supply curve shifting to the right.

These factors will also result in firms supplying more goods and services at any given price level in the short run, which we show by the short-run aggregate supply curve shifting to the right. During most years, the aggregate demand curve will also shift to the right, indicating that aggregate expenditure will be higher at every price level. Aggregate expenditure usually increases for three key reasons: 1. As population grows and incomes rise, consumption will increase over time. 2. As the economy grows, firms expand capacity, and new firms are established, increasing investment spending. 3. An expanding population and an expanding economy require increased government services, such as more police officers and teachers, so government purchases will expand.

The Role of Investment Banks By the 2000s, further changes had taken place in the mortgage market. First, investment banks became significant participants in the secondary market for mortgages. As we have seen, investment banks, such as Morgan Stanley, differ from commercial banks in that they do not take in deposits and rarely lend directly to households. Instead, investment banks concentrate on providing advice to firms issuing stocks and bonds or considering mergers with other firms. Investment banks began buying mortgages, bundling them into mortgage-backed securities, and reselling them to investors.

These mortgage-backed securities proved very popular with investors because they often paid higher interest rates than other securities that investors believed had comparable default risk. Second, by the height of the housing bubble in 2005 and early 2006, lenders had greatly loosened the standards for obtaining a mortgage loan. Traditionally, only borrowers with good credit histories and who were willing to make a down payment equal to at least 20 percent of the value of the house they were buying would be able to receive a mortgage. By 2005, however, lenders were issuing many mortgages to subprime borrowers with flawed credit histories. In addition, "Alt-A" borrowers—who stated but did not document their incomes—and borrowers who made very small down payments found it easier to get loans. Lenders also created new types of adjustable-rate mortgages that allowed borrowers to pay a very low interest rate for the first few years of the mortgage and then pay a higher rate in later years.

Subprime loans are loans granted to borrowers with flawed credit histories. Some mortgage lenders that had concentrated on making subprime loans suffered heavy losses and went out of business, and most banks and other lenders tightened the requirements for borrowers.

This credit crunch made it more difficult for potential homebuyers to obtain mortgages, further depressing the market.

Shifts in the Money Demand Curve : Changes in Technology We saw in Chapter 14, Section 14.1, that countries including India, Sweden, and the United States have moved closer to being cashless economies. Rather than use currency or checks, people are using apps like Apple Pay, Android Pay, and Venmo on their smartphones to purchase goods and services or to send funds to family and friends.

This technological change has decreased the demand for money at each interest rate, shifting the money demand curve to the left.

Figure 15.5 shows what happens when the Fed decreases the money supply. The money market is initially in equilibrium, at an interest rate of 4 percent and a money supply of $3.5 trillion. If the Fed decreases the money supply to $3.4 trillion, households and firms will be holding less money than they would like, relative to other financial assets, at an interest rate of 4 percent.

To increase their money holdings, they will sell Treasury bills and other short-term financial assets and withdraw funds from certificates of deposit and other interest-paying bank accounts. Banks will have to offer higher interest rates to retain depositors, and sellers of Treasury bills and similar securities will have to offer higher interest rates to find buyers. Rising short-term interest rates increase the opportunity cost of holding money, causing a movement up the money demand curve. Equilibrium is restored at an interest rate of 5 percent.

Because it can take a long time for a change in monetary policy to affect real GDP, the Fed tries to set policy according to what it forecasts the state of the economy will be in the future, when the policy change actually affects the economy.

To reduce the severity of business cycles, the Fed must often act before a recession or an acceleration of inflation shows up in the economic data. So, good policy requires good economic forecasts based on models that describe accurately how the economy functions.

2 of 4 Goals of Monetary Policy : High Employment In addition to price stability, high employment (or a low rate of unemployment) is an important monetary policy goal. Unemployed workers and underused factories and office buildings reduce GDP below its potential level.

Unemployment can cause workers who lack jobs to suffer financial distress and lower self-esteem. The goal of high employment extends beyond the Fed to other branches of the federal government. At the end of World War II, Congress passed the Employment Act of 1946, which stated that it was the "responsibility of the Federal Government ... to foster and promote ... conditions under which there will be afforded useful employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power." Because price stability and high employment are explicitly mentioned in the Employment Act, it is sometimes said that the Fed has a dual mandate to attain these two goals.

The Fed relies on macroeconomic data to formulate monetary policy. One key piece of economic data is GDP, which is calculated quarterly by the Bureau of Economic Analysis (BEA).

Unfortunately for Fed policymakers, the GDP data the BEA provides are frequently revised, and the revisions can be large enough that the actual state of the economy can be different from what it at first appeared to be. The BEA's advance estimate of a quarter's GDP is not released until about a month after the quarter has ended. This delay can be a problem for policymakers because it means that they will not receive an estimate of GDP for the period from January through March, for instance, until the end of April. Presenting even more difficulty is the fact that the advance estimate will be subject to a number of revisions. The second estimate of a quarter's GDP is released about two months after the end of the quarter. The third estimate is released about three months after the end of the quarter. Although the BEA used to refer to the third estimate as the "final estimate," in fact, it continues to revise its estimates through the years. The BEA releases its first annual, second annual, and third annual estimates one, two, and three years after the third estimate. And that is not the end: Benchmark revisions occur in later years.

In the money market, the adjustment from one equilibrium to another equilibrium is different from the adjustment in the market for a good. In Figure 15.4, the money market is initially in equilibrium, with an interest rate of 4 percent and a money supply of $3.5 trillion.

When the Fed increases the money supply by $100 billion, households and firms have more money than they want to hold at an interest rate of 4 percent. What do households and firms do with the extra $100 billion? They are most likely to use the money to buy short-term financial assets, such as Treasury bills, or to deposit the money in interest-paying bank accounts, such as certificates of deposit.

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: (continued) Net exports. Recall that net exports is equal to spending by foreign households and firms on goods and services produced in the United States minus spending by U.S. households and firms on goods and services produced in other countries. The value of net exports depends partly on the exchange rate between the U.S. dollar and foreign currencies.

When the value of the dollar rises, households and firms in other countries will pay more for goods and services produced in the United States, but U.S. households and firms will pay less for goods and services produced in other countries. As a result, the United States will export less and import more, so net exports will fall. When the value of the dollar falls, net exports will rise. If interest rates in the United States rise relative to interest rates in other countries, investing in U.S. financial assets will become more desirable, causing foreign investors to increase their demand for dollars, which will increase the value of the dollar. As the value of the dollar increases, net exports will fall. If interest rates in the United States decline relative to interest rates in other countries, the value of the dollar will fall, and net exports will rise.

When the Fed engages in open market operations, it buys and sells Treasury securities electronically with primary dealers, which are commercial banks, investment banks, and securities dealers. Rather than buy or sell securities outright, sometimes the Fed engages in temporary transactions called repurchase agreements.

With a repurchase agreement, the Fed buys a security from a financial firm, which promises to buy it back from the Fed the next day. With a reverse repurchase agreement, the Fed does the opposite: It sells a security to a financial firm, while at the same time promising to buy it back from the firm the next day. In effect, the Fed is borrowing funds overnight from the firm that purchases the security. By raising the interest rate it is willing to pay on these loans, the Fed reduces the willingness of the financial firms it deals with in these transactions to lend at a lower rate. Note that because the primary dealers are not eligible to receive interest on deposits at the Fed, the Fed needs to use changes in the interest rate it pays on reverse repurchase agreements as an additional tool in controlling short-term interest rates.

Equilibrium in the Money Market In Figure 15.4, we include both the money demand and money supply curves. We can use this figure to see how the Fed affects the money supply and the interest rate. For simplicity, we assume that the Federal Reserve is able to completely control the money supply.

With this assumption, the money supply curve is a vertical line, and changes in the interest rate have no effect on the quantity of money supplied. Just as with other markets, equilibrium in the money market occurs where the money demand curve crosses the money supply curve. If the Fed increases the money supply, the money supply curve will shift to the right, and the equilibrium interest rate will fall. In Figure 15.4, when the Fed increases the money supply from $3.5 trillion to $3.6 trillion, the money supply curve shifts to the right, from MS1 to MS2, and the equilibrium interest rate falls from 4 percent to 3 percent.

Inflation Targeting Many economists and central bankers believe that inflation targeting provides a useful framework for carrying out monetary policy. With inflation targeting,

a central bank publicly sets an explicit target for the inflation rate over a period of time, and the government and the public then judge the performance of the central bank on the basis of its success in hitting the target. Beginning in the 1980s, inflation targeting was adopted by a number of central banks around the world, including the Bank of England and, after its founding in the late 1990s, the European Central Bank. After many years of not having an explicit inflation target, the Fed announced in 2012 that it would attempt to maintain an average inflation rate of 2 percent per year.

Ultimately, the ability of the Fed to use monetary policy to affect economic variables such as real GDP depends on its ability to

affect long-term real interest rates, such as the real interest rates on mortgages and corporate bonds. Because the federal funds rate is a short-term nominal interest rate, the Fed sometimes has difficulty affecting long-term real interest rates. Nevertheless, for purposes of the following discussion, we will assume that the Fed is able to use changes in the federal funds rate to affect long-term real interest rates.

The overview of monetary policy we just finished contains a key idea: The Fed can use monetary policy to affect

aggregate demand, thereby changing the price level and the level of real GDP. The discussion of monetary policy illustrated by Figure 15.7 is simplified, however, because it ignores two important facts about the economy: 1. The economy experiences continuing inflation, with the price level rising every year. 2. The economy experiences long-run growth, with the LRAS curve shifting to the right every year.

Why Would a Bank Pay a Negative Interest Rate? One basic fact about the financial system is always true: If you borrow money from a bank, you have to pay the bank interest on the loan. "Always," as it turns out, does not include

at least not in Europe. Some banks there were in the surprising—and unwelcome to them—situation of making interest payments to borrowers rather than receiving interest payments from borrowers. One borrower in Spain boasted, "I'm going to frame my bank statement, which shows that Bankinter is paying me interest on my mortgage.

The Fed uses the federal funds rate as a monetary policy target because it controls this interest rate and

because it believes that changes in the federal funds rate will ultimately affect economic variables that are related to its monetary policy goals.

Unfortunately, economic forecasts and models can be unreliable because

changes in aggregate demand and short-run aggregate supply can be unpredictable. For example, the forecasts of most economists at the end of 2006 and the beginning of 2007 did not anticipate the severity of the recession that began in December 2007. Only after financial market conditions began to deteriorate rapidly did economists significantly reduce their forecasts of GDP growth in 2008 and 2009.

Because only banks can borrow or lend in the federal funds market, the federal funds rate is not directly relevant for households and firms. However,

changes in the federal funds rate usually result in changes in interest rates on both short-term financial assets, such as Treasury bills, and long-term financial assets, such as corporate bonds and mortgages. A change in the federal funds rate has a greater effect on short-term interest rates than on long-term interest rates, and its effect on long-term interest rates may occur only after a lag in time. Although a majority of economists support the Fed's choice of the interest rate as its monetary policy target, some economists believe the Fed should concentrate on the money supply instead.

How Interest Rates Affect Aggregate Demand Changes in interest rates affect aggregate demand, which is the total level of spending in the economy. Recall that aggregate demand has four components:

consumption, investment, government purchases, and net exports.

The Fed's New Policy Tools (continued) To see why, suppose that the Fed is paying banks 1.00% on their reserve balances, but the federal funds rate is only 0.50%. Banks could borrow funds in the federal funds market at 0.50%, deposit the money in their reserve balances at the Fed, and

earn a risk-free 0.50%. Competition among banks to obtain the funds to carry out this risk-free profit would force up the federal funds rate to 1.00%, which is the rate at which banks could no longer earn a profit from this strategy.

That's financial history." Why would a bank pay someone to borrow money? The answer is that the interest rates on these loans were

not fixed but were instead adjusted based on changes in short-term interest rates that depend on the actions of central banks in Europe. When some of these interest rates became negative, banks had to automatically make the interest rates on some of their mortgage loans negative as well. With a negative interest rate, the lender has to pay interest to the borrower.

When interest rates rise on financial assets such as U.S. Treasury bills, the amount of interest that households and firms lose by holding money increases. When interest rates fall,

the amount of interest households and firms lose by holding money decreases. Remember that opportunity cost is what you have to forgo to engage in an activity. The interest rate is the opportunity cost of holding money.

Despite the name, the Fed does not actually set the federal funds rate. Instead, the rate is determined by

the demand for and supply of reserves. Because the Fed can increase and decrease the supply of bank reserves through open market operations, it can set a target for the federal funds rate and can usually come very close to hitting it. The FOMC announces a target for the federal funds rate after each meeting. Figure 15.6 shows how over the years the Fed has pushed the federal funds rate up and down as it tries to achieve its policy goals.

The federal funds rate is

the interest rate banks charge each other on loans in the federal funds market. The loans are usually very short term, often just overnight.

In conducting monetary policy, the Fed often concentrates on the federal funds rate, which is

the interest rate that banks charge each other on short-term loans. In December 2008, the Fed reduced its target for the federal funds rate to almost zero, and it kept it there for nearly seven years.

Changes in interest rates also affect homebuilders and manufacturers that sell durable goods because

their customers frequently borrow money to buy these goods. Changes in interest rates indirectly affect other businesses because those changes in interest rates cause changes in aggregate demand. Not surprisingly, many businesses watch the Fed carefully for signs of whether interest rates are likely to rise or fall.

To understand why the demand curve for money is downward sloping, consider that households and firms have a choice between holding money and holding other financial assets, such as U.S. Treasury bills. In making the choice, households and firms take into account that:

• Money has one particularly desirable characteristic: You can use it to buy goods, services, or financial assets. • Money also has one undesirable characteristic: It earns either a zero interest rate or a very low interest rate. The currency in your wallet earns no interest, and the money in your checking account earns either no interest or very little interest.

The Fed uses its policy tools to achieve its monetary policy goals. Recall that the Fed's policy tools are

• open market operations, • discount policy—making discount loans to banks and changing the discount rate it charges on those loans—and • changes in reserve requirements.