FTC1 Chapter 17

The ripple effects that follow a change in the federal funds rate changes what three components of aggregate expenditure?

1. Consumption expenditure, 2. Investment, and 3. Net exports

The Role of Congress

Congress plays no role in making monetary policy decisions, but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress. The Fed makes two reports each year, one in February and another in July. These reports, along with the Fed Chairman's testimony before Congress and the minutes of the FOMC, communicate the Fed's thinking on monetary policy to lawmakers and the public.

what is core inflation and how does it differ from total PCE inflation?

Core inflation excludes the changes in the prices of food and fuel. The total PCE inflation rate includes the changes in all consumer prices. The core inflation rate fluctuates less than the total PCE inflation rate.

Objectives

The Fed has other goals and objectives related to keeping the economy working well. The Fed is tasked with supervising and regulating banking institutions to maintain the stability of the financial system. Financial stability is a situation in which financial markets and institutions function normally to allocate capital resources and risk. Such stability is a prerequisite for attaining the Fed's monetary policy goals.

Review

The Fed sets monetary policy through its Federal Open Market Committee (FOMC), which works to help the economy perform efficiently. The FOMC maintains financial stability, works to attain maximum employment levels, and curtails inflation. The FOMC uses the federal funds rate as its monetary policy instrument. To ensure that the federal funds rate is at an appropriate level, the Fed makes use of open market operations, which involve the purchase or sale of government securities in the open market.

What is the formal role of the President of the United States related to the Board?

is limited to appointing the members and the Chairman of the Board of Governors

A monetary policy rule that makes the quantity of money grow at k percent per year, where k equals the growth rate of potential GDP?

k-percent rule

Which of the following is NOT a monetary policy goal?

keeping a high exchange rate for the dollar

If the Fed buys U.S. government securities,

the federal funds rate will fall.

Which of the following is NOT an alternative rule for monetary policy?

natural unemployment rate targeting rule.

In the long run, demand and supply in the loanable funds market depend only on what real forces?

on saving and investment decisions

If the Fed is concerned about inflation, its actions ________ long-term interest rates so that investment ________ and net exports ________. *

raise; decreases; decrease

If the Fed's policies aim to increase aggregate demand, the Fed must fear

recession

Congress plays no role in making monetary policy decisions, but the Federal Reserve Act requires the Board of Governors to?

report on monetary policy to Congress

When the Fed raises the federal funds rate, the economy slows and when the Fed cuts the federal funds rate, the economy?

speeds up

Targeting rule

A targeting rule is a decision rule for monetary policy that sets the policy instrument at a level that makes the forecast of the ultimate policy goal equal to its target. In contrast to an investment rule, a targeting rule uses subjective reasoning to match the instrument in use to the goal. In recent years the FOMC has followed a targeting rule. In August of 2011, the committee released a statement saying they would keep the federal funds rate between 0% and 0.25% because they believed this would promote the ongoing economic recovery and help ensure that inflation over time was at consistent, mandated levels.

Arrange the items into the correct order. Check your answers when you are finished.

An open market sale causes the federal funds rate and other short-term interest rates to fall. When banks buy government securities in the open market sale, their excess reserves rise. Banks' loans to consumers and businesses increase, along with the quantity of money. The increase in loans to the public increases the supply of loanable funds and lowers the equilibrium real interest rate. Rising aggregate demand raises the equilibrium price level and equilibrium real GDP.

Interest rates

As is common with central banks all over the world, the FOMC chooses to use a short-term interest rate as its monetary policy instrument. In the United States this interest rate is called the federal funds rate. The federal funds rate is the price of loans in interbank market for federal funds, or reserves. This is the market for overnight loans of reserves. In recent times of financial crisis or instability, the Fed has also targeted longer-term interest rates. The FOMC has made policy decisions that seek to lower the interest rates on long-term government bonds, which in turn affect the interest consumers pay on car or home loans.

A monetary policy that is based on an expert assessment of the current economic situation?

Discretionary monetary policy

The U.S. Federal Reserve uses the monetary base as its policy instrument.

FALSE

The interest rate at which banks can borrow and lend reserves in the federal funds market?

Federal funds rate

A situation in which financial markets and institutions function normally to allocate capital resources and risk

Financial stability

Two alternative decision-making strategies might be used by a central bank and they are summarized as what two alternative rules?

Instrument rule and Targeting rule

AGGREGATE DEMANDS FOR CONTRACTIONARY

In response to rising rates, consumption expenditure, investment, and net exports decrease. In total, the rising real interest rate results in a decrease in aggregate demand. A decrease in aggregate demand will lead to a decline in real GDP. Contractionary monetary policy has made its way to the real economy.

The Federal Funds Rate

The Fed's choice of monetary policy instrument is the federal funds rate. Given this choice, the Fed permits the monetary base and the quantity of money to find their own equilibrium values and has no preset targets for them.

Which of the following is a problem in pursuing monetary policy

The lag between a change in the quantity of money and its effect on economic activity may be long.

Price stability delivers moderate long-term interest rates because the nominal interest rate equals the real interest rate plus the inflation rate.

With stable prices, the nominal interest rate is close to the real interest rate and, most of the time, this rate is likely to be moderate.

MONETARY POLICY TRANSMISSION

You've seen that the Fed's goal is to keep the inflation rate around 2 percent a year and to keep the output gap close to zero. You've also seen how the Fed uses its market power to set the federal funds rate at the level that is designed to achieve these objectives

A negative output gap that results in lost output and unemployment above the natural unemployment rate?

a recessionary gap

The Fed's monetary policy objectives has what two distinct parts

a statement of goals and a prescription of the means by which to pursue the goals

The Fed's goals are often described as a "dual mandate" to

achieve stable prices and also maximum employment

By using open market operations, the Federal Reserve

adjusts the supply of reserves to keep the federal funds interest rate equal to its target.

A positive output gap that brings rising inflation?

an inflationary gap

When the output gap is positive, it represents ________ gap, and when it is negative, it represents ________ gap.

an inflationary; a recessionary

The goal of "maximum employment" means?

attaining the maximum sustainable growth rate of potential GDP, keeping real GDP close to potential GDP, and keeping the unemployment rate close to the natural unemployment rate.

The annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator) excluding the prices of food and fuel?

core inflation rate

When the Fed conducts an open market operation and buys government securities, the federal funds rate and the quantity of reserves will fall.

false

The federal funds rate is

he interest rate banks charge each other on overnight loans.

The Fed pays close attention to the business cycle and tries to steer a steady course between inflation and recession. To gauge the state of output and employment relative to full employment, the Fed looks at a large number of indicators that include?

the labor force participation rate, the unemployment rate, measures of capacity utilization, activity in the housing market, the stock market, and regional information gathered by the regional Federal Reserve Banks. All these data are summarized in the Fed's Beige Book.

In the short run, when the Fed raises the federal funds rate,

the real interest rate temporarily increases, thereby decreasing investment and consumption expenditure.

Discretionary monetary policy is monetary policy that is based on the judgment of the monetary policymakers about the current needs of the economy.

true

Under a gold standard, monetary policy has no direct control over the nation's inflation rate.

true

When the Fed sees that the inflation rate is too high, the FOMC will sell government securities in the open market.

true

The inflation rate responds with a longer time lag that averages around?

two years

On the average, after the Fed takes action to change the course of the economy, real GDP begins to change about?

one year later

Although rules beat discretion, there are three alternative rules that the Fed might have chosen. They are?

1. An inflation targeting rule, 2. A money targeting rule, and 3. Nominal GDP targeting rule

The "price" of monetary base is the federal funds rate,

the interest rate at which banks can borrow and lend reserves in the federal funds market. The Fed can target the monetary base or the federal funds rate, but not both. If the Fed wants to decrease the monetary base, the federal funds rate must rise; and if the Fed wants to raise the federal funds rate, the monetary base must decrease.

INTEREST RATES FOR CONTRACTIONARY

First, an open market purchase causes the federal funds rate and other short-term interest rates to rise. Interest rates in the long-term bond market will also rise, but often by less and more slowly. The rise in interest rates increases the demand for U.S. dollars as investors move their money from abroad. The U.S. dollar appreciates as a result and the exchange rate rises.

Interest rates FOR EXPANSIONARY

First, an open market sale causes the federal funds rate and other short-term interest rates to fall. Long-term bond interest rates may also fall, but usually by less. The decline in interest rates increases the demand for U.S. dollars by foreign investors as investors can find better rates elsewhere. The U.S. dollar depreciates as a result. In other words, the exchange rate falls.

What is the long-term corporate bond rate?

It is the interest rate that businesses pay on the loans that finance their purchases of new capital and that influences their investment decisions.

In the long run, these goals are in harmony and reinforce each other. Price stability is the key goal.

It provides the best available environment for households and firms to make the saving and investment decisions that bring economic growth. So price stability encourages the maximum sustainable growth rate of potential GDP.

A variable that the Fed can directly control or closely target and that influences the economy in desirable ways?

Monetary policy instrument

Second Goal of Monetary Policy

Monitoring the core inflation rate Securing stable prices

A monetary policy rule that adjusts the interest rate to achieve a target growth rate for nominal GDP?

Nominal GDP targeting

First goal

The FOMC monitors its success toward the first goal of monetary policy, maximum employment, by tracking the output gap. When the economy experiences a positive output gap the rate of inflation increases. Conversely, a negative output gap results in unemployment. The Fed tries to smooth out the business cycle between these extremes by minimizing the output gap.

Interest Rate Changes

The first effect of a monetary policy decision by the FOMC is a change in the federal funds rate. Other interest rates then change. These interest rate effects occur quickly and relatively predictably.

The Role of the President

The formal role of the President of the United States is limited to appointing the members and the Chairman of the Board of Governors.

Federal Open Market Committee

U monetary policy is made by the Federal Open Market Committee (FOMC), which consists of the Fed's Board of Governors and five Federal Reserve Bank presidents. The FOMC holds eight regularly scheduled meetings, or more if deemed necessary.

Select the item to complete the sentence correctly. Check your answers when you are finished.

-Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve a(n) explicit inflation target and explains how its policy actions will achieve that target. -Economist Milton Friedman is known for the k-percent rule, which states that the quantity of money should grow at a rate of k percent per year, where k equals the growth rate of potential GDP. -Under such a gold standard system, the central bank has no direct control over its inflation rate because the inflation rate is determined by the quantity of gold discovered.

The pursuit of financial stability by the Fed is not an abandonment of the mandated goals of maximum employment and stable prices.

-Rather, it is a prerequisite for attaining those goals. Financial instability has the potential to bring severe recession and deflation—falling prices—and undermine the attainment of the mandated goals. -To pursue its mandated monetary policy goals, the Fed must make the general concepts of maximum employment and stable prices precise and operational.

Means for Achieving the Goals

-The "economy's long-run potential to increase production" is the growth rate of potential GDP. -The "monetary and credit aggregates" are the quantities of money and loans. -By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep the price level stable.

The goal of "stable prices" is interpreted to mean?

-keeping the inflation rate low and predictable -Success in achieving this goal also ensures "moderate long-term interest rates."

CHAPTER SUMMARY Key Points

1 Describe the objectives of U.S. monetary policy, the framework for achieving those objectives, and the Fed's monetary policy actions. • The Federal Reserve Act requires the Fed to use monetary policy to achieve the "dual mandate" of maximum employment and stable prices. • The Fed's goals can come into conflict in the short run. • The Fed translates the goal of stable prices as a core inflation rate of between 1 and 2 percent a year. • The Fed's monetary policy instrument is the federal funds rate. • The Fed sets the federal funds rate at the level that makes its forecast of inflation and other goals equal to their targets. • The Fed hits its federal funds rate target by using open market operations and in times of financial crisis by quantitative easing and credit easing. 2 Explain the transmission channels through which the Fed influences real GDP and the inflation rate. • A change in the federal funds rate changes other interest rates, the exchange rate, the quantity of money and loans, aggregate demand, and eventually real GDP and the inflation rate. • Changes in the federal funds rate change real GDP about one year later and change the inflation rate with an even longer time lag. 3 Explain and compare alternative monetary policy strategies. • The main alternatives to setting the federal funds rate are an inflation targeting rule, a money targeting rule, or a nominal GDP targeting rule. • Rules dominate discretion in monetary policy because they better enable the central bank to manage inflation expectations.

AGGREGATE DEMANDS FOR EXPANSIONARY

Consumer and business behavior is strongly influenced by the real interest rate. Two components of real GDP in particular will change if the real interest rate declines. Consumption expenditure and investment increase as a result of a lower real interest rate. Net exports may also increase as a result of a fall in the exchange rate. Consumption, investment, and net exports are all part of aggregate demand. The change in the real interest rate results in an increase in aggregate demand. Rising aggregate demand raises the equilibrium price level and equilibrium real GDP. Expansionary monetary policy has made its way to the real economy.

PURCHASES AND SALES

If the committee wants to lower the federal funds rate, they undertake an open market purchase of government securities. Therefore, the quantity of reserves increases and the federal funds rate falls. If the committee wants to raise the federal funds rate, they undertake an open market sale of government securities. Thus, the quantity of reserves decreases and the federal funds rate rises. In an open market purchase, the FOMC buys government securities from a bank and pays for the purchase by increasing the bank's reserves. Conversely, with an open market sale the Fed is selling government securities to a bank and receiving payment for the sale by deducting from the bank's reserves.

Three Rule-Based Strategies Proponents of rule-based monetary policy argue that rules are important because with known rules, households and firms can form more accurate inflation expectations. The economy will operate better when there is a more accurate forecast of inflation.

Inflation Targeting Money targeting Gold price targeting

A monetary policy strategy in which the central bank makes a public commitment to achieving an explicit inflation target and to explaining how its policy actions will achieve that target?

Inflation targeting

Inflation Targeting

Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and explains how its policy actions will achieve that target. Under an inflation target, policymakers raise interest rates when inflation appears to be above the target, and lower interest rates when inflation appears to be below the target. The Fed has given guidance about what they think is a reasonable inflation rate, but central banks in other countries, like Canada and New Zealand, have successfully used specific inflation targeting rules to keep their inflation rate low.

Money targeting

Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and explains how its policy actions will achieve that target. Under an inflation target, policymakers raise interest rates when inflation appears to be above the target, and lower interest rates when inflation appears to be below the target. The Fed has given guidance about what they think is a reasonable inflation rate, but central banks in other countries, like Canada and New Zealand, have successfully used specific inflation targeting rules to keep their inflation rate low.

A decision rule for monetary policy that sets the policy instrument by a formula based on the current state of the economy?

Instrument rule

TAYLOR RULE

One of the most famous instrument rules was first proposed by economist John Taylor. According to the so-called Taylor rule, the federal funds rate is increased or decreased according to what is happening to both real GDP and inflation. Specifically, if real GDP rises 1% above potential GDP, the federal funds rate should be raised by 0.5%, relative to the current inflation rate. Five arguments for the Taylor rule are: -Without a rule, policymakers might be tempted to choose a suboptimal inflation policy. -Current and future policy actions should be stated in order to evaluate the effects of policy. -Maintaining a policy rule will build more credibility for future policy actions. -By having a way to predict future policy decisions, uncertainty will be reduced. -Policy rules will help educate the public and policymakers about the operations of the central bank (Taylor, 1998).

The Practice of a Policy Rule To keep the federal funds rate at an appropriate level, the FOMC uses open market operations.

PURCHASES AND SALES IMPACT

Rules or Discretion

Rules Advocates of rules for monetary policy argue that discretionary policy suffers from potential incompetence and abuse of power. Those who oppose rules for monetary policy say finding the appropriate rule is difficult, and discretionary policy is more flexible and needed for quick responses to constantly changing economic circumstances. Discretionary Discretionary monetary policy is based on an expert assessment of the current economic situation. Advocates for such a policy argue that policymakers at central banks have the needed knowledge and foresight to assess the economic situation and institute the appropriate policy. Critics counter that such discretion can result in incompetence and abuse of power. It is possible a central banker without good skills gets the job. Also, some central bankers may have political interests that influence their decisions.

The federal funds rate is the interest rate banks charge each other on overnight loans.

TRUE

A decision rule for monetary policy that sets the policy instrument at a level that makes the central bank's forecast of the ultimate policy goals equal to their targets?

Targeting rule

What is the mandate of the Federal Reserve Act

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

The Role of the Fed

The FOMC makes a monetary policy decision at eight scheduled meetings a year and publishes its minutes three weeks after each meeting.

Second goal

The FOMC monitors its success toward the second goal of monetary policy, stable prices, by watching what is called the core inflation rate. The core inflation rate is the annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator) excluding the prices of food and fuel. The PCE deflator is an alternative measure of inflation to the consumer price index (CPI). When the PCE index was introduced to the public as a core inflation measure, the Fed chairman at the time said that the Fed would seek to keep the PCE deflator low and stable enough so that it would not enter materially into the decisions of households and firms. The Fed would have a guideline for inflation, but no specific target inflation rate.

Summary

The Fed sets monetary policy through the Federal Open Market Committee (FOMC), which is tasked with ensuring the economy operates as efficiently as possible. One of the Fed's jobs is to adopt the appropriate action in the face of either recession or inflation. When the Fed does take specific actions, it can take several months or even longer before those actions translate into visible results. There are debates over whether it makes more sense to follow a rules-based approach to setting policy or a discretionary approach. Rules are more specific but also more constraining.Discretionary decision-making is more flexible but also subject to human error.

Review

The Fed will adopt an expansionary monetary policy during a recession. This involves lowering the federal funds rate through an open market sale of government securities. The transmission of expansionary monetary policy begins with short-term interest rates and ends with a change in aggregate demand. When inflation is the concern, and when real GDP is above potential GDP, the Fed will adopt a contractionary monetary policy. Contractionary policy involves open market operations that raise the federal funds rate. Monetary policy transmission can take over a year to take root.

What makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy?

The Federal Reserve Act

Federal Reserve System

The Federal Reserve System was founded by Congress in 1913 and serves as the central bank for the United States. The bylaws of this organization require its Board of Governors and Federal Open Market Committee to "maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." This mandate requires the Fed to pursue these sometimes conflicting goals simultaneously. The Fed must keep the inflation rate low and the economy growing so that the people can find work.

Review

The debate over whether to follow a rules-based monetary strategy or a discretionary one has plenty of support and opposition on both sides. A rules-based approach would allow for more specific, definitive action. However, choosing the rule or rules that are best for each situation could be constraining . A discretionary approach would allow policymakers to be more flexible in their decisions and actions. But human error could mean the risk of incompetent decisions or even corrupt activity.

What is the Fed's monetary policy instrument and what influences the level at which the Fed sets it?

The federal funds rate is the Fed's monetary policy instrument and the inflation rate and output gap are two of the influences on the level at which the Fed sets the federal funds rate.

Gold price targeting

The gold price targeting rule occurs when a central bank ties its currency to the value of gold. This is often called a gold standard. The Fed, for example, can intervene in the market for gold and keep the dollar price of gold at a specified amount. Under such a gold standard system, the central bank has no direct control over its inflation rate because the inflation rate is determined by the quantity of gold discovered. The lack of flexibility was a key reason the gold standard was dropped by the and other countries in the early 1970s.

What is the most significant interest rate to be influenced by the federal funds rate?

The long-term corporate bond rate

BANK RESERVES FOR CONTRACTIONARY

The next effect is a decrease in bank reserves. When banks sell government securities to the Fed, excess reserves will fall. Banks then cut back on their lending so loans to consumers and businesses decline, and the quantity of money falls. Recall, demand and supply in the market for loanable funds determine the long-run real interest rate. As loans to the public fall, the supply of loanable funds declines and the equilibrium real interest rises.

BANK RESERVES FOR EXPANSIONARY

The next effect is an increase in bank reserves. When banks buy government securities in the open market sale, their excess reserves rise. Banks then have an incentive to loan these excess reserves, so loans to consumers and businesses rise and the quantity of money increases. Demand and supply in the market for loanable funds determine the long-run real interest rate. The increase in loans to the public increases the supply of loanable funds and lowers the equilibrium real interest rate.

What are the objectives of U.S. monetary policy?

The objectives of U.S. monetary policy are to achieve stable prices (interpreted as a core inflation rate of about 2 percent per year) and maximum employment (interpreted as full employment).

Monetary Policy Objectives

The objectives of monetary policy are ultimately political. In the United States, these objectives are set out in the mandate of the Board of Governors of the Federal Reserve System, which is defined by the Federal Reserve Act of 1913 and its subsequent amendments.

-The percentage deviation of real GDP from potential GDP, summarizes the state of aggregate demand relative to potential GDP -A positive output gap—an inflationary gap—brings rising inflation. A negative output gap—a recessionary gap—results in lost output and unemployment above the natural unemployment rate. The Fed tries to minimize the output gap.

The output gap

Money and Bank Loans

The quantity of money and bank loans change when the Fed changes the federal funds rate target. A rise in the federal funds rate decreases the quantity of money and bank loans; and a fall in the federal funds rate increases the quantity of money and bank loans. These changes occur for two reasons: The quantity of deposits and loans created by the banking system changes and the quantity of money demanded changes.

IMPACT

These open market operations impact the real economy by influencing the exchange of money between banks. The Fed's open market operations determine the supply of reserves. If the Fed wants banks to lend more, and spur economic activity, it will lower the federal funds rate through an open market purchase. This lowers the opportunity cost of holding reserves and encourages banks to lend. If the Fed thinks there is too much money in the economy it will raise the federal funds rate through an open market sale and raise the opportunity cost of holding reserves, which in turn encourages banks to reduce their outstanding loans.

Ripple Effects of the Fed's Actions

These ripple effects stretch out over a period of between one and two years. The interest rate and exchange rate effects are immediate. The effects on money and bank loans follow in a few weeks and run for a few months. Real long-term interest rates change quickly and often in anticipation of the short-term rate changes. Spending plans change and real GDP growth changes after about one year. The inflation rate changes between one year and two years after the change in the federal funds rate. But these time lags are not entirely predictable and can be longer or shorter. We're going to look at each stage in the transmission process, starting with the interest rate effects.

Choosing a Policy Instrument

To conduct its monetary policy, the Fed must select a monetary policy instrument, a variable that the Fed can directly control or closely target and that influences the economy in desirable ways. As the sole issuer of the monetary base, the Fed is a monopoly A monopoly can fix the quantity of its product and leave the market to determine the price; or it can fix the price of its product and leave the market to choose the quantity.

Operational "Maximum Employment" Goal

To gauge the state of output and employment relative to full employment, the Fed looks at a large number of indicators that include the labor force participation rate, the unemployment rate, measures of capacity utilization, activity in the housing market, the stock market, and regional information gathered by the regional Federal Reserve Banks. All these data are summarized in the Fed's Beige Book.

Monetary Policy Instruments

To reach its goals the FOMC must choose an instrument, or policy tool. A monetary policy instrument is a variable that the Fed can directly control or closely target. To be effective this instrument must influence the economy in desirable ways. The following provides more information on these tools. Interest rates Instrument rule Taylor rule Targeting rule

First Goal of Monetary Policy

Tracking and minimizing the output gap Seeking maximum employment

Instrument rule

When making a decision about monetary policy, the Fed can use an alternative decision-making strategy called an instrument rule. An instrument rule is a decision rule for monetary policy that sets the policy instrument at a level that is based on the current state of the economy. With an instrument rule, monetary policy is evaluated and conducted with a contingency plan, rather than as a one-time change in policy.

Contractionary Monetary Policy

When monetary policymakers believe inflation is the greater risk and real GDP is above potential GDP, they will undertake contractionary monetary policy. Contractionary policy involves open market operations that raise the federal funds rate. The effect of the monetary policy change is transmitted in the reverse direction of an expansionary policy and real GDP decreases. INTEREST RATES BANK RESERVES AGGREGATE DEMANDS

Quick Overview

When the Fed lowers the federal funds rate, other short-term interest rates and the exchange rate also fall. The quantity of money and the supply of loanable funds increase. The long-term real interest rate falls. The lower real interest rate increases consumption expenditure and investment. The lower exchange rate makes U.S. exports cheaper and imports more costly, so net exports increase. Easier bank loans reinforce the effect of lower interest rates on aggregate expenditure. Aggregate demand increases, which increases real GDP and the price level relative to what they would have been. Real GDP growth and inflation speed up. When the Fed raises the federal funds rate, as the sequence of events that we've just reviewed plays out, the effects are in the opposite directions.

Expansionary Monetary Policy

When the economy has an output gap, or is in a recession, the Fed will adopt an expansionary monetary policy. Recall that an output gap occurs when real GDP is less than potential GDP. The Fed will undertake expansionary monetary policy by lowering the federal funds rate using an open market sale of government securities. The transmission of expansionary monetary policy begins with short-term interest rates and ends with a change in aggregate demand. INTEREST RATES BANK RESERVES AGGREGATE DEMANDS