Macro Chapter 15

Changes in interest rates affect total spending in the​ economy, or aggregate demand. Interest rates affect only three of the four components of aggregate​ demand, since interest rates have no effect on government purchases.

1. Consumption. When interest rates increase​ (decrease), consumption of consumer durable goods tends to fall​ (rise). Since many consumers finance the purchase of​ big-ticket durable​ goods, such as appliances and​ cars, higher​ (lower) interest rates increase​ (decrease) the cost of borrowing. 2. Investment. When interest rates increase​ (decrease), the cost of borrowing money for new investment increases​ (decreases). Further, since the purchase of new homes is included in this​ category, higher​ (lower) interest rates will decrease​ (increase) the number of mortgages sought by households. 3. Net exports. When the interest rates in the U.S. rise​ (fall) relative to interest rates in other​ countries, investing in U.S. assets becomes more​ (less) desirable. This increases​ (decreases) demand for U.S. dollars and increases​ (decreases) the value of the dollar. As the value of the dollar increases​ (decreases), net exports will fall​ (rise) because U.S. goods and services are now relatively more​ (less) expensive.

This economic condition is often met with an expansionary monetary policy which​ includes:

1. Decrease in the discount rate 2. Decrease in the reserve requirement 3. Open market purchase of government securities.

Contractionary monetary​ policy

1. Increasing the reserve requirement 2. Increasing the discount rate 3. Conducting an open market sale of government securities

The Fed has set four monetary policy goals that are intended to promote a​ well-functioning economy:

1. Price Stability​ (not low​ prices). 2. High Employment​ (Low Unemployment). 3. Economic Growth. 4. Stable Financial Markets.

Economic Growth

As an economy​ grows, living standards tend to increase. In achieving high employment and price​ stability, the Fed promotes economic growth.

Monetary policy

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

As the figure to the right​ indicates, the Fed can affect both the money supply and interest rates.​ However, in recent​ years, the Fed targets interest rates in monetary policy more often than it does the money supply. Which interest rate does the Fed​ target?

the federal funds rate.

According to the Taylor rule​, what is the federal funds target rate under the following​ conditions? ≻Equilibrium real federal funds rate equals 2​% ≻Target rate of inflation equals 2% ≻Current inflation rate equals 1​% ≻Real GDP is 1​% below potential real GDP The federal funds target rate equals

2%

According to the Taylor rule​, what is the federal funds target rate under the following​ conditions? ≻Equilibrium real federal funds rate equals 3​% ≻Target rate of inflation equals 3% ≻Current inflation rate equals 2​% ≻Real GDP is 2​% below potential real GDP The federal funds target rate equals

3.5%

Why did the Fed help JP Morgan Chase buy Bear​ Stearns?

A. Commercial banks would be reluctant to lend to investment banks. C. Failure of Bear Stearns would lead to a larger investment bank failure.

In the figure to the​ right, when the money supply increased from MS1 to MS2​, the equilibrium interest rate fell from​ 4% to​ 3%. Why?

A. ​Initially, firms hold more money than they want relative to other financial assets. B. Increased demand for Treasury securities drives down their interest rate. C. Increased demand for Treasury securities drives up their prices. D. All of the above.

Aggregate Demand and Aggregate Supply Model

An extension of the basic​ AD-AS model that introduces the following​ conditions: 1. The economy experiences continuing​ inflation, with the price level rising every year. 2. The economy experiences​ long-run economic​ growth, with the LRAS curve shifting to the right every year.

Aggregate Demand

The total level of spending the​ economy, comprised of four​ components: consumption,​ investment, government​ purchases, and net exports.

In the figure to the​ right, the opportunity cost of holding money _______ when moving from Point A to Point B on the money demand curve.

decreases

The goals of monetary policy tend to be interrelated. For​ example, when the Fed pursues the goal of​ __________, it also can achieve the goal of​ ________________ simultaneously.

high​ employment; economic growth

What two institutions did Congress create in order to increase the availability of mortgages in a secondary​ market?

"Fannie Mae" and​ "Freddie Mac"

Inflation targeting Arguments in​ favor

1. Real GDP returns to its potential level. 2. Households and firms have accurate expectations of future price level. 3. Institutionalized U.S. monetary policy. 4. Promote accountability on the part of the Fed.

Inflation targeting Arguments against

1. Reduced flexibility of monetary policy. 2. Assumes the Fed can accurately forecast inflation. 3. Accountability for inflation reduces the likelihood that it would achieve other policy goals.

In the dynamic​ AD-AS model we​ assume:

1. The economy experiences inflation​ and, 2. the economy experiences long run growth. That​ is, the LRAS curve shifts to the right each year. In​ addition, the AD and the SRAS curves also shift to the right each year.

Impact of a change in the money supply on the interest rate:

1. When the Fed increases the money​ supply, households and firms will initially hold more money than they​ want, relative to other financial assets. 2. Households and firms often buy Treasury bills with the additional money they do not want to hold. 3. The increase in demand drives up the price of these assets and drives down their interest rates. 4.​ Eventually, interest rates will drop enough that households and firms will be willing to hold the extra money the Fed has created. 5. The reverse is true in the event of a decrease in the money supply. To​ summarize: When the Fed increases the money​ supply, the​ short-term interest rate must fall until it reaches a level at which firms and households are willing to hold the extra money.

According to the Taylor rule​, what is the federal funds target rate under the following​ conditions? ≻Equilibrium real federal funds rate equals 4​% ≻Target rate of inflation equals 4% ≻Current inflation rate equals 3% ≻Real GDP is 1​% below potential real GDP The federal funds target rate equals

6.0%

Taylor Rule

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

Changes in interest rates affect aggregate demand. Which of the following is affected by changes in interest rates​ and, as a​ result, impacts aggregate​ demand?

B. Consumption of durable goods C. Business investment projects D. The value of the dollar

How do investment banks differ from commercial​ banks?

C. Investment banks generally do not lend to households. D. Investment banks do not take deposits.

What is inflation​ targeting?

Committing the central bank to achieve an announced level of inflation.

Inflation targeting

Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. Arguments in​ favor: 1. Real GDP returns to its potential level. 2. Households and firms have accurate expectations of future price level. 3. Institutionalized U.S. monetary policy. 4. Promote accountability on the part of the Fed. Arguments​ against: 1. Reduced flexibility of monetary policy. 2. Assumes the Fed can accurately forecast inflation. 3. Accountability for inflation reduces the likelihood that it would achieve other policy goals.

Procyclical policy

If the Fed is late in recognizing a​ recession, the implementation of an expansionary monetary policy to reduce the severity of the recession could potentially take effect during the next expansion. In this​ case, the increase in aggregate demand that results from the expansionary policy will come too late and cause an increase in the inflation rate in the next phase. ​Furthermore, if the Fed is late in recognizing an​ expansion, then its attempts to control inflation with contractionary monetary policy could potentially take effect at the beginning of the next contractionary phase of the business cycle. The decrease in aggregate demand that results from the contractionary policy comes too late and actually worsens the contracting economy.

Expansionary monetary​ policy:

In reaction to an economy that is producing below its​ capacity, the Fed conducts expansionary monetary policy. Expansionary monetary​ policy: 1. Decreasing the reserve requirement 2. Decreasing the discount rate 3. Conducting an open market purchase of government securities

Contractionary monetary​ policy:

In reaction to an economy that is producing beyond its​ capacity, the Fed conducts contractionary monetary policy. Contractionary monetary​ policy: 1. Increasing the reserve requirement 2. Increasing the discount rate 3. Conducting an open market sale of government securities

In the figure to the​ right, which of the following events is most likely to cause a shift in the money demand​ (MD) curve from MD1 to MD2 ​(Point A to Point ​C)​?

Increase in real GDP or increase in the price level

Fed funds target rate =

Inflation rate + rate equilibrium fed funds rate + (1/2 x inflation gap) + ( 1/2 x output gap) where: Real equilibrium fed funds​ rate: Rate consistent with real GDP being equal to potential GDP in the long run. Inflation​ rate: The current rate of inflation. Inflation​ gap: The difference between the current inflation rate and the targeted inflation rate.​ (Current inflation−target rate of​ inflation) Output​ gap: The percentage difference between real GDP and potential GDP.

Which of the following is NOT a monetary policy goal of the Federal Reserve bank​ (the Fed)?

Low prices

Consider the figure to the right. Can the Fed achieve a​ $900 billion money supply​ (MS) AND a​ 5% interest rate​ (point C)?

No. The Fed cannot target both the money supply and the interest rate simultaneously.

Suppose the economy is in equilibrium in the first period at point A. In the second​ period, the economy reaches point B. What policy would the Fed likely pursue in order to move AD2 to AD Subscript 2 comma policy AD2, policy and reach equilibrium​ (point C) in the second​ period? ​ (What policy will increase the price level and increase actual real​ GDP?)

Open market purchase of government securities

If the Federal Reserve is late to recognize a recession and implements an expansionary policy too​ late, the result could be an increase in inflation during the beginning of the next phase. Even though the goal had been to reduce the severity of the​ recession, the poor timing caused another​ problem: inflation. This is an example of what type of​ policy?

Procyclical policy

Price Stability​ (not low​ prices).

Rising prices erode the value of money as a medium of exchange and as a store of value. Current and former chairmen of the Federal Reserve argue that if inflation is low over the long​ run, the Fed will have the flexibility it needs to lessen the impact of recessions.

The Fed uses monetary policy to offset the effects of a recession​ (high unemployment and falling prices when actual real GDP falls short of potential​ GDP) and the effects of a rapid expansion​ (high prices and​ wages). Can the​ Fed, therefore, eliminate​ recessions?

The Fed can only soften the magnitude of recessions, not eliminate them.

Nobel laureate Milton Friedman and his followers belong to a school of thought known as monetarism. What do the monetarists argue the Fed should​ target?

The Fed should target the money​ supply, not the interest​ rate, and that it should adopt the monetary growth rule.

Opportunity cost

The​ highest-valued alternative that must be given up to engage in an activity.

the federal funds rate.

Though the Fed can affect both the money supply and the interest​ rate, it has generally focused more on interest rates. In​ July, 1993, then Fed Chairman Alan Greenspan informed the U.S. Congress that the Fed would rely less on M1 and M2 money supply targets and more on interest rates.​ Specifically, the Fed targets the federal funds rate.

High Employment​ (Low Unemployment).

Unemployed workers and empty factories reduce real GDP below its potential level.

Stable Financial Markets

When financial markets are inefficient in matching lenders​ (savers) with​ borrowers, resources are lost. The Fed promotes stability in the financial markets so that sufficient funds will flow from savers to borrowers.

When the Federal Open Market Committee​ (FOMC) decides to increase the money​ supply, it ____ U.S. Treasury securities. If the FOMC wishes to decrease the money​ supply, it _____ U.S. Treasury securities.

buys; sells

Potential​ GDP

is given by LRAS06. LRAS does not change as a result of the policy. ​Rather, it shifted due to economic growth which is due​ to: 1. Changes in labor 2. Changes in capital 3. Changes in technology

The federal funds rate

is the rate that banks charge each other for​ short-term loans of excess reserves.

The _____ is considered the most relevant interest rate when conducting monetary policy.

short-term nominal interest rate