Macroeconomics Chapter 15: Monetary Policy (Final)

Inflation targeting

An approach to monetary policy that requires that the central bank try to keep the inflation rate near a predetermined target rate

Certificate of Deposit (CD)

A bank-issued asset in which customers deposit funds for a specified amount of time and earn a specified interest rate

Money supply curve

A graphical representation of the relationship between quantity of money supplied by the Federal Reserve and the interest rate

Money demand curve

A graphical representation of the relationship between the interest rate and the quantity of money demanded. The money demand curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money

Liquidity preference model of the interest rate

A model of the market for money in which the interest rate is determined by the supply and demand for money

Taylor rule for monetary policy

A rule that sets the federal funds rate according to the level of the inflation rate and either the output gap or the unemployment rate

Why does the liquidity preference model determine the interest rate in the short run?

According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shifting the money supply curve. In practice, the Fed uses open-market operations to achieve a target federal funds rate, which other short-term interest rates generally track. Although long-term interest rates don't necessarily move with short-term interest rates, they reflect expectations about what's going to happen to short-term rates in the future.

How does the Federal Reserve implement monetary policy? Why is monetary policy the main tool for stabilizing the economy?

Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. Contractionary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short-run. The Federal Reserve and other central banks try to stabilize the economy, limiting fluctuations of actual output around potential output, while also keeping inflation low but positive. Under a Taylor rule for monetary policy, the target federal funds rate rises when there is high inflation and either a positive output gap or very low employment; it falls when there is low or negative inflation and either a negative output gap or high unemployment. Some central banks, including the Fed, engage in inflation targeting, which is forward-looking policy rule, whereas the Taylor rule method is a backward-looking policy rule. Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the preferred policy tool for stabilizing the economy. However, because interest rates cannot fall much below zero without causing significant problems, there is a zero lower bound for interest rates. As a result, the effectiveness of monetary policy is limited.

Why do economists believe in monetary neutrality?

In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: Changes in the money supply have no real effect on the economy in long run.

Expansionary monetary policy

Monetary policy that, through lowering the interest rate, increases aggregate demand and therefore output

Contractionary monetary policy

Monetary policy that, through the raising of the interest rate, reduces aggregate demand and therefore output

Zero lower bound for interest rates

Statement of the fact that interest rates cannot fall below zero without causing significant problems

Target federal funds rate

The Federal Reserve's desired level for the Federal Funds rate. The Federal Reserve adjusts the money supply through the purchase and sale of Treasury bills until the actual rate equals desired rate

Monetary neutrality

The concept that changes in the money supply have no real effects on the economy in the long run and only result in a proportional change in price level

Long-term interest rates

The interest rate on financial assets that mature a number of years into the future

Short-term interest rates

The interest rate on financial assets that mature within less than a year

What is the money demand curve?

The money demand curve arises from a trade-off between the opportunity cost of holding money and the liquidity that money provides. Americans hold substantial sums in cash and in zero-interest bank accounts linked to debit cards or money transmitters like Paypal and Venmo. By doing so they forgo the interest rate that could have been earned by putting those funds into an interest-bearing asset like a certificate of deposit (CD). The opportunity cost of holding money depends on short-term interest rates, not long-term interest rates. Changes in the aggregate price level, real GDP, technology, and institutions shift the money demand curve