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
