1. Lectures in Macroeconomics- Charles W. Upton Can The Federal Reserve System set interest rates?

2. Can the Federal Reserve System Set Interest Rates Newspapers and Interest Rates The FOMC meets, and makes a decision about monetary policy.

3. Can the Federal Reserve System Set Interest Rates Setting Interest Rates The FOMC meets, and makes a decision about monetary policy. Fed Cuts Interest Rates!

4. Can the Federal Reserve System Set Interest Rates Interest Rate Management The Economy is humming along nicely, but not nicely enough that someone doesn’t want lower interest rates. Can it be done? Y M PoPo roro

5. Can the Federal Reserve System Set Interest Rates Increase the Money Supply! Y curve shifts up and to the right M curve shifts up and to the left. P up; r falls. Y M PoPo roro r1r1 P1P1

6. Can the Federal Reserve System Set Interest Rates The Newspaper Headline Y curve shifts up and to the right M curve shifts up and to the left. P up; r falls. Y M PoPo roro r1r1 P1P1 Fed Cuts Interest Rates!

7. Can the Federal Reserve System Set Interest Rates Not so fast!

8. Can the Federal Reserve System Set Interest Rates Orders to New York FOMC sets a target for r, say r 1. New York Trading Desk then increases the money supply enough to reach r 1 Y M PoPo roro r1r1 P1P1

9. Can the Federal Reserve System Set Interest Rates Orders to New York FOMC sets a target for r, say r 1. New York Trading Desk then increases the money supply enough to reach r 1 Y M PoPo roro r1r1 P1P1 Note: the FOMC sets a target for a nominal rate. Holding expected inflation constant, we can translate that into a target for the real rate.

10. Can the Federal Reserve System Set Interest Rates What does this mean? FOMC sets a target for r, say r 1. New York Trading Desk then increases the money supply enough to reach r 1 Y M PoPo roro r1r1 P1P1 In our terms: The Federal Reserve System is changing the money supply, but they target an interest rate – a nominal interest rate

11. Can the Federal Reserve System Set Interest Rates Does this Mean they Set r? FOMC sets a target for r, say r 1. New York Trading Desk then increases the money supply enough to reach r 1 Y M PoPo roro r1r1 P1P1 Not Exactly

12. Can the Federal Reserve System Set Interest Rates Permanent Effects The Quantity Theory works. In time, we move to 2P o and no change in r. Y M PoPo roro 2P o Recall this slide

13. Can the Federal Reserve System Set Interest Rates Continually Increasing M Suppose the Federal Reserve System keeps increasing the Money Supply to keep r at r 1. Y M PoPo roro r1r1 P1P1

14. Can the Federal Reserve System Set Interest Rates Lincoln’s Law

15. Can the Federal Reserve System Set Interest Rates Lincoln’s Law Continuing to increase the money supply is inflationary and that will boost expected inflation!

16. Can the Federal Reserve System Set Interest Rates In for a dime, in for a dollar… If  e is going up, and the FOMC wants to keep r N constant, they must reduce r R.

17. Can the Federal Reserve System Set Interest Rates Continually Increasing M If inflationary expectations rise by  e, the target real interest rate is reduced by  e. More money is required Y M PoPo roro r1r1 P1P1  e

18. Can the Federal Reserve System Set Interest Rates Lincoln’s Law Round 2!

19. Can the Federal Reserve System Set Interest Rates Lincoln’s Law When the government tries to cut interest rates, it may end up raising them.

20. Can the Federal Reserve System Set Interest Rates The Late 1970’s High –Interest rates –Inflation rate –Rate of growth of money supply

21. Can the Federal Reserve System Set Interest Rates The Late 1970’s High –Interest rates –Inflation rate –Rate of growth of money supply Paul Volker’s solution –Cut rate of growth of money supply

22. Can the Federal Reserve System Set Interest Rates Cut the Money Supply! This is a 100% recycled graph. Y M PoPo roro r1r1 P1P1

23. Can the Federal Reserve System Set Interest Rates Cut the Money Supply! This is a 100% recycled graph. Y M PoPo roro r1r1 P1P1

24. Can the Federal Reserve System Set Interest Rates The Problem Volker had no credibility For a while,  e > 

25. Can the Federal Reserve System Set Interest Rates The Impact Volker had no credibility For a while,  e >  U  -  e

26. Can the Federal Reserve System Set Interest Rates Conclusion In the Short run, increases (decreases )in the money supply can cut (increase) interest rates. Any effect is temporary. And don’t forget about changing inflationary expectations.

27. Can the Federal Reserve System Set Interest Rates Conclusion In the Short run, increases (decreases )in the money supply can cut (increase) interest rates. Any effect is temporary. And don’t forget about changing inflationary expectations. Back to the demand and supply of loans!

28. Can the Federal Reserve System Set Interest Rates End ©2003 Charles W. Upton. All rights reserved