1. The Federal Reserveand Monetary Policy F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

2. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 25 1 What happens to interest rates when the economy recovers from a recession? Rising Interest Rates During an Economic Recovery 2 Is it better for decisions about monetary policy to be made by a single individual or by a committee? The Effectiveness of Committees 3What are the advantages and disadvantages of the Federal Reserve becoming more transparent about its actions and decisions and disclosing more information to the public? Making the Federal Reserve More Transparent

3. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 25 money market The market for money in which the amount supplied and the amount demanded meet to determine the nominal interest rate. transaction demand for money The demand for money based on the desire to facilitate transactions. THE MONEY MARKET 14.1 The Demand for Money INTEREST RATES AFFECT MONEY DEMAND

4. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 25 THE MONEY MARKET 14.1 INTEREST RATES AFFECT MONEY DEMAND The Demand for Money  FIGURE 14.1 Demand for Money

5. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 25 THE MONEY MARKET 14.1 The Demand for Money THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND  FIGURE 14.2 Shifting the Demand for Money

6. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 25 THE MONEY MARKET 14.1 The Demand for Money OTHER COMPONENTS OF MONEY DEMAND illiquid Not easily transferable to money. liquidity demand for money The demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs. speculative demand for money The demand for money that arises because holding money over short periods is less risky than holding stocks or bonds.

7. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 25 open market operations The purchase or sale of U.S. government securities by the Fed. HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY 14.2 Open Market Operations open market purchases The Fed’s purchase of government bonds from the private sector. open market sales The Fed’s sale of government bonds to the private sector.

8. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 25 discount rate The interest rate at which banks can borrow from the Fed. HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY 14.2 Other Tools of the Fed federal funds market The market in which banks borrow and lend reserves to and from one another. federal funds rate The interest rate on reserves that banks lend each other. CHANGING RESERVE REQUIREMENTS CHANGING THE DISCOUNT RATE

9. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 25 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 14.3  FIGURE 14.3 Equilibrium in the Money Market

10. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 25 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 14.3  FIGURE 14.4 Federal Reserve and Interest Rates

11. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 25 RISING INTEREST RATES DURING AN ECONOMIC RECOVERY APPLYING THE CONCEPTS #1: What happens to interest rates when the economy recovers from a recession? Economists have often noticed that interest rates start to rise: As an economy recovers from a recession. As the economy grows quickly. Why should a recovery be associated with higher interest rates? The extra income being generated by firms and individuals during the recovery will increase the demand for money. Because the demand for money increases while the supply of money remains fixed, interest rates rise. The Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy. The Fed cuts back on the supply of money to raise interest rates. The public should expect rising interest rates during a period of economic recovery and rapid GDP growth.

12. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 25 BERNANKE’S STEADY COURSE There are still fears among some economists that the Fed may not react fast enough to a slowing economy. The general consensus is the cuts will begin to come late next year if the economy continues to show signs of weakness. Fed chief Ben Bernanke appears to be filling Greenspan’s shoes well. He generated positive buzz for the recent decision to leave rates unchanged for the second time at the Fed’s September 20 meeting. Many analysts feared the Fed might react to inflation pressures by increasing rates again. However, it appears Bernanke may favor a softer approach. The financial markets responded positively with the Dow Jones Industrial Average moving up 72 points for the day. Extra Application 4 The expectation that interest rates will soon fall usually pushes stock prices higher. Lower interest rates decrease the cost of doing business for firms and also push the intrinsic value of stocks higher due to discounting expected cash flows at a lower rate. Both of these factors cause investors to reassess stock values and increase demand for stocks resulting in pushing prices higher.

13. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 25 GETTING THE PRICE RIGHT The Fed receives economic data ahead of the general public and many Fed watchers believe that core personal consumption expenditure (PCE) data play a bigger role in the Fed’s decision-making than the CPI or PPI. The PCE data is considered to be more responsive to economic changes and thus a better measure of inflation. It is difficult to separate the different inflation measures. The PCE is compiled by the Commerce Department and uses both CPI and PPI data (compiled by the Labor Department) to adjust for inflation. The government also monitors import prices and compiles an Import Price Index that indicated import prices increased by 1.6% in May. So, what does the Fed look at? The Fed probably considers all of this information when making interest rate determinations. However, how much weight each factor carries is indeterminate since we are on the outside looking in. All the markets have the inflation jitters largely due to Ben Bernanke’s control of the Fed. Investors have yet to determine Bernanke’s likely reaction to economic news and are concerned over how the Fed might react to personal income and spending data soon to be released. If inflation appears imminent, the Fed will likely raise rates. Extra Application 5

14. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 25 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 14.3 Interest Rates and Bond Prices HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES

15. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 25 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 14.4  FIGURE 14.5 The Money Market and Investment Spending

16. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 25 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 14.4  FIGURE 14.6 Monetary Policy and Interest Rates

17. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 25 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 14.4  FIGURE 14.7 Money Supply and Aggregate Demand

18. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 25 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 14.4

19. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 25 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 14.4 Monetary Policy and International Trade exchange rate The rate at which currencies trade for one another in the market. depreciation of a currency A decrease in the value of a currency.

20. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 25 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 14.4 Monetary Policy and International Trade appreciation of a currency An increase in the value of a currency.

21. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 21 of 25 THE EFFECTIVENESS OF COMMITTEES APPLYING THE CONCEPTS #2: Is it better for decisions about monetary policy to be made by a single individual or by a committee? Professor Alan Blinder was convinced that committees were not effective for making decisions about monetary policy. Blinder developed an experiment to see whether individuals or groups make better decisions and who makes them more rapidly. The experiment was designed to explore how quickly individuals and groups could distinguish changes in underlying trends from random events. Example: If unemployment were to rise in one month, such a rise could be- a temporary aberration. the beginning of a recession. Problems: Changing monetary policy would be a mistake if the rise were temporary. Waiting too long to change policy would be costly if the change were permanent. Who is better at making these sorts of determinations? Committees make decisions as quickly and are more accurate than individuals making decisions by themselves.

22. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 22 of 25 MAKING THE FEDERAL RESERVE MORE TRANSPARENT APPLYING THE CONCEPTS #3: What are the advantages and disadvantages of the Federal Reserve becoming more transparent about its actions and decisions and disclosing more information to the public? In recent years, the Fed has gradually become more open in its deliberations. But should the Fed go further in describing its intended future policies? Some members of the FOMC believe that the financial markets need more information so that they have a clearer idea of what future Fed policy and short-term interest rates are likely to be. Other members feel that the financial markets understand the implicit rules that the Fed follows and that issuing a more complex public statement will just confuse matters. Now the members of the FOMC participate in drafting statements. The Fed clearly recognizes that its statements may be just as important as its actions.

23. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 23 of 25 FED SUCCEEDS BY DOING NOTHING The fear is that stagflation, slow growth and high inflation, similar to the late 1970s may return. If the current growth and inflation trends continue, many believe the Fed will increase rates at the next meeting to curb inflation. Others believe that even slower growth will force the Fed to lower interest rates to stimulate the economy. To date the Fed seems content to leave rates unchanged and attempt to influence the markets through commentary, or “jawboning.” Look for the Fed to threaten raising rates to curb inflation with the hopes that talking tough will keep the economy growing and prices in check. Changing interest rates is likely a last resort in the current environment. Fed watchers believe the nation’s central bank will leave interest rates unchanged for now but agree on very little else after that. Some believe the next move will be down, others believe the next interest rate move will be up. The point of contention lies with the economy. While the economy has slowed considerably, inflation is still higher than central bank targets. Extra Application 6

24. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 24 of 25 MONETARY POLICY CHALLENGES FOR THE FED 14.5 Lags in Monetary Policy Influencing Market Expectations: From the Federal Funds Rate to Interest Rates on Long-Term Bonds Looking Ahead: From the Short Run to The Long Run

25. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 25 of 25 appreciation of a currency depreciation of a currency discount rate exchange rate federal funds market federal funds rate illiquid liquidity demand for money money market open market operations open market purchases open market sales speculative demand for money transaction demand for money