© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 39 Monetary Policy, Toll Brothers, and the Housing Market The Sequel: Housing Bubble Sub-prime mortgage crisis Recession of By driving down interest rates, the Fed succeeded in heading off what some economists had predicted would be a prolonged and severe recession.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 38 What Is Monetary Policy? Monetary policy How the Federal Reserve manages the money supply and interest rates to pursue its economic goals. 1 Price stability 2 High employment 3 Economic growth 4 Stability of financial markets and institutions The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy:

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets The Fed tries to keep both the unemployment and inflation rates low, but it can’t affect either of these economic variables directly. The Fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level. Monetary Policy Targets The federal funds rate is the Fed’s most important direct target variable The federal funds rate affects the money supply. Money supply growth affects inflation, unemployment, and growth.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets The Demand for Money (An increase in the price of bonds) Substitute away from bonds toward money.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 38 Shifts in the Money Demand Curve

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 38 Equilibrium in the Money Market The Impact on the Interest Rate When the Fed Increases the Money Supply People try to buy bonds. Bond prices fall.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 38 Federal Funds Rate Targeting, January 1997–May 2007 Federal funds rate The interest rate banks charge each other for overnight loans of reserves (deposits held at the Fed). When Fed increases supply of reserves by buying something, fed funds rate falls. When Fed decreases supply of reserves by selling something, fed funds rate rises.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 38 Monetary Policy and Economic Activity Consumption Investment Net exports Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: Expansionary monetary policy The Federal Reserve increasing the money supply and decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserve adjusting the money supply to increase interest rates to reduce inflation.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 38 The Inflation and Deflation of the Housing Market “Bubble” Making the Connection

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 38 Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 38 The Fed Responds to the Terrorist Attacks of September 11, 2001 Making the Connection The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 Using Monetary Policy to Fight Inflation FIGURE 14.9 A Contractionary Monetary Policy in 2000

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 38 Solved Problem 14-3 The Effects of Monetary Policy Learning Objective 14.3 YEARPOTENTIAL REAL GDPREAL GDPPRICE LEVEL 2010$13.3 trillion $13.7 trillion$13.6 trillion142 The hypothetical information in the table shows what the values for real GDP and the price level will be in 2011 if the Fed does not use monetary policy.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 38 Monetary Policy and Economic Activity A Summary of How Monetary Policy Works BEST: Buy Ease Sell Tighten

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 38 Some Issues Regarding the Conduct of Monetary Policy Rather than use an interest rate as its monetary policy target, the Fed should target the money supply. Economists who make this argument belong to the Monetarist School. The leader of the monetarist school was Nobel laureate Milton Friedman. Friedman and his followers favored replacing monetary policy with a monetary growth rule. Steady money growth  steady, predictable inflation Steady money growth  automatic stabilizer. 1. Should the Fed Target the Money Supply? Problem is, it’s hard to get the money supply where you want it. The public’s changing split of its money holdings between currency and demand deposits changes the money multiplier.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? The Fed Can’t Target Both the Money Supply and the Interest Rate

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 38 Monetary Policy and Economic Activity 3. Can the Fed Get Timing Right? The Effect of a Poorly Timed Monetary Policy on the Economy Friedman’s complaint about discretionary monetary policy: “Too much too late”

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 38 Taylor rule A rule developed by John Taylor -- a Stanford professor and advisor to Presidents Bush -- that links the Fed’s target for the federal funds rate to economic variables. 4. Should the Fed adhere to a simple rule … or exercise discretion? Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap According to Taylor rule, if inflation rises by one percentage point, the Federal Funds rate should rise by 1 ½ percentage points. The real federal funds rate then rises by ½ %, slowing inflation. 5. Should the Fed Target Inflation? Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of Is the Independence of the Federal Reserve a Good Idea? The Case for Fed Independence The More Independent the Central Bank, the Lower the Inflation Rate

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 38 How Does the Fed Measure Inflation? Personal Consumption Expenditure Price Index: A Chained Index

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 38 Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule K e y T e r m s