Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Stabilizing Aggregate Demand: The Role of the Fed

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Usefulness of Monetary Policy  Monetary policy  Can be changed quickly  Is more flexible and responsive than fiscal policy  Therefore, monetary policy is used more actively than fiscal policy to stabilize the economy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Money Supply and Interest Rates  Changing the money supply  Changes interest rates  Nominal interest rate is the “price” of money

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Forms of Money  Money  Refers to a set of assets  Cash and checking accounts  Is a type of financial asset  Is a way of holding wealth  Cash, government bonds, rare stamps, etc.  Portfolio allocation decision  The decision about the forms in which to hold one’s wealth

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Demand for Money  Demand for money  The amount of wealth an individual chooses to hold in the form of money  Businesses must also must decide how much money to hold  Businesses hold more than half of the total money stock  Cost-benefit criterion tells us that an individual should increase money holdings if the benefit of doing so exceeds the cost

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Benefits of Holding Money  Benefits of holding money  Usefulness in making transactions  Factors that affect the demand for money ( note that credit cards have decreased the demand for money )  Income  Technological and financial innovation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Costs of Holding Money  Costs of holding money  Opportunity costs  The interest that could have been earned by holding interest-bearing assets  Bonds and stocks pay a positive nominal return  Most forms of money pay little or no interest

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Macroeconomic Factors Affecting Money Demand  Nominal interest rate  Affects the cost of holding money  Real output  Affects the benefits of money  Price level  Affects the benefits of money

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Nominal Interest Rate  A nominal interest rate (i)  Determines the opportunity cost of holding money  The higher the nominal interest rate  The greater the opportunity cost of holding money and the less money demanded  The nominal interest rate  Some average measure of interest rates  Thousands of different assets each with their own rate of return, or interest rate  Rates tend to rise and fall together

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real Income or Output Y  Real income or Output (Y)  An increase in real income raises the quantity of goods and services that people and businesses want to buy and sell  Higher transactions require more money to be held, increasing the demand for money

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide The Price Level (P)  The higher the prices of goods and services, the more dollars that are needed to make a given set of transactions  Higher transactions require more money to be held, thereby increasing the demand for money

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Money Demand Curve  Money demand curve  Relates the aggregate quantity of money demanded M to the nominal interest rate i  Because an increase in the nominal interest rate increases the opportunity cost of holding money, the money demand curve slopes downward  Reducing the quantity of money demanded

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Money Demand Curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Shift in the Money Demand Curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Equilibrium in the Money Market  Federal Reserve System controls the U.S. money supply  Quantity of money (M) is set by the Fed  Equilibrium  Occurs at the intersection of supply and demand  Price is the nominal interest rate (i)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Equilibrium in the Market for Money

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Reaching Equilibrium  Recall the inverse relationship between interest rates and bond prices  If the nominal interest rates were too low  The public’s quantity demanded for money is greater than the quantity supplied  The public wants to hold more money  So, they sell some of the interest-bearing assets  Which depresses the price of bonds  Which increases interest rates (i)  As interest rates rise the quantity demanded of money falls and equilibrium results

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide How the Fed Controls the Nominal Interest Rate  When the Fed changes the money supply  The equilibrium nominal interest rate changes  The Fed’s primary tool  Open-market operations  Buying bonds in order to increase the money supply  Selling bonds in order to decrease the money supply

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Fed Lowers the Nominal Interest Rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Fed Stabilizes the Interest Rate After an Increase in Money Demand

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Can the Fed Control the Real Interest Rate?  By controlling the money supply  The Fed controls the nominal interest rate  However, important economic decisions depend on the real interest rate  Decisions to save and invest

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Controlling the Real Interest Rate  Most economists believe the Fed can control the real interest rate  Definition of the real interest rate: r = i –   The Fed can control the nominal interest rate (i) quite precisely  Inflation (  changes relatively slowly after policy changes

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Controlling the Real Interest Rate in the LR  Because inflation changes slowly  Changing nominal interest rates causes real interest rates to change by the same amount  However, in the long-run the real interest rate is determined by  Balance of saving and investment  Several years or more

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Federal Funds Rate,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Federal Funds Rate  The Fed targets the federal funds rate  Interest rates tend to move together  This causes other interest rates to change in the same direction  There is not an exact relationship  The Fed’s control of other interest rates is somewhat less precise than its control of the federal funds rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Monetary Policy on the Economy  Aggregate demand depends on the real interest rate  A lower real interest rate encourages higher spending  As the Fed changes the real interest rate it changes aggregate demand in the desired direction, thereby changing aggregate output and employment

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD and the Real Interest Rate  Higher real interest rate  Increases the reward for saving  Increases in saving S  Decreases consumption spending C  Increases the cost of borrowing  Decreases consumption spending C  Cars cost more  Decreases investment I  Buying new machinery and homes cost more  Lower real interest rates have the opposite effect  Decreasing financing costs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fed Fights a Recession  Facing a recessionary gap  Fed reduces real interest rates  Stimulating C and I  Increasing AD  Increasing output and employment  Expansionary monetary policy or monetary easing  A reduction in interest rates by the Fed, made with the intention of reducing a recessionary gap

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Fed Fights a Recession

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fed Fights Inflation  Facing an expansionary gap  Fed increases real interest rates  Reducing C and I  Decreasing AD  Decreasing output and employment  Contractionary monetary policy or monetary tightening  An increase in interest rates by the Fed, made with the intention of reducing an expansionary gap

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Fed Fights Inflation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fed’s Policy Reaction Function  Policy reaction function describes how the action a policymaker takes depends on the state of the economy  Ideally policymakers should try to react in such a way as to optimize economic performance

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig An Example of a Fed Policy Reaction Function

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Art or Science?  Manipulating the models overstates the precision of monetary policy  The real world is complex and our knowledge of the economy is imperfect  Fed policymakers only have an approximate idea of the effect of a given change in the real interest rate on AD, output, and employment  The Fed proceeds cautiously avoiding large changes at any one time