Module Monetary Policy and the Interest Rate 31 Module Monetary Policy and the Interest Rate KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output Why monetary policy is the main tool for stabilizing the economy

Jim Cramer’s Pleas to Ben Bernanke

The Fed Reverses Course

Monetary Policy and the Interest Rate: Targeting the Fed Funds Rate We are ready to use the model of the money market to explain how the Federal Reserve can use monetary policy to stabilize the economy in the short run.   Suppose the Fed took steps to increase the money supply. This will usually be the result of an open market operation to buy Treasury bills from large commercial banks. The increase in the money supply causes short-term interest rates to fall in the money market. Now suppose the Fed took steps to decrease the money supply. This will usually be the result of an open market operation to sell Treasury bills to large commercial banks. The decrease in the money supply causes short-term interest rates to rise in the money market. Usually the Fed adjusts the money supply to target a specific federal funds rate. If the current federal funds rate is higher than the target, the Fed will increase the money supply so that the rate falls to the target. If the current federal funds rate is lower than the target, the Fed will decrease the money supply so that the rate rises to the target.

Expansionary Monetary Policy The Economy Investment spending is usually quite sensitive to changes in the interest rate. When interest rates fall, we see an increase in investment spending. Some types of consumption spending also increase when the interest rate falls. Examples: car/truck buying, college educations, real estate.   Since both investment spending and consumption spending are important components of aggregate demand, it would therefore make sense that when the interest rate falls, AD should rise. Note: the instructor can draw the AD/AS graph with AD to the left of potential output. Ask the students, “What could the Fed do about this recession”? Expansionary Monetary Policy chain of events The Fed observes that the economy is in a recessionary gap. The Fed increases the money supply. The interest rate falls. Investment and consumption increase. AD shifts to the right. Real GDP increases, unemployment rate decreases, the aggregate price level rises. The Money Market

Contractionary Monetary Policy The Money Market Note: the instructor can draw the AD/AS graph with AD to the right of potential output. Ask the students, “What could the Fed do about this inflation”?   Contractionary Monetary Policy chain of events The Fed observes that the economy is in an inflationary gap. The Fed decreases the money supply. The interest rate rises. Investment and consumption decrease. AD shifts to the left. Real GDP decreases, unemployment rate increases, the aggregate price level falls. The Economy

Fed Policy and the Output Gap The Federal Reserve engages in expansionary monetary policy (they lower the interest rate) when the output gap (the difference between potential RGDP and actual GDP) becomes negative. The Federal Reserve engages in contractionary monetary policy (they raise the interest rate) when the output gap becomes positive. Note: If the instructor would rather spend time focusing on past macroeconomic FRQ’s, this section could be skipped.   The Fed is not only concerned with the level of real GDP and whether the economy is producing a full employment, but the Fed is also concerned with price stability. The Fed also monitors inflation so that the economy doesn’t suffer unexpected spikes in the inflation rate. In practice, this simply means that the Fed’s goals and policies are multifaceted. Some economists have suggested that the Fed (and other central banks) operates with a monetary “rule” that dictates monetary policy. The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. The rule Taylor originally suggested was as follows: Federal funds rate = 1 + (1.5 inflation rate) + (0.5 output gap) Example: inflation is 3% and real GDP is 4% below potential GDP FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 % Stanford Economist, John Taylor

Fed Policy and the Inflation Rate The Federal Reserve engages in expansionary monetary policy (they lower the interest rate) when the inflation rate falls. The Federal Reserve engages in contractionary monetary policy (they raise the interest rate) when the inflation rate rises. Note: If the instructor would rather spend time focusing on past macroeconomic FRQ’s, this section could be skipped.   The Fed is not only concerned with the level of real GDP and whether the economy is producing a full employment, but the Fed is also concerned with price stability. The Fed also monitors inflation so that the economy doesn’t suffer unexpected spikes in the inflation rate. In practice, this simply means that the Fed’s goals and policies are multifaceted. Some economists have suggested that the Fed (and other central banks) operates with a monetary “rule” that dictates monetary policy. The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. The rule Taylor originally suggested was as follows: Federal funds rate = 1 + (1.5 inflation rate) + (0.5 output gap) Example: inflation is 3% and real GDP is 4% below potential GDP FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 % Stanford Economist, John Taylor

Monetary Policy in Practice Stanford economist John Taylor proposes that the Fed follow a rule Fed Funds = ... 1+(1.5 X π%)+(0.5 X Output Gap) **(π%) represents the inflation rate Note: If the instructor would rather spend time focusing on past macroeconomic FRQ’s, this section could be skipped.   The Fed is not only concerned with the level of real GDP and whether the economy is producing a full employment, but the Fed is also concerned with price stability. The Fed also monitors inflation so that the economy doesn’t suffer unexpected spikes in the inflation rate. In practice, this simply means that the Fed’s goals and policies are multifaceted. Some economists have suggested that the Fed (and other central banks) operates with a monetary “rule” that dictates monetary policy. The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. The rule Taylor originally suggested was as follows: Federal funds rate = 1 + (1.5 inflation rate) + (0.5 output gap) Example: inflation is 3% and real GDP is 4% below potential GDP FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 % Stanford Economist, John Taylor

Monetary Policy in Practice In practice it appears that the Fed does follow the Taylor rule. The Taylor rule reflects more closely what the Fed actually does with the Federal Funds rate Note: If the instructor would rather spend time focusing on past macroeconomic FRQ’s, this section could be skipped.   The Fed is not only concerned with the level of real GDP and whether the economy is producing a full employment, but the Fed is also concerned with price stability. The Fed also monitors inflation so that the economy doesn’t suffer unexpected spikes in the inflation rate. In practice, this simply means that the Fed’s goals and policies are multifaceted. Some economists have suggested that the Fed (and other central banks) operates with a monetary “rule” that dictates monetary policy. The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. The rule Taylor originally suggested was as follows: Federal funds rate = 1 + (1.5 inflation rate) + (0.5 output gap) Example: inflation is 3% and real GDP is 4% below potential GDP FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 % Stanford Economist, John Taylor

Inflation Targeting The Fed tries to keep inflation low but positive The Fed does not explicitly commit itself to a particular rate of inflation Inflation Targeting (setting a target inflation rate or range) is the policy of other countries’ central banks Pros of inflation targeting argue that it makes Fed policy more transparent and keeps the Fed accountable Opponents argue that it limits the Fed to dealing only with inflation when there may be other concerns Other nations have adopted a policy of keeping interest rates at a level that creates a specific level of price inflation, or at least attempts to keep inflation rates within an acceptable range.   One major difference between inflation targeting and the Taylor rule is that inflation targeting is forward­ -­ looking rather than backward­ -­ looking. That is, the Taylor rule adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation. Advocates of inflation targeting argue that it has two key advantages, transparency and accountability. Transparency: Economic uncertainty is reduced because the public knows the objective of an inflation­ -­ targeting central bank. Accountability: The central bank’s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable.