1. 1 Frank & Bernanke 3 rd edition, 2007 Ch. 14: Stabilizing the Economy: The Fed

2. 2 What is Demand for Money? Demand for Money (Liquidity Preference) Demand for Money (Liquidity Preference) The amount of wealth an individual chooses to hold in the form of money. The amount of wealth an individual chooses to hold in the form of money. The portfolio allocation decision is made by comparing return relative to risk. The portfolio allocation decision is made by comparing return relative to risk. Risk can be reduced by diversifying the portfolio. Risk can be reduced by diversifying the portfolio. Most people choose to hold some wealth as money. Most people choose to hold some wealth as money.

3. 3 The Demand for Money Money (currency + checking deposits) is one of the assets a person, a household, a business holds. Money (currency + checking deposits) is one of the assets a person, a household, a business holds. The benefit of money is its acceptability in paying debts (liquidity). The benefit of money is its acceptability in paying debts (liquidity). The cost of money is the opportunity cost of losing a return on other assets one could hold. The cost of money is the opportunity cost of losing a return on other assets one could hold.

4. 4 Demand for Money by K’s Restaurant Currently holding $50,000/day; Interest rate = 6% Currently holding $50,000/day; Interest rate = 6% Two ways to reduce cash holdings: Two ways to reduce cash holdings: Increase cash pickups costing $500/yr; reduce cash holdings by $10,000. Increase cash pickups costing $500/yr; reduce cash holdings by $10,000. Use a computerized cash management service costing $800/yr plus more cash pickups of $500/yr; reduce cash holdings by $20,000 Use a computerized cash management service costing $800/yr plus more cash pickups of $500/yr; reduce cash holdings by $20,000 Benefit:.06(10,000) or.06(20,000) Benefit:.06(10,000) or.06(20,000) Cost: $500 or $1,300. Cost: $500 or $1,300. What is the cash holdings? How do they change when i = 8%? What is the cash holdings? How do they change when i = 8%?

5. 5 Consuelo’s Balance Sheet AssetsLiabilities Cash$80Student loan$3,000 Checking account1,200Credit card balance250 Shares of stock1,000 Car (market value)3,500 Furniture500 Total$6,280$3,250 Net Worth$3,030 Demand for money = $1,280 To hold more money Sell stocks Credit card cash advance To hold less money Buy stocks Reduce her credit card balance

6. 6 The Demand for Money If the opportunity cost of holding money increases, less money will be held in portfolio. If the opportunity cost of holding money increases, less money will be held in portfolio. The higher the nominal interest rate, the lower is the demand for money. The higher the nominal interest rate, the lower is the demand for money. The more the income, the more will be the amount kept in money form: the higher will be the demand for money. The more the income, the more will be the amount kept in money form: the higher will be the demand for money. The higher the price level, the higher will be the demand for money. The higher the price level, the higher will be the demand for money.

7. 7 A Shift In The Money Demand Curve Money M Nominal interest rate i MD MD’ Shifts in MD Changes in Y & P MD will increase if Y or P increase Technological changes Foreign demand

8. 8 Shifts in Money Demand Businesses hold more than half of the total money stock. Businesses hold more than half of the total money stock. Changes in real income (real GDP). Changes in real income (real GDP). Changes in price level. Changes in price level. Technological change and sophisticated financial markets have reduced the demand for money in the U.S. Technological change and sophisticated financial markets have reduced the demand for money in the U.S. Changes in foreign holdings of USD. Changes in foreign holdings of USD. Between 1960 and 2004 M 1 as a percent of GDP fell from 28% to 12%. Between 1960 and 2004 M 1 as a percent of GDP fell from 28% to 12%. Psychological changes. Psychological changes. Seasonal changes. Seasonal changes.

9. 9 Foreign Holdings of USD More than $300 billion in currency circulating outside the U.S. More than $300 billion in currency circulating outside the U.S. Foreign citizens will hold dollars to avoid the impact of high inflation. Foreign citizens will hold dollars to avoid the impact of high inflation. Foreign citizens will hold dollars to protect against political instability. Foreign citizens will hold dollars to protect against political instability.

10. 10 FOMC Decision On March16, 2004 the FOMC declared that it will keep the federal funds rate at 1.00%. On March16, 2004 the FOMC declared that it will keep the federal funds rate at 1.00%. On March 22, 2005, the FOMC raised the federal funds rate to 2.75%. On March 22, 2005, the FOMC raised the federal funds rate to 2.75%. On March 21, 2007 the FOMC announced On March 21, 2007 the FOMC announced How does the Fed keep the federal funds rate constant or lower or higher? What is the connection of this interest rate to the money supply? How does the Fed keep the federal funds rate constant or lower or higher? What is the connection of this interest rate to the money supply?

11. 11 Money Supply By engaging in open market operations, the Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system. By engaging in open market operations, the Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system. If the demand for money remains the same, the action of the Fed affects the federal funds rate. If the demand for money remains the same, the action of the Fed affects the federal funds rate. S up; D same => P down S up; D same => P down

12. 12 Equilibrium in the Market for Money Explain how and why the market reaches equilibrium.

13. 13 Equilibrium in the Market for Money If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is. If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is. How do people adjust their portfolios? How do people adjust their portfolios? They buy other assets with the excess money in their checking accounts. They buy other assets with the excess money in their checking accounts. The price of bonds (non-money assets) goes up: interest rate goes down. The price of bonds (non-money assets) goes up: interest rate goes down.

14. 14 Fed’s Control of Nominal Interest Rate By buying or selling bonds, the Fed increases or decreases the supply of money in the system. By buying or selling bonds, the Fed increases or decreases the supply of money in the system. Shifting the supply curve to the right or to the left, lowers or raises the nominal interest rate. Shifting the supply curve to the right or to the left, lowers or raises the nominal interest rate. The Fed directly affects the federal funds rate. The Fed directly affects the federal funds rate.

15. 15 http://www.federalreserve.gov/newsevents/press/monetary/20090203a.htm

16. 16 The Federal Funds Rate, 1970-2004 http://research.stlouisfed.org/publications/mt/page9.pdf

17. 17 The Fed Wants to Raise i Fed sells bonds Fed sells bonds The money supply falls The money supply falls Creates a shortage of money Creates a shortage of money People sell non-money assets People sell non-money assets Non-money asset prices fall and the interest rate increases Non-money asset prices fall and the interest rate increases

18. 18 Interest Rates and Money Supply The Fed cannot set the interest rate and the money supply independently. The Fed cannot set the interest rate and the money supply independently. The Fed controls the money supply by controlling bank reserves. The Fed controls the money supply by controlling bank reserves. Bank reserves influence the federal funds rate. Bank reserves influence the federal funds rate. Therefore, the federal funds rate reflects the impact of open market operations. Therefore, the federal funds rate reflects the impact of open market operations.

19. 19 The Fed and Money Supply Second Way : Discount Window Lending Second Way : Discount Window Lending The lending of reserves by the Federal Reserve to commercial banks The lending of reserves by the Federal Reserve to commercial banks Discount Rate (primary credit rate): The interest rate that the Fed charges commercial banks to borrow reserves. Discount Rate (primary credit rate): The interest rate that the Fed charges commercial banks to borrow reserves.

20. 20 The Fed and Money Supply Third Way: Changing Reserve Requirements Third Way: Changing Reserve Requirements Set by the Fed Set by the Fed The minimum values of the ratio of bank deposits that commercial banks are allowed to maintain The minimum values of the ratio of bank deposits that commercial banks are allowed to maintain Lowering the reserve ratio increases the ability of banks to make loans and therefore expand the money supply. Lowering the reserve ratio increases the ability of banks to make loans and therefore expand the money supply. Increasing the reserve ratio reduces the ability of banks to make loans and create money. Increasing the reserve ratio reduces the ability of banks to make loans and create money.

21. 21 The New Tools http://www.federalreserve.gov/monetarypolicy/default.htm

22. 22 Fed Funds Rate vs. Prime If Fed can affect the federal funds rate, why should we care? If Fed can affect the federal funds rate, why should we care? We might be interested in the interest rates on CDs, mortgage rates, credit card interest rates? We might be interested in the interest rates on CDs, mortgage rates, credit card interest rates? Usually, interest rates all go hand in hand. Usually, interest rates all go hand in hand. When the Fed increases the federal funds rate, banks increase their prime rates, too. When the Fed increases the federal funds rate, banks increase their prime rates, too.

23. 23 Real and Nominal Interest Rates If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does? If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does? Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate. Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate.

24. 24 Real and Nominal Interest Rates Remember the Fisher Effect: Remember the Fisher Effect: i = r +  i = r +   f the expected inflation hasn’t changed but the Fed has increased i, then r is also increased.  f the expected inflation hasn’t changed but the Fed has increased i, then r is also increased. In the long run  adjusts and it is the savings and investments that determine the real rate of interest. In the long run  adjusts and it is the savings and investments that determine the real rate of interest.

25. 25 The Federal Reserve and Interest Rates Can the Fed Control the Real Interest Rate? Can the Fed Control the Real Interest Rate? Long-run impact of Fed policy Long-run impact of Fed policy Prices adjust to changing economic conditions. Prices adjust to changing economic conditions. The real interest rate is determined by the balance of savings and investment. The real interest rate is determined by the balance of savings and investment. The Fed has less effect on spending in the long run. The Fed has less effect on spending in the long run.

26. 26 How much control does the Fed have over spending? The Fed has direct control over the federal funds rate. The Fed has direct control over the federal funds rate. The federal funds rate may influence, but does not control other interest rates which influence spending. The federal funds rate may influence, but does not control other interest rates which influence spending. The inability of the Fed to precisely control other interest rates complicates monetary policy. The inability of the Fed to precisely control other interest rates complicates monetary policy.

27. 27 Aggregate Expenditures and the Real Interest Rate Real interest rates and consumption Real interest rates and consumption High real interest rates increases the incentive to save. High real interest rates increases the incentive to save. If savings increase, consumption decreases. If savings increase, consumption decreases. High real interest rates reduces consumption. High real interest rates reduces consumption. Real interest rates and investment spending Real interest rates and investment spending High real interest rates increases the cost of investment spending. High real interest rates increases the cost of investment spending. The increased cost reduces profitability of investment spending and investment falls. The increased cost reduces profitability of investment spending and investment falls. High real interest rates reduces investment spending. High real interest rates reduces investment spending. Real interest rates and NX Real interest rates and NX R up => $ up => NX down R up => $ up => NX down

28. 28 Real Interest Rates and Aggregate Demand Y = C + I + G + NX Y = C + I + G + NX C = 400 + 0.8(Y-T) - 200r C = 400 + 0.8(Y-T) - 200r I = 300 - 600r I = 300 - 600r G = 250; T = 200; NX = 10 G = 250; T = 200; NX = 10 Explain in words how this economy operates. Explain in words how this economy operates.

29. 29 Solving for the Unknowns If the real interest rate is 3%, find the values of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y. If the real interest rate is 3%, find the values of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y. If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph. If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph.

30. 30 Fighting Recession The Fed reduced the fed funds rate 11 times in 2001-2002. The Fed reduced the fed funds rate 11 times in 2001-2002. In the second half of 2000, the rate stayed at 6.5%. In the second half of 2000, the rate stayed at 6.5%. In 2002, it had been 1.75% until Nov. 6 and the Fed decided to lower it further. In 2002, it had been 1.75% until Nov. 6 and the Fed decided to lower it further. What was the effect of Fed’s lowering of interest rates on AD? What was the effect of Fed’s lowering of interest rates on AD?

31. 31 The Fed Fights A Recession Output Y Planned aggregate expenditure PAE Y = PAE 5,000 Recessionary gap E Expenditure line (r = 5%) 4,800 Y* Expenditure line (r = 1%) F A reduction in r shifts the expenditure line upward Multiplier = 5 Output gap = 200 Fed wants to increase PAE by 200/5 = 40 C = 1,010 – 1,000r 1% change in r will change C by 10 Reduce r to 0.01

32. 32 Fighting Inflation From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4.75% to 6.50%. From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4.75% to 6.50%. At the beginning of 1977 the fed funds rate was 4.5%. By the end of 1978 it was 10%. A year later it was 13.75%. By April 1980, it reached 17.6%. At the beginning of 1977 the fed funds rate was 4.5%. By the end of 1978 it was 10%. A year later it was 13.75%. By April 1980, it reached 17.6%. What happens to AD? What happens to AD?

33. 33 Raising Interest Rates From June 2004 to June 2005 the Fed Funds Rate rose from 1.0% to 3.25%. From June 2004 to June 2005 the Fed Funds Rate rose from 1.0% to 3.25%. Real GDP growth of nearly 6% in late 2003 and 4.4% in 2004 and a falling unemployment rate to 5.6% in June 2004 indicated the possible emergence of an expansionary gap. Real GDP growth of nearly 6% in late 2003 and 4.4% in 2004 and a falling unemployment rate to 5.6% in June 2004 indicated the possible emergence of an expansionary gap.

34. 34 The Fed Fights Inflation Output Y Planned aggregate expenditure PAE Expenditure line (r = 5%) Y = PAE 4,800 Expansionary gap E 4,600 Y* G Expenditure line (r = 9%) An increase in r shifts the expenditure line downward

35. 35 Inflation and the Stock Market Inflation is watched very closely by the Fed. Inflation is watched very closely by the Fed. Any sign of inflation makes Fed increase interest rates. Any sign of inflation makes Fed increase interest rates. Higher real interest rates slow down the economy and lower future profits. Higher real interest rates slow down the economy and lower future profits. Higher real interest rates lower the price of bonds and shift the demand away from stocks to bonds, lowering stock prices. Higher real interest rates lower the price of bonds and shift the demand away from stocks to bonds, lowering stock prices.

36. 36 Policy Reaction Function If there is a pattern of policies adopted under the same economic circumstances, then we have a policy reaction function. If there is a pattern of policies adopted under the same economic circumstances, then we have a policy reaction function. For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation. For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation.

37. 37 Taylor Rule Taylor explained the behavior of the Fed as a reaction to output gap and inflation. Taylor explained the behavior of the Fed as a reaction to output gap and inflation. If there is a positive, recessionary output gap, the Fed wants to stimulate the economy. If there is a positive, recessionary output gap, the Fed wants to stimulate the economy. If there is a negative, expansionary gap, the Fed wants to slow down the economy. If there is a negative, expansionary gap, the Fed wants to slow down the economy. The Fed also reacts to higher inflation by raising the real interest rate and slowing down the economy. The Fed also reacts to higher inflation by raising the real interest rate and slowing down the economy.

38. 38 Taylor Rule r = 0.01 –0.5 [(Y* - Y)/Y*] + 0.5 π How does the Fed react when inflation rises? How does the Fed react when output gaps appear? What will the real and nominal interest rates be given different values?

39. 39 A Monetary Policy Reaction Function for the Fed 0.00 (= 0%)0.02 (= 2%) 0.010.03 0.020.04 0.030.05 0.040.06 Rate of inflation,  Real interest rate set by Fed, r

40. 40 An Example of a Fed Policy Reaction Function Real interest rate set by Fed, r 0.01 0.02 0.03 0.04 0.05 0.06 0.020.030.04 Fed’s monetary policy reaction function Inflation 