1. 14-1 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy Copyright © 2012 Pearson Prentice Hall. All rights reserved.

2. The Federal Reserve and Monetary Policy Brock Williams P R E P A R E D B Y Little did Ben S. Bernanke know when he took over the reins as chairman of the Federal Reserve on February 1, 2006, that he would face a novel and complex crisis brought on by the fall in housing prices and its reverberations throughout the entire financial system in 2007 and 2008. CHAPTER 14 Copyright © 2012 Pearson Prentice Hall. All rights reserved.

3. 14-3 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy 1 2 3 How has the Fed recently expanded its role in financial markets? Beyond Purchasing Treasury Securities What happens to interest rates when the economy recovers from a recession? Rising Interest Rates during an Economic Recovery Is it better for decisions about monetary policy to be made by a single individual or by a committee? The Effectiveness of Committees A P P L Y I N G T H E C O N C E P T S

4. 14-4 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy 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 Demand for Money INTEREST RATES AFFECT MONEY DEMAND THE MONEY MARKET 14.1

5. 14-5 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy The Demand for Money  FIGURE 14.1 Demand for Money THE MONEY MARKET (cont’d) 14.1 P R I N C I P L E O F O P P O R T U N I T Y C O S T The opportunity cost of something is what you sacrifice to get it. As interest rates increase from r 0 to r 1, the quantity of money demanded falls from M 0 to M 1.

6. 14-6 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy The Demand for Money THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND  FIGURE 14.2 Shifting the Demand for Money THE MONEY MARKET (cont’d) 14.1 R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or income— its purchasing power—not the face value of money or income. Changes in prices and real GDP shift the demand for money.

7. 14-7 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy 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. THE MONEY MARKET (cont’d) 14.1

8. 14-8 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy open market operations The purchase or sale of U.S. government securities by the Fed. 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. HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY 14.2

9. 14-9 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy discount rate The interest rate at which banks can borrow from the Fed. 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 HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY (cont’d) 14.2 If the Fed wishes to increase the supply of money, it can reduce banks’ reserve requirements so they have more money to loan out.

10. 14-10 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy BEYOND PURCHASING TREASURY SECURITIES APPLYING THE CONCEPTS #1: How has the Fed recently expanded its role in financial markets?? Traditionally, to expand the money supply, the Fed purchased treasury securities. It credited the reserve accounts in banks and, in part, determined the money and credit in the economy. The Fed did not intervene in security or credit markets. After the crisis of 2008, the Fed changed policy and expanded its involvement. The Fed increased its assets from less than $1 trillion to over $2 trillion. In 2010 the Fed held over $1 trillion in mortgage-backed securities. Critics suggest the Fed has crossed a political threshold that may pose risks to its long-term independence. The Fed has reduced its investments in many markets, but increased its holdings of mortgage-backed securities and is still playing a direct role in the housing market. A P P L I C A T I O N 1

11. 14-11 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy  FIGURE 14.3 Equilibrium in the Money Market HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 14.3 Equilibrium in the money market occurs at an interest rate of r*, at which the quantity of money demanded equals the quantity of money supplied.

12. 14-12 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy  FIGURE 14.4 Federal Reserve and Interest Rates HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY (cont’d) 14.3 Changes in the supply of money will change interest rates.

13. 14-13 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy Interest Rates and Bond Prices HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES Bond prices rise as interest rates fall. Increased money demand will increase interest rates. HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY (cont’d) 14.3

14. 14-14 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy RISING INTEREST RATES DURING AN ECONOMIC RECOVERY APPLYING THE CONCEPTS #2: What happens to interest rates when the economy recovers from a recession? Economists have often noticed that as an economy recovers from a recession, interest rates start to rise. Some observers think this is puzzling because they associate higher interest rates with lower output. Why should a recovery be associated with higher interest rates? The simple model of the money market helps explain why interest rates can rise during an economic recovery. One key to understanding this phenomenon is that 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. Another factor is that the Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy. In this case, the Fed cuts back on the supply of money to raise interest rates. In both cases, however, the public should expect rising interest rates during a period of economic recovery and rapid GDP growth. A P P L I C A T I O N 2

15. 14-15 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy  FIGURE 14.5 The Money Market and Investment Spending INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14.4 The equilibrium interest rate r* is determined in the money market. At that interest rate, investment spending is given by I*.

16. 14-16 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy  FIGURE 14.6 Monetary Policy and Interest Rates As the money supply increases, interest rates fall from r 0 to r 1. Investment spending increases from I 0 to I 1. INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14.4

17. 14-17 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy  FIGURE 14.7 Money Supply and Aggregate Demand When the money supply is increased, investment spending increases, shifting the AD curve to the right. Output increases and prices increase in the short run. INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14.4

18. 14-18 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14.4

19. 14-19 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy 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. INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14.4

20. 14-20 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy Monetary Policy and International Trade appreciation of a currency An increase in the value of a currency. INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d) 14.4

21. 14-21 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy Lags in Monetary Policy Influencing Market Expectations: From the Federal Funds Rate to Interest Rates on Long-Term Bonds MONETARY POLICY CHALLENGES FOR THE FED 14.5 Inside lags are the time it takes for policymakers to recognize and implement policy changes. Outside lags are the time it takes for policy to actually work. It is important to recognize that the Fed directly controls only very short-term interest rates in the economy, not long-term interest rates. For the Fed to control investment spending, it must also somehow influence long-term rates. It can do this indirectly by influencing short- term rates. The Fed also tries to influence long-term rates by influencing market expectations about future short-term interest rates and inflation.

22. 14-22 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy THE EFFECTIVENESS OF COMMITTEES APPLYING THE CONCEPTS #3: Is it better for decisions about monetary policy to be made by a single individual or by a committee? When Professor Alan Blinder returned to teaching after serving as vice-chairman of the Federal Reserve from 1994 to 1996, he was convinced that committees were not effective for making decisions about monetary policy. With another researcher, Blinder developed an experiment to determine whether in fact individuals or groups make better decisions. The results of the experiment showed that committees make decisions as quickly as, and more accurately than, individuals making decisions by themselves. Moreover, it was not the performance of the individual committee members that contributed to the superiority of committee decisions—the actual process of having meetings and discussions appears to have improved the group’s overall performance. In later research, Blinder also found that it did not really matter whether the committee had a strong leader. His findings suggest it is the wisdom of the group, not its leader, that really matters. And to the extent the leader has too much power—and the committee functions more like an individual than a group—monetary policy will actually be worse! A P P L I C A T I O N 3

23. 14-23 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy Looking Ahead: From the Short Run to the Long Run MONETARY POLICY CHALLENGES FOR THE FED (cont’d) 14.5 Monetary policy can affect output in the short run when prices are largely fixed, but in the long run changes in the money supply affect only the price level and inflation. In the long run, the Federal Reserve can only indirectly control nominal interest rates, and it can’t control real interest rates— the rate after inflation is figured in. In the next part of the book, we will explain how output and prices change over time, and how the economy makes the transition by itself from the short to the long run regardless of what the Fed does.

24. 14-24 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 14 The Federal Reserve and Monetary Policy 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 K E Y T E R M S