1Stabilizing The Economy: The Role Of The FedStabilizing The Economy: The Role Of The FedPrinciples of Macroeconomics Dr. Gabriel X. MartinezAve Maria UniversityChapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed22Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. How do we deal with recessions? How do How do we deal with recessions? How do we deal with inflation?we deal with inflation?Monetary policy is more flexible than fiscal Monetary policy is more flexible than fiscal policy.policy.Controlling the money supply is the primary task Controlling the money supply is the primary task of Central Banks.of Central Banks.The supply of money determines the interest The supply of money determines the interest rate, given the demand for money.rate, given the demand for money.The Central BankThe Central Bankand Interest Ratesand Interest RatesChapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed33Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Monetary PolicyMonetary Policy““The term "monetary policy" refers to the The term "monetary policy" refers to the actions undertaken by a central bank, such actions undertaken by a central bank, such as the Federal Reserve, to influence the as the Federal Reserve, to influence the availability and cost of money and credit to availability and cost of money and credit to help promote national economic goals.help promote national economic goals.””http://http://www.federalreserve.gov/fomcwww.federalreserve.gov/fomc//..Chapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed44Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Monetary PolicyMonetary PolicyMonetary Policy is Monetary Policy is indirectindirect..Lower interest rates increase investment, which Lower interest rates increase investment, which increases PAE, which increases Y.increases PAE, which increases Y.Chapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed55Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Monetary PolicyMonetary PolicyIn January 2001, there were signs of a In January 2001, there were signs of a recessionary gap, so the Fed took these actions:recessionary gap, so the Fed took these actions:January 2001 January 2001 ––drop rate to 6.00 percent*drop rate to 6.00 percent*March 2001 March 2001 ––drop rate to 5.00 percentdrop rate to 5.00 percentApril 2001 April 2001 ––drop rate to 4.50 percent*drop rate to 4.50 percent*May 2001 May 2001 ––drop rate to 4.00 percentdrop rate to 4.00 percentJune 2001 June 2001 ––drop rate to 3.75 percentdrop rate to 3.75 percentAugust 2001 August 2001 ––drop rate to 3.50 percentdrop rate to 3.50 percentSeptember 2001 September 2001 ––drop rate to 3.00 percent*drop rate to 3.00 percent*October 2001 October 2001 ––drop rate to 2.50 percentdrop rate to 2.50 percentNovember 2001 November 2001 ––drop rate to 2.00 percentdrop rate to 2.00 percentDecember 2001 December 2001 ––drop rate to 1.75 percentdrop rate to 1.75 percentSource: Source: http://http://www.federalreserve.govwww.federalreserve.gov//Chapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed66Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. CurrentCurrentMonetaryMonetaryPolicyPolicyOn September 20, 2005, the Fed decided to raise its target On September 20, 2005, the Fed decided to raise its target of the interof the inter--bank rate (the Fed Funds rate) by 25 basis bank rate (the Fed Funds rate) by 25 basis points to 3.75%.points to 3.75%.3.75% is still much below the historical average (5.78%), 3.75% is still much below the historical average (5.78%), so policy is still expansionary.so policy is still expansionary.ItIt’’s likely that the Fed will continue to raise interest rates:s likely that the Fed will continue to raise interest rates:““with appropriate monetary policy action, the upside and with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the With underlying inflation expected to be contained, the Committee believes that Committee believes that policy accommodation can be policy accommodation can be removedremovedat a pace that is likely to be measured.at a pace that is likely to be measured.””2Chapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed77Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. CurrentCurrentMonetaryMonetaryPolicyPolicyWhen the Federal Reserve raises interest When the Federal Reserve raises interest rates, it raises the opportunity cost of rates, it raises the opportunity cost of holding money.holding money.This discourages people from borrowing This discourages people from borrowing money.money.Because much of investment is financed Because much of investment is financed from borrowing, investment slows down and from borrowing, investment slows down and so does output.so does output.The Demand for MoneyThe Demand for MoneyChapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed99Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Demand for MoneyDemand for MoneyThe amount of wealth an individual chooses to The amount of wealth an individual chooses to hold in the form of money.hold in the form of money.The Demand for MoneyThe Demand for MoneyWealthMoneyNon-moneyassetsCashChecking AccountsBondsStocksCollectablesChapter 27: Stabilizing the Chapter 27: Stabilizing the Economy: The Role of the FedEconomy: The Role of the Fed1010Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. ConsueloConsuelo’’s Balance Sheets Balance SheetAssets LiabilitiesCash $80 Student loan $3,000Checking account 1,200 Credit card balance 250Shares of stock 1,000Car (market value)