ECON 201 1st EditionFinal Exam Study Guide - Monetary policy- the actions the federal reserve takes to manage the money supply and interest rates to pursue macroeconomics policy goals- The goals of monetary policy- the fed has 4 main monetary policy goals that are intended to promote a well-functioning economy:o Price stabilityo High employmento Stability of financial markets and institutionso Economic growth- price stability- maintaining price, inflation (inflation rate measured as the percentage change in CPI)- high employment- the goal of high employment extends beyond the fed to other branches of thefederal government- stability of financial markets and institutions- when financial markets and institutions are not efficient in matching savers and borrowers, resources are lost- economic growth- policy makers aim to encourage stable economic growth because stable growth allows households and firms to plan accurately and encourage the long-run investment that is needed to sustain growth- monetary policy targets-o the fed tries to keep both the unemployment and inflation rates low, but it can’t affect either of these economic variables directly o the fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level- the demand for money- the money demand curve slopes downward because lower interest rates cause households and firms to switch from financial assets such as the U.S. treasury bills to money- money demand curve- all other things being equal, a fall in interest rate will increase the quantity of money demanded, vice versaThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- shifts in the money demand curve- changes in real GDP or the price level cause the money demand curve to shift- the impact on the interest rate when the fed increases money supply- households and firms will initially hold more money than they want, money supply (vertical line) shift right- the impact on the interest rate when the fed decreases money supply- households and firms will hold less money, money supply (vertical line) shift left- why do we need two models of the interest rate? The loanable funds model is concerned with the long-term real rate of interest, and the money market model is concerned with the short term nominal rate of interest- there are many different interest rates in the economy- for purposes of monetary policy, the fed has targeted the interest rate known as the federal funds rate- federal funds rate- the interest rate banks charge each other for overnight loans- the fed does not set the federal funds rate, but its ability to increase or decrease bank reserves quickly through open market operations keeps the actual federal funds rate close to the fed’s target rate- changes in interest rates will not affect government purchases, but they will affect the other 3 components of aggregate demand:o consumptiono investmento net exports- expansionary monetary policy- the federal reserve increasing the money supply and decreasing interest rates to increase real GDP- contractionary monetary policy- the federal reserve adjusting the money supply to increase interest rates to reduce inflation- bank creates money supply- federal reserve controls the bank by:o open market operationso discount rateo required reserve ratio- when the economy begins in a recession, an expansionary monetary policy causes aggregate demand to shift to the right, increasing real GDP and the price level. With real GDP back at its potential level, the fed can meet its goal of high employment- when the economy begins higher than potential GDP, a contractionary monetary policy causes aggregate demand to shift to the left, decreasing real GDP and the price level. With real GDP back at its potential level, the Fed can meet its goal of price stability- keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do, not completely eliminate recessions- the effect of a poorly timed monetary policy: the fed’s expansionary monetary policy results in too great an increase in aggregate demand during the next expansion, which causes an increase in the inflation rate- with monetary policy, it’s the interest rate – not the money – that counts - Expansionary policy-  FOMC orders an expansionary policy  the money supply increases and interest rates fall  investment, consumption, and net exports all increase  the AD curve shifts to the right  real GDP and the price level rise- Contractionary policy-  FOMC orders a contractionary policy  the money supply decreases and interest rates rise  investment, consumption, and net exports all decrease  the AD curve shifts to the left  real GDP and the price level fall- Effects of monetary policy on real GDP and the price level: expansion monetary policyo When the economy begins in equilibrium, without monetary policy, aggregate demand will shift right, which is not enough to keep the economy at full employment because long run aggregate supply has shifted righto The economy will be in short run equilibrium now, and by lowering interest rates, the Fed increases investment, consumption, and net exports sufficiently to shift aggregate demand right againo The economy will now again be in equilibrium, which is its full employment level, and a higher price level. The price level will be higher than it would have been if the fed had not acted to increase spending in the economy- Using monetary policy to fight inflation: contractionary monetary policyo when the economy begins in equilibrium with real GDP equal to potential GDP, potential GDP increases, as long run aggregate supply increased( went left)o the fed raised interest rates because it believed the housing boom was causing aggregate demand to increase too rapidly. Without the increase in interest rates, aggregate demand would have shifted right, and the new short run equilibrium would have occurred and real GDP would have been greater than potential GDPo the increase in interest rates resulted in aggregate demand increasing to the right and equilibrium occurring - some economists have argued that rather than use an interest rate as its monetary policy target, the fed should