Chapter 10PreviewThe Federal Reserve and Monetary PolicyThe Monetary Policy CurveFIGURE 10.1 The Monetary Policy CurveThe Taylor Principle: Why the Monetary Policy Curve Has an Upward SlopeShifts in the MP CurveFIGURE 10.2 Shifts in the Monetary Policy CurvePolicy and Practice: Autonomous Monetary Easing at the Onset of the 2007-2009 Financial CrisisFIGURE 10.3 The Inflation Rate and the Federal Funds Rate, 2007-2010The Aggregate Demand CurveDeriving the Aggregate Demand Curve GraphicallyFIGURE 10.4 Deriving the AD CurveBox: Deriving the Aggregate Demand Curve AlgebraicallyFactors that Shift the Aggregate Demand CurveFIGURE 10.5 Shift in the AD Curve From Shifts in the IS CurveFactors that Shift the Aggregate Demand Curve (cont’d)FIGURE 10.6 Shift in the AD Curve From Autonomous Monetary Policy TighteningThe Money Market and Interest RatesLiquidity Preference and the Demand for MoneyLiquidity Preference and the Demand for Money (cont’d)Slide 22Demand Curve for MoneySupply Curve for MoneySlide 25Supply Curve for Money (cont’d)FIGURE 10.7 Equilibrium in the Money MarketEquilibrium in the Money MarketChanges in the Equilibrium Interest RateChanges in the Equilibrium Interest Rate (cont’d)FIGURE 10.8 Response to Shift in the Demand Curve from a Rise in IncomeFIGURE 10.9 Response to Shifts in the Supply Curve (a)FIGURE 10.9 Response to Shifts in the Supply Curve (b)Chapter 10 AppendixKeynesian Theories of Money DemandPutting the Three Motives TogetherPortfolio Theories of Money DemandPortfolio Theory and Keynesian Liquidity PreferenceOther Factors That Affect the Demand for MoneyOther Factors That Affect the Demand for Money (cont’d)Slide 41TABLE 10A1.1 Factors That Determine the Demand for MoneyEmpirical Evidence on the Demand for MoneySlide 44Copyright © 2012 Pearson Addison-Wesley. All rights reserved.Chapter 10Monetary Policy and Aggregate DemandCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-2Preview•To understand the positive relationship between real interest rates and inflation, which is called the monetary policy (MP) curve•To develop the aggregate demand curve using the monetary policy curve and the IS curveCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-3The Federal Reserve and Monetary Policy•The Fed of the United States conducts monetary policy by setting the federal funds rate—the interest rate at which banks lend to each other•Because the real interest rate is (Chapter 2), and if prices are sticky, changes in monetary policy does not immediately affect inflation and expected inflation•When the Federal Reserve lowers the federal funds rate, real interest rates fall; and when the Federal Reserve raises the federal funds rate, real interest rates rise. er i= - pCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-4The Monetary Policy Curve•The monetary policy (MP) curve shows how monetary policy, measured by the real interest rate, reacts to the inflation rate, :•The MP curve is upward sloping: real interest rates rise when the inflation rate rises where autonomous component of responsiveness of to inflationr rr rr= +l p=l =pCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-5FIGURE 10.1 The Monetary Policy CurveCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-6The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope•The key reason for an upward sloping MP curve is that central banks seek to keep inflation stable•Taylor principle: To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation, so that r rises when rises•Schematically, if a central bank allows r to fall when rises, then : ppad adr Y r Yp p p�������( =AD)adYCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-7Shifts in the MP Curve•Two types of monetary policy actions that affect interest rates:1. Automatic (Taylor principle) changes as reflected by movements along the MP curve2. Autonomous changes that shift the MP curve–Autonomous tightening of monetary policy that shifts the MP curve upward (in order to reduce inflation)–Autonomous easing of monetary policy that shifts the MP curve downward (in order to stimulate the economy)Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-8FIGURE 10.2 Shifts in the Monetary Policy CurveCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-9Policy and Practice: Autonomous Monetary Easing at the Onset of the 2007-2009 Financial Crisis•When the financial crisis started in August 2007, inflation was rising and economic growth was quite strong •The MP curve would have suggested that the Fed would continue to keep raising the federal funds rate•Instead the Fed lowered the federal funds rate•This reflects that the Fed pursued autonomous monetary policy easing, thus shifting the MP curve down, because the Fed perceived the economy to weaken in the near future due to the financial crisisCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-10FIGURE 10.3 The Inflation Rate and the Federal Funds Rate, 2007-2010Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-11The Aggregate Demand Curve•The aggregate demand curve represents the relationship between the inflation rate and aggregate demand when the goods market is in equilibriumCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-12Deriving the Aggregate Demand Curve Graphically •The AD curve is derived from:–The MP curve–The IS curve•The AD curve has a downward slope: As inflation rises, the real interest rate rises, so that spending and equilibrium aggregate output fallCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-13FIGURE 10.4 Deriving the AD CurveCopyright © 2012 Pearson Addison-Wesley. All rights reserved. 10-14Box: Deriving the Aggregate Demand Curve Algebraically•The numerical version of the AD curve can be derived from (1) the numerical IS curve from Chapter 9 , and (2) then substituting in for r from the numerical MP curve•Similarly, the general version of the AD curve can be derived by substituting in for r from the MP curve using the algebraic version of the IS curve in Chapter 9: ( 12 )Y r= -( 1.0 0.5 ) :r = + p12 (1.0 0.5 ) (12 1) 0.5 11 0.5Y = - + p = - - p =