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ECON 1202: CHAPTER 15
Monetary policy
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The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals.
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Goals of Monetary policy
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1) Price stability
2) High employment
3) Stability of financial markets and institutions
4) Economic growth
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Monetary tools
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Open market operations
discount policy
reserve requirements
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Monetary targets
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money supply
the interest rate
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Shifts in money demand curve
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Shift to left: a decrease in real GDP or a decrease in the price level
Shift to right: an increase in real GDP or a increase in the price level
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The money market model
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• Concerned with short-term nominal rate of interest
• Most relevant for the Fed: changes in money supply directly affect this interest rate
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Federal funds rate
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The interest rate banks charge each other for overnight loans
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How interest rate affect consumption
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Lower interest rates encourage buying on credit, which typically affects the sale of durables. Lower rates also discourage saving.
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How interest rates affect investment
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Lower interest rates encourage capital investment by firms:
• By making it cheaper to borrow (sell corporate bonds).
• By making stocks more attractive for households to purchase, allowing firms to raise funds by selling additional stock.
Also encourages new residential investment
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How interest rates affect net exports
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High U.S. interest rates attract foreign funds, raising the $US exchange rate, causing net exports to fall; and vice versa.
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Expansionary monetary policy
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The Federal Reserve's decreasing interest rates to increase GDP
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Contractionary monetary policy
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The Federal Reserve's increasing interest rates to reduce inflation.
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Keeping interests rate low for too long
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The Fed encourages real GDP to go far beyond potential GDP which means
• High inflation
• The next recession will be more severe
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Taylor Rule
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A rule developed by John Taylor that links the Fed's target for the federal funds rate to economic variables.
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Federal funds target rate formula
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Current inflation + ral equilibrium federal funds + (.5 X inflation gap) + (.5 X output gap)
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Inflation gap
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the difference between current inflation and a target rate
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Output gap
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the percentage difference between real GDP and potential GDP
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Inflation targeting
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Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.
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A bubble in the market
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A situation in which prices are too high relative to the underlying value of the asset.
Bubbles can form due to:
• Herding behavior: failing to correctly evaluate the value of the asset, and instead relying on other people’s apparent evaluations; and/or
• Speculation: believing that prices will rise even higher, and buying the asset intending to sell it before prices fall.
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Recent fed policies
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Creation of secondary market in mortgages
Investment banks participation is secondary market for mortgages
Feds loan up 200 billion of treasury securities in exchange for mortgage-backed securities
Congress passed the Troubled Asset Relief Program (TARP), providing funds to banks in exchange for stock—another
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