MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 14

C H A P T E R 14The 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 c

C H A P T E R 14

The Federal Reserve

and Monetary Policy

The Federal Reserve and

Monetary Policy

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

C H A P T E R 14

The Federal Reserve

and Monetary Policy

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

C H A P T E R 14

The Federal Reserve

and Monetary Policy

• money market

The market for money in which theamount supplied and the amountdemanded meet to determine thenominal 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

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 r0 to r1, the quantity of

money demanded falls from

M0 to M1.

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)

and real GDP shift

the demand for

money.

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 holdingstocks or bonds

THE MONEY MARKET (cont’d)

14.1

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 governmentbonds 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

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

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

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.

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)

14.3Changes in the supply of money will change interest rates.

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

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

A P P L I C A T I O N 2

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*.

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 r0 to r1 Investment spending increases

from I0 to I1.

INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (cont’d)

14.4

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

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

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

C H A P T E R 14

The Federal Reserve

and Monetary Policy

Monetary Policy and International Trade

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-short-term rates by

influencing market expectations about future short-term interest rates

and inflation.

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

A P P L I C A T I O N 3

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.

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

speculative demand for money transaction demand for money

K E Y T E R M S