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Stabilizing The
Economy: The Role
Of The Fed
Principles of Macroeconomics
Dr. Gabriel X. Martinez
Ave Maria University
The Central Bank
and Interest Rates
 How do we deal with recessions? How do
we deal with inflation?
 Monetary policy is more flexible than fiscal
policy.
 Controlling the money supply is the primary task
of Central Banks.
 The supply of money determines the interest
rate, given the demand for money.
Copyright c 2004 by The McGraw-Hill
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
2
Monetary Policy
 “The term "monetary policy" refers to the
actions undertaken by a central bank, such
as the Federal Reserve, to influence the
availability and cost of money and credit to
help promote national economic goals.”
http://www.federalreserve.gov/fomc/.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
3
Monetary Policy
 Monetary Policy is indirect.
 Lower interest rates increase investment, which
increases PAE, which increases Y.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
4
Monetary Policy
 In January 2001, there were signs of a
recessionary gap, so the Fed took these actions:
January 2001 – drop rate to 6.00 percent*
March 2001 – drop rate to 5.00 percent
April 2001 – drop rate to 4.50 percent*
May 2001 – drop rate to 4.00 percent
June 2001 – drop rate to 3.75 percent
August 2001 – drop rate to 3.50 percent
September 2001 – drop rate to 3.00 percent*
October 2001 – drop rate to 2.50 percent
November 2001 – drop rate to 2.00 percent
December 2001 – drop rate to 1.75 percent
Source: http://www.federalreserve.gov/
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
5
Current Monetary Policy
 On September 20, 2005, the Fed decided to raise its target
of the inter-bank rate (the Fed Funds rate) by 25 basis
points to 3.75%.
 3.75% is still much below the historical average (5.78%),
so policy is still expansionary.
 It’s likely that the Fed will continue to raise interest rates:
 “with appropriate monetary policy action, the upside and
downside risks to the attainment of both sustainable
growth and price stability should be kept roughly equal.
With underlying inflation expected to be contained, the
Committee believes that policy accommodation can be
removed at a pace that is likely to be measured.”
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
6
Current Monetary Policy
 When the Federal Reserve raises interest
rates, it raises the opportunity cost of
holding money.
 This discourages people from borrowing
money.
 Because much of investment is financed
from borrowing, investment slows down and
so does output.
Copyright c 2004 by The McGraw-Hill
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
7
The Demand for Money
The Demand for Money
 Demand for Money
 The amount of wealth an individual chooses to
hold in the form of money.
Cash
Money
Checking
Accounts
Wealth
Non-money
assets Bonds
Stocks
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
Collectables
9
Consuelo’s Balance Sheet
Assets
Cash
Liabilities
$80
Checking account
1,200
Shares of stock
1,000
Car (market value)
3,500
Furniture
Total
Student loan
Credit card balance
$3,000
250
500
$6,280
$3,250
Net Worth
$3,030
•Demand for money = $1,280
•To hold less money
•To hold more money
•Buy stocks
•Sell stocks
•Reduce credit card balance
•Get a Credit card cash advance
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
10
The Demand for Money
 The Demand for Money
 How much money to hold (demand for money)
is determined by the cost-benefit principle.
Benefit of holding money
used to make transactions
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vs.
Cost of holding money; the
opportunity cost of foregone
interest
Chapter 27: Stabilizing the
Economy: The Role of the Fed
11
The Demand for Money
 Example
 How much money should Kim’s restaurants
hold?
 Currently holding $50,000/day
 To reduce cash holdings by $10,000, she can
have the armored service come take the cash to
bank more often, which costs $500/yr.
 This comes out to a cost of 5%.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
12
The Demand for Money
 How much money should Kim’s
restaurants hold?
 Interest rate = 4%
 The cost of the armored service is 5%.
 Benefit < Cost.
 4% < 5%, so does not pay to get the armored
service more often.
 So she will hold $50,000 in cash.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
13
The Demand for Money
 How much money should Kim’s
restaurants hold?
 What if the interest rate = 6%?
 The cost of the armored service is 5%.
 Benefit > Cost.
 6% > 5%, so pays to get the service more
often.
 So she will hold $40,000 in cash.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
14
The Demand for Money
 How much money should Kim’s restaurant
hold?
 What if she can buy a computer system that
will reduce her cash holdings by another
$10,000, but at a cost of $700 per year?
 Not worth it if the interest rate is below 7%.
 If the interest rate = 8%,
 8% > 7%, so it pays to get the software.
 So she will hold $30,000 in cash.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
15
The Demand for Money
 Example
 How much money should Kim’s restaurant
hold?
Nominal
interest
rate i
 If the interest rate = 4%, hold $50,000 in cash
 If the interest rate = 6%, hold $40,000 in cash
 If the interest rate = 8%, hold $30,000 in cash
MD
Money M
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
16
Nominal interest rate i
The Demand for Money
8%
6%
4%
MD
30,000 40,000
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50,000
Chapter 27: Stabilizing the
Economy: The Role of the Fed
Money M
17
The Demand for Money
 Macroeconomic Factors that Affect the
Demand for Money
 The Cost of holding money
 The nominal interest rate (i)
 The quantity of money demanded is inversely related
to the nominal interest rate.
• i is the annual percentage increase in the nominal value of
a financial asset; also known as the market interest rate.”
 Recall money is a store of value. Bonds are also
stores of value, but bonds earn interest while money
doesn’t.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
18
The Demand for Money
Nominal interest rate i
Demand for money
is inversely related
to the nominal
interest rate (i)
MD
Money M
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
19
The Demand for Money
 The Benefit of holding money
 Real income or output (Y)
 An increase in real income will increase the demand
for money and vice versa
 Recall money is a medium of exchange. We
use it for transactions. Higher income means
more transactions will take place.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
20
The Demand for Money
 The Benefit of holding money
 The price level (P)
 The higher the price level, the greater the demand for
money and vice versa
 Since money is a medium of exchange and we
use it for transactions, higher prices mean more
money is needed per transaction.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
21
Nominal interest rate i
A Shift In The Money Demand
Curve
Shifts in MD
• Changes in Y & P
• MD will increase if Y or P
increase
• Technological changes
• Foreign demand
MD’
MD
Money M
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
23
The Demand for Money
 Economic Naturalist
 Why does the average Argentine hold more
U.S. dollars than the average US citizen?
 More than $300 billion in currency circulating outside
the U.S. (which is more than half the total amount
issued).
 Non-US citizens will hold dollars to avoid the impact
of high inflation.
 Non-US citizens will hold dollars to protect against
political instability.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
24
The Supply of Money
The Supply of Money
 The Supply of Money and Money Market
Equilibrium
 M = C + D = C + R/rD
 The Fed prints all the bills in the US.
 The Treasury mints the coins.
 The amount of currency (C + R) in existence is
independent of the interest rate.
 rD depends
• on the Fed’s required reserve ratio (independent of i)
• and on bank’s loan and deposit activity (depends on i).
We’ll ignore this.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
26
The Supply of Money
 The Supply of Money and Money Market
Equilibrium
 We’ll assume that
the Money Supply, C + R/rD,
is independent of the interest rate.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
27
Equilibrium in the
Market For Money
Nominal interest rate
Money supply curve, MS
i
i1
M
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
28
Equilibrium in the
Market For Money
Equilibrium in the
Market For Money
Nominal interest rate
Money supply curve, MS
i
E
Money demand curve, MD
M
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
30
Equilibrium in the
Market For Money
 People put some of their wealth in the form
of bonds.
 Bonds are attractive because they
pay interest.
 But they are not liquid: they can’t
use them to buy milk.
 So there’s a trade-off between
money and bonds.
 We reach equilibrium by changing the
interest rate.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
Source:
www.rainf
all.com/
posters/
WWI/cata
log11.htm
31
Equilibrium in the
Market For Money
 Suppose that the interest rate is below the
equilibrium interest rate.
 Then you’d rather hold more money …
 … actually, you’d rather hold more money
that what is actually available.
 What will happen?
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
32
Equilibrium in the
Market For Money
 If you want to hold more money, you’ve got
to sell bonds.
 As you sell bonds, the price of bonds goes
down.
$100
$ PB 
1 i
 As the price of bonds goes down, the
interest rate rises.
 This happens until the equilibrium i is
reached.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
33
Equilibrium in the
Market For Money
 Recap: If the interest rate is below the
equilibrium interest rate,
 People sell bonds in order to hold more
money.
 Bond prices fall, interest rates rise…
 Until equilibrium is reached.
$100
$ PB 
1 i
• This exact formula is only true for a one-period bond. For
more details, take ECO 342.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
34
Equilibrium in the
Market For Money
Nominal interest rate
Money supply curve, MS
i
E
If interest = i1
• Qmd > Qms
• People sell interest bearing
assets to hold more money
• Price of financial assets
falls and interest rates rise
i1
Money demand curve, MD
M
M1
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
35
Equilibrium in the
Market For Money
 Again,
 Suppose i1 < i. Then the opportunity cost of
holding money is low:
people’s
the
CB’s
>
quantity of money demanded money supply.
Wealth = Money + Bonds.
 If people want to hold more money, they want to
hold fewer bonds: the prices of bonds fall.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
36
Equilibrium in the
Market For Money
 Bond prices and interest rates are
inversely related.
 Suppose you buy a US government bond (i.e., a
debt of the US government) at $PB and hold it
until the government pays you back the full
amount (say, $100).
 Then your return is:
$100  $ PB

i
$ PB
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$100
$ PB 
1 i
Chapter 27: Stabilizing the
Economy: The Role of the Fed
37
Equilibrium in the
Market For Money
 If Md > MS, people want to hold fewer bonds.
They sell the bonds, and the prices of bonds
fall.
 If Bond Prices fall, interest rates rise.
 As interest rates rise, holding money
becomes less attractive and the quantity of
money demanded falls.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
38
Equilibrium in the
Market For Money
Nominal interest rate
Money supply curve, MS
i
E
If interest = i1
• Qmd > Qms
• People sell interest bearing
assets to hold more money
• Price of bonds falls and
interest rates rise
i1
Money demand curve, MD
M
M1
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
39
Nota Bene
 If i < equilibrium i,
 Md > MS.
 That is, the quantity demanded of money
exceeds the quantity supplied of money.
 There is “excess demand for money.”
 It is false to say “the demand for money is
above the supply of money.”
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
?
40
How the Central Bank Controls
the Nominal Interest Rate
The Central Bank
and Interest Rates
 The Fed controls the supply of money with
open-market operations.
 An open-market purchase of bonds by the
Fed will increase the money supply.
 An open-market sale of bonds by the Fed
will decrease the money supply.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
42
The Fed Lowers the
Nominal Interest Rate
Nominal interest rate
MS MS’
i
i’
E
F
The Fed wants to lower i
• Fed buys bonds
• The money supply increases
• Creates an excess supply of
money
• Trying to get rid of the excess
money, people buy interest
bearing assets
• Bond prices rise and interest rates
fall
MD
M
M’
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
43
The Central Bank
and Interest Rates
 Suppose the CB wants to lower i
 CB purchases bonds, gives money in return.
 The money supply rises.
 If interest rates don’t change, the quantity of money
demanded is lower than the quantity of money
supplied.
• People are holding more money (MS)
than what they want (MD)
 There is an excess supply of money
 People buy bonds to get rid of the excess of money.
 Bond prices rise and the interest rates fall.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
44
Nota Bene
 Why would people want to “get rid of excess
money”?
 Sounds rather un-capitalistic.
 Remember that
Money
≠
Income
≠
Wealth
 People are merely re-distributing their
wealth.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
45
The Central Bank
and Interest Rates
 Suppose the CB wants to raise i
 CB sells bonds, gets money in return.
 The money supply falls.
 If interest rates don’t change, the quantity of money
demanded is higher than the quantity of money
supplied.
• People are holding less money (MS)
than what they want (MD)
 There is an excess demand of money
 People sell bonds to get money.
 Bond prices fall and the interest rates rise.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
46
The Fed Lowers the
Nominal Interest Rate
Nominal interest rate
MS’ MS
i’
i
The Fed wants to raise i
• Fed sells bonds
• The money supply decreases
• Creates an excess demand for
money
• Trying to get back some money,
people sell interest bearing assets
• Bond prices fall and interest rates
rise.
F
E
MD
M’
M
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
47
The Central Bank
and Interest Rates
 It’s clear that the Fed has quite a bit of
control on the money supply.
 Through the money supply, it affects the
interest rate.
 In practice, the effects of monetary policy
are exerted through interest rates
 The public is more familiar with interest rates
than with “the money supply.”
 Interest rates can be monitored easily
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
48
The Central Bank
and Interest Rates
 Economic Naturalist
 What’s so important about the federal funds rate
(the inter-bank rate)?
 The CB controls the money supply by controlling
bank reserves.
 Bank reserves influence the inter-bank rate.
 Therefore, the inter-bank rate reflects the impact of
open market operations.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
49
The Central Bank
and Interest Rates
 The Fed takes actions that affect the Fed
Funds rate, but it does not set the rate.
 The federal funds rate is the rate of interest
that banks charge each other for very shortterm loans.
 The Fed does not set the federal funds rate.
It establishes the rate as a target then
manipulates the money supply to bring the
rate in line with the target.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
50
The Federal Funds
Rate, 1970-2002
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
51
Real Interest Rates
Monetary Policy
 Monetary Policy is indirect.
 Higher interest rates reduce investment and
consumption, which reduces PAE, which
decreases Y.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
53
Monetary Policy
 Monetary Policy and Investment.
 When the Federal Reserve raises interest rates,
it raises the cost of borrowing money.
 Because much of investment is financed from
borrowing, investment slows down and so does
output.
r
I
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
54
Monetary Policy
 Monetary Policy and Saving.
 When the Federal Reserve raises interest rates,
it raises the benefit of saving rather than
spending.
r
 Consumers defer their
consumption plans and save a
C
larger proportion of their income.
  higher interest rates reduce C, reduce PAE,
and reduce Y.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
55
Real Interest Rates
 Consumption decisions depend on the real
interest rate, not the nominal interest rate.
 Consumers who save care about their
purchasing power in the future: the stuff they
will be able to buy tomorrow.
 So we have to eliminate the effect of inflation.
r
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
C
56
Real Interest Rates
 Investment decisions depend on the real
interest rate, not the nominal interest rate.
 Firms that purchase capital care about the
productivity of the capital: the stuff they will
produce with their capital goods.
 So we have to eliminate the effect of inflation.
r
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
I
57
The Central Bank
and Interest Rates
 The Real Interest Rate
 The real interest rate = nominal interest –
inflation
r i - 
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
58
The Central Bank
and Interest Rates
 Can the CB Control the Real Interest Rate?
 The Fed controls the nominal interest rate.
interest rate
Nominal
Money supply
curve, MS
i
E
Money demand
curve, MD
Money
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
59
The Central Bank
and Interest Rates
 Inflation adjust slowly to changing
economic conditions.
 If the economy is experiencing an expansionary
gap, inflation will eventually rise.
 Workers will tire of working overtime and will demand
higher wages.
 If the economy is experiencing an recessionary
gap, inflation will eventually fall.
 Unemployment will encourage workers to accept
lower wages.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
60
The Central Bank
and Interest Rates
 But Inflation doesn’t jump when the CB
changes the interest rate.
 Suppose the CB changes i today.
 Expansionary or recessionary gaps will arise,
but only a while later (12 – 18 months).
 Meanwhile, inflation has remained roughly
unaffected.
 This means that a change in i changes r, the
real interest rate.
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Chapter 27: Stabilizing the
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61
The Central Bank
and Interest Rates
 The CB can Control the Real Interest Rate
in the short run.
 The Fed controls the nominal interest rate.
 But inflation adjust slowly to changing
economic conditions.
 Inflation does not adjust rapidly to changing
economic policies.
 Therefore, if the Fed changes the nominal
interest rate, the real rate will generally change
by the same amount in the short run.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
62
The Central Bank
and Interest Rates
 The CB can Control the Real Interest Rate
in the short run.
 The Fed controls the nominal interest rate.
 But inflation adjust slowly.
r i -
r  i  0
 Therefore, if the Fed changes the nominal
interest rate, the real rate will generally change
by the same amount in the short run.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
63
The Central Bank
and Interest Rates
 Short-run impact of CB policy
 Prices do not vary greatly in the short run.
 Changes in the money supply can change
nominal and real interest.
 Real interest influences consumption and
investment.
 CB’s ability to influence spending is strongest in
the short run.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
64
The Central Bank
and Interest Rates
 Long-run impact of CB policy
 Prices adjust to changing economic conditions.
 Changes in the money supply will be fully
reflected in inflation.
 The real interest rate is determined by the
balance of savings and investment, not by
monetary policy.
 The CB has less effect on spending in the long
run.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
65
The Effects of Federal Reserve
Actions on the Economy
The Effects of Federal Reserve
Actions on the Economy
 The Fed can control i and r in the short run.
 PAE is influenced by r.
 r affects I (and C).
 Lower r increases PAE
 Higher r reduces PAE
 The Fed can stabilize output and
employment.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
68
An Expansionary Monetary Policy
Eliminates A Recessionary Gap
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
Expenditure line
PAE = 950 + 0.8Y
E
An decrease in r increases I
(and C), which shifts the
expenditure line upward
F
960
950
Recessionary gap
45o
4,750 4,800
Output Y
Y*
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
69
The Effects of Federal Reserve
Actions on the Economy
 Planned Aggregate Expenditure and the
Real Interest Rate
 Real interest rates and investment spending
 High real interest rates increase the cost of
investment spending.
 The increased cost reduces profitability of investment
spending and investment falls.
 High real interest rates reduce investment spending.
I  I  b1Y  b2 r
P
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
70
The Effects of Federal Reserve
Actions on the Economy
 Planned Aggregate Expenditure and the
Real Interest Rate
 Real interest rates and consumption
 High real interest rates increase the incentive to
save.
 If savings increase, consumption decreases.
 High real interest rates reduce consumption.
C  C  c(Y  T )  ar
Copyright c 2004 by The McGraw-Hill
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
71
The Effects of Federal Reserve
Actions on the Economy
 Planned Aggregate Expenditure and the
Real Interest Rate
C  C  c(Y  T )  ar
I  I  b1Y  b2 r
P
PAE  C  I  G  NX
P


PAE  C  c(Y  T )  ar  I  b1Y  b2 r  G  NX
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
72
The Effects of Federal Reserve
Actions on the Economy
 Planned Aggregate Expenditure and the
Real Interest Rate


PAE  C  cT  I  G  NX  a  b r  c  b Y
PAE  C  c(Y  T )  ar  I  b1Y  b2 r  G  NX
2
Autonomous Expenditure
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
1
Induced
Expenditure
73
The Effects of Federal Reserve
Actions on the Economy
 Short-run Equilibrium Output and the Real
Interest Rate


PAE  C  cT  I  G  NX  a  b2 r  c  b1 Y
Y  PAE


Y  C  cT  I  G  NX  a  b2 r  cY

1
C  cT  I  G  NX   a  b2 r
Y
1  c  b1
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Chapter 27: Stabilizing the
Economy: The Role of the Fed

74
The Effects of Federal Reserve
Actions on the Economy
 Short-run Equilibrium Output and the Real
Interest Rate

1
C  cT  I  G  NX   a  b2 r
Y
1  c  b1

 Higher interest rates reduce equilibrium output
by making consumption and investment more
expensive.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
75
The Effects of Federal Reserve
Actions on the Economy
 Example
 Assume:
 C = 640 + .8(Y – T) – 400r
• – 400r : a 1% increase in r reduces C by 4
units
Copyright c 2004 by The McGraw-Hill
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
76
The Effects of Federal Reserve
Actions on the Economy
 Example
 Assume:
 IP = 250 – 600r
• – 600r : a 1% increase in r reduces I by 6
units
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
77
The Effects of Federal Reserve
Actions on the Economy
 Example
 Assume:
 C = 640 + .8(Y – T) – 400r
• – 400r : a 1% increase in r reduces C by 4 units
 IP = 250 – 600r
• – 600r : a 1% increase in r reduces I by 6 units
 G = 300
 NX = 20
 T = 250
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
78
The Effects of Federal Reserve
Actions on the Economy
 Example
 PAE = C + IP + G + NX
PAE  640  0.8(Y - 250) - 400r   250 - 600r   300  20
PAE  (640  0.8  250  400r )  (250  600r )  300  20  0.8Y
Autonomous spending depends on r
PAE  1010  1000r   0.8Y
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
Induced spending
depends on Y
79
The Effects of Federal Reserve
Actions on the Economy
 Example
 PAE = C + IP + G + NX
PAE  1010  1000r   0.8Y
Autonomous spending depends on r
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
80
The Effects of Federal Reserve
Actions on the Economy
 Example
 The real interest rate and short-run equilibrium
output
 Assume the Fed sets the r at 0.05 (5 percent)
PAE  1010  1000  0.05  0.8Y
PAE  1010  50  0.8Y
PAE  960  0.8Y
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
81
The Effects of Federal Reserve
Actions on the Economy
 Example
 Equilibrium occurs when Y = PAE
PAE  960  0.8Y
Y  PAE
Y  960  0.8Y
1
Y
960  5  960  4800
1 0.8
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
82
The Effects of Federal Reserve
Actions on the Economy
 Example
 Suppose r = 10%
PAE  640  0.8(Y - 250) - 400r   250 - 600r   300  20
PAE  1010  1000r   0.8Y
PAE  1010  1000  0.10  0.8Y
PAE  910  0.8Y
Y  PAE  910  0.8Y
1
Y
910  5  910  4550
1 0.8
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
83
The Effects of Federal Reserve
Actions on the Economy
Y

r
0
Y
5050
0.02
0.04
0.06
0.08
4950
4850
4750
4650
0.1
0.12
4550
4450

1
C  cT  I  G  NX   a  b2r 
1 c
Copyright c 2004 by The McGraw-Hill
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1
1010  1000r 
Y
1  0.8
Chapter 27: Stabilizing the
Economy: The Role of the Fed
84
Fighting Recession and
Overheating
Fighting Recession and
Overheating
 The CB fights a recession
 Assume Y* = 5000.
 If r = 5%, we found above that Y = 4800
  Recessionary gap of 200
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
86
Fighting Recession and
Overheating
 The CB fights a recession




 Recessionary gap of 200
The CB wants to increase Y by 200.
The mpc = 0.8, so the multiplier = 5
 It must increase C and I by 200/5 = 40
1
(I  C )  5  (I  C )
1 c
Y 200
(I  C ) 

 40
5
5
Y 
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
87
Fighting Recession and
Overheating
PAE  1010  1000r   0.8Y
 Every percentage point (0.01) decrease in r
increases PAE by 10.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
88
The Fed Fights A Recession
Y = PAE
Expenditure
line (r = 1%)
Planned aggregate expenditure PAE
• Multiplier = 5
• Output gap = 200
• Fed wants to
increase PAE by
200/5 = 40
• PAE = 1,010 –
1,000r
• 1% change in r will
change PAE by 10
• Reduce r from 5%
to 1% to increase
autonomous
spending by 40.
Expenditure line
(r = 5%)
F
E
Recessionary gap
4,800
Copyright c 2004 by The McGraw-Hill
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A reduction in r shifts the
expenditure line upward
5,000
Y*
Chapter 27: Stabilizing the
Economy: The Role of the Fed
Output Y
89
Fighting Recession and
Overheating
 Economic Naturalist
 The Fed cut the federal funds rate 23 times
between 1989 and 1992.
 Fed Funds Rate
• March, 1989 = 9.9%
• March, 1991 = 6.1%
• December, 1992 = 2.9%
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
90
Fighting Recession and
Overheating
 Economic Naturalist
 Why did the Fed cut the federal funds rate 23
times between 1989 and 1992?
 Recession begins in summer 1990
 Credit crunch
 But there was a very slow (“Jobless”) recovery
 The drastic cuts helped the economy get back on its
feet.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
91
Fighting Recession and
Overheating
 Suppose, instead, that output was above
potential output.
 Above potential output
 People work overtime
 Machines get worn out more quickly
 Resources are overstretched.
 Wages and prices are likely to rise if there’s
an expansionary gap: if inflation is perceived
as damaging, it will be fought.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
92
The Fed Prevents Inflation
Planned aggregate expenditure PAE
Y = PAE
Expenditure
line (r = 5%)
Expenditure line
(r = 9%)
E
G
An increase in r shifts the
expenditure line downward
Expansionary gap
4,600 4,800
Y*
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
Output Y
93
The Policy Reaction Function
The Policy Reaction Function
 If there’s a recessionary gap,
 The CB is likely to cut interest rates to
encourage higher spending and reduce
unemployment.
 In a recession, inflation is very low.
 Low inflation is associated with low interest
rates.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
95
The Policy Reaction Function
 “The Committee continues to believe that …
[there are] conditions that may generate
economic weakness in the foreseeable
future.”
 “The Federal Open Market Committee
decided today to lower its target for the
federal funds rate by 50 basis points to 4-1/2
percent.” (April 18, 2001)
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
96
The Policy Reaction Function
 If there’s an expansionary gap,
 The CB is likely to raise interest rates to
discourage spending and limit inflation.
 In an expansion, inflation is very high.
 High inflation is associated with high interest
rates.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
97
The Policy Reaction Function
 “The Committee remains concerned that increases
in demand will continue to exceed the growth in
potential supply, which could foster inflationary
imbalances that would undermine the economy's
record economic expansion. ”
 “The Federal Open Market Committee voted today
to raise its target for the federal funds rate by 25
basis points to 6 percent.” (March 21, 2000)
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
98
The Policy Reaction Function
 So there’s something of a stable relation
between interest rates and inflation.
 It is derived from the behavior of the CB.
 A rise in inflation leads to higher interest
rates.
 A fall in inflation leads to lower interest rates.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
99
A Policy Reaction
Function For The CB
CB’s policy reaction function
Real interest rate set by CB, r
0.06
0.05
0.04
0.03
0.02
0.01
Copyright c 2004 by The McGraw-Hill
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0.02
0.03
Inflation 
0.04
Chapter 27: Stabilizing the
Economy: The Role of the Fed
100
A Policy Reaction
Function For The CB
 Policy Reaction Function
 Describes how the action a policymaker takes
depends on the state of the economy.
 For example, the “Taylor Rule” says that
typically the Fed adjusts (or should adjust) the
interest rate to respond to output gaps and
inflation.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
101
A Policy Reaction
Function For The CB
 The Taylor rule
Y * - Y 
r  0.01 - 0.5
  0.5 
 Y* 
 The Fed responds to output gaps and
inflation:
 A positive output gap (a recession) leads the
Fed to lower real interest rates.
 An increase in inflation, causes the Fed to raise
real interest rates.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
102
A Policy Reaction
Function For The CB
Rate of inflation, 
Real interest rate set by Fed, r
0.00 (= 0%)
0.02 (= 2%)
0.01
0.03
0.02
0.04
0.03
r  r  g
0.04
r  0.02  
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
0.05
0.06
103
A Policy Reaction
Function For The CB
 If you are hold bonds with fixed interest
rates or if your income is comes from a
pension (and the benefits are fixed in
nominal terms)…
 you are really averse to inflation.
 You’d be ready to face a huge amount of
unemployment in exchange for low inflation.
 You’d be called “conservative” or “an
inflation hawk.”
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
104
A Policy Reaction
Function For The CB
 If you are worker whose wages are adjusted
for inflation, or if you are a business owner
and your income goes up when prices go
up…
 You’d be very averse to unemployment
 You’d be OK with higher levels of inflation.
 You’d be called “liberal” or an “inflation
dove.”
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
105
A Policy Reaction
Function For The CB
 A determinant of the Fed’s policy reaction
function is its objective for inflation.
 The slope of the reaction function indicates how
aggressively the Fed will pursue its target.
 A steep reaction function reflects a “conservative”
Central Banker, one who is less likely to tolerate
inflation.
 A flat reaction function reflects a “liberal” Central
Banker, one who is more likely to tolerate inflation.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
106
A Policy Reaction
Function For The CB
r  0.02  2
“conservative” policy
reaction function
Real interest rate set by CB, r
0.06
“liberal” policy reaction
function
0.05
0.04
0.03
0.02
0.01
Copyright c 2004 by The McGraw-Hill
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0.02
0.03
Inflation 
0.04
Chapter 27: Stabilizing the
Economy: The Role of the Fed
107
A Policy Reaction
Function For The CB
“conservative” policy
reaction function
Real interest rate set by CB, r
0.06
“liberal” policy reaction
function
0.05
0.04
r  0.02  
0.03
0.02
0.01
Copyright c 2004 by The McGraw-Hill
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0.02
0.03
Inflation 
0.04
Chapter 27: Stabilizing the
Economy: The Role of the Fed
108
What We’ve Learned
 The demand for money depends negatively
on interest rates and positively on output.
 If you graph it in a (money, interest rate) graph,
it’s downward sloping.
 The supply of money is determined by the
Central Bank.
 The nominal interest rate adjusts to make
QMS and QMD equal.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
109
What We’ve Learned
 Through open market operations (buying
and selling government bonds) the Central
Bank can change the quantity of money.
 Because MS shifts, the nominal interest rate
rises or falls.
 The Central Bank can use changes in the
nominal interest rate to affect output.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
110
What We’ve Learned
 Although the Central Bank only has direct
influence on the nominal interest rate, it also
affects the real interest rate because
inflation changes slowly.
 The Central Bank can fight a recession by
lowering real interest rates.
 This encourages C and I, raising PAE and Y.
 The Central Bank can prevent the economy
from overheating by raising real interest
rates.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
111
What We’ve Learned
 Central Banks typically reacts to inflation
with higher real interest rates. (By reducing
Y, they eventually reduce inflation.)
 They react to recessions with lower real
interest rates . (Which leads to higher Y.)
 There’s a Policy Reaction Function that tells
us that higher inflation leads to higher real
interest rates.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
112
By way of summary
 If inflation rises because there’s an
expansionary gap,
 The Fed reduces the money supply, making
i rise faster than inflation, which raises r.
 Higher r lowers PAE and Y.
 The expansionary gap is closed.
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Chapter 27: Stabilizing the
Economy: The Role of the Fed
113