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Transcript
Module 38(74) Monetary Policy and the Interest Rate Module Objectives What students will learn: • How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output • Why monetary policy is the main tool for stabilizing the economy Module Outline I.The Fed, the Money Supply, and the Interest Rate A. Definition: The target federal funds rate is the Federal Reserve’s desired federal funds rate. B. The Open Market Desk of the Federal Reserve Bank of New York adjusts the money supply through the purchase and sale of Treasury bills until the actual federal funds rate equals the target federal funds rate. C. If the actual federal funds rate is higher than the target rate, the Fed will increase the money supply by making an open-market purchase of Treasury bills, which will increase the money supply and push the money supply curve to the right, thereby lowering the interest rate. 181 182 module 38(74) monetary policy and interest rate D. If the actual federal funds rate is lower than the target federal funds rate, the Fed will decrease the money supply by making an open-market sale of Treasury bills, which will decrease the money supply and push the money supply curve to the left, thereby raising the interest rate. E. Long-term interest rates 1. Long-term interest rates do not always move with short-term interest rates. 2. Long-term interest rates reflect expectations concerning what is going to happen to short-term rates. If long-term rates are higher than short-term rates, the market expects short-term rates to rise. 3. Buying long-term bonds is more risky because if you are forced to sell a long-term bond early, you may not receive the price you were expecting. II.Monetary Policy and Aggregate Demand A.Expansionary and contractionary monetary policy 1. Definition: Expansionary monetary policy is monetary policy that increases aggregate demand. 2. Expansionary monetary policy reduces the interest rate, causing the aggregate demand curve to shift to the right, and so it is used to eliminate a recessionary gap. 3. Definition: Contractionary monetary policy is monetary policy that reduces aggregate demand. 4. Contractionary monetary policy increases the interest rate, causing the aggregate demand curve to shift to the left, and so it is used to eliminate an inflationary gap. B.Monetary policy in practice 1. Monetary policy is used to fight recessions and ensure price stability. 2. The Federal Reserve tends to raise interest rates when the output gap is positive and rising, and lower interest rates when the output gap is falling and negative. module 38(74) monetary policy and the interest rate C. The Taylor rule method of setting monetary policy 1. Definition: A Taylor rule for monetary policy is a rule that sets the federal funds rate according to the level of the inflation rate and either the output gap or the unemployment rate. 2. Monetary policy, rather than fiscal policy, is the main tool of stabilization policy. D.Inflation targeting 1. Definition: Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy to hit that target. 2. In 2012, the Federal Reserve announced an inflation target of 2%. 3. Inflation targeting is based on a forecast of inflation, whereas the Taylor rule method adjusts monetary policy in response to past inflation. 4. The advantages of inflation targeting are transparency and accountability. The disadvantage is that it can be too restrictive when some other goal takes priority over achieving the inflation target. E. The zero lower bound problem 1. The Taylor rule successfully predicted monetary policy from 1998 to 2008. After this time the rule suggested a negative interest rate. 2. Definition: The zero lower bound for interest rates means that interest rates cannot fall below zero. 3. Interest rates cannot be negative because you can always hold cash, which has a zero interest rate and is therefore better than a negative interest rate. Teaching Tips Monetary Policy and Aggregate Demand Creating Student Interest Ask students why the Federal Reserve would take action to reduce interest rates. Most students at this point will be able to recognize that lower interest rates will stimulate spending and output. Ask students if lower interest rates will necessarily increase spending and output. This question is more difficult because you are trying to get them to realize that the Federal Reserve has limited power. Interest rates can fall, but only to zero. What happens if people still do not want to spend? This is a nice introduction to the problem of the zero lower bound. Now ask students why the Fed would take action to increase interest rates. Remind students that more spending and output are good for the economy because unemployment is lower, but in the long run too much spending can lead to higher inflation. Presenting the Material This module can be divided into three topics: how the Fed adjusts the money supply to target the federal funds rate, how a change in the interest rate will influence aggregate demand, and finally a discussion of how the Fed decides when to increase or decrease the target federal funds rate. Students should remember the discussion of open market operations from an earlier module. This earlier discussion used a balance sheet approach to explain how an open 183 184 module 38(74) monetary policy and the interest rate market purchase by the Fed will lead to an increase in bank reserves and eventually to an increase in the money supply as the excess reserves are lent out. The first part of this module uses the money market graph to explain the same concept and highlight the connection between changes in the money supply and interest rates. Students struggle with this concept, so take time to review the balance sheet approach and use the money market graph to explain what is happening. Students have already been exposed to the idea that changes in fiscal policy will shift the AD curve. The extension to monetary policy is fairly straightforward, but make sure students understand the process. Any shift in aggregate demand is based on the change in the interest rate causing a change in spending as borrowing changes. In the case of expansionary monetary policy, if banks elect not to lend and/or firms elect not to borrow, the process will break down. This leads into the zero lower bound discussion and an explanation of quantitative easing. Finish the presentation with a discussion of the Taylor rule and inflation targeting to highlight the Fed’s difficulty with knowing exactly what to do regarding a change in policy. You might also pull a recent Fed release and discuss what is in the report. Common Student Pitfalls • The target versus the market. Make sure students understand that interest rates are set by supply and demand in the money market. The fact that the Fed sets the interest rates does not mean that the money market does not function. The Fed sets a target federal funds rate and pursues that target by adjusting the supply of money so that the equilibrium interest rate equals the target it has set. • When the Fed can change monetary policy. Students may mistakenly believe that the Fed is restricted to altering monetary policy just eight times a year at its regularly scheduled meetings. This, however, is not the case. Sometimes the Fed has convened between its regularly scheduled meetings to adjust key monetary policy tools. This was true especially in 2001, when the Fed met and reduced the federal funds rate 10 times in an effort to circumvent a recession. • Money supply and aggregate supply. Students may mistakenly think that changes in the money supply affect aggregate supply. This misperception is most likely due to their seeing the word supply in each phrase. Emphasize to students that a change in the money supply affects key interest rates, such as the prime rate of interest paid by very large business borrowers, and mortgage interest rates paid by consumers. As a result, changes in the money supply affect consumer spending and business investment and therefore shift the aggregate demand curve, not the aggregate supply curve. Case Studies in the Text Economics in Action The Fed Reverses Course—This EIA reviews the Fed’s monetary policy decisions between 2004 and 2008. Ask students the following questions: 1. What monetary policy was the Fed pursuing prior to the summer of 2007? (Answer: generally raising interest rates) 2. What monetary policy did the Fed begin pursuing in 2007? (Answer: expansionary—decreasing the Federal funds rate) 3. Why did the Fed reverse course in 2007? (Answer: the crisis in financial markets) module 38(74) monetary policy and the interest rate What the Fed Wants, the Fed Gets—This EIA discusses the evidence regarding whether the Fed’s monetary policy actions lead to economic expansions or contractions. Ask students the following questions: 1. What relationship do the data show between interest rates and the state of the economy? (Answer: High interest rates are associated with an expanding economy and low interest rates are associated with a slumping economy.) 2. Why does this relationship hold? (Answer: Because the Fed raises interest rates to combat inflation when the economy expands and lowers interest rates to strengthen the economy when it is slumping.) 3. How did Christina Romer and David Romer determine whether or not monetary policy matters? (Answer: They looked at the effects of monetary policy decisions that were not made in response to the business cycle.) Activities You’re on the Federal Open Market Committee (15 minutes) Pair students and ask them to complete the following exercises. 1. Assume you are a member of the Federal Open Market Committee. The economic data indicate that inflationary pressures are growing. What policy would you recommend regarding the target federal funds rate? 2. How in practice can the Fed achieve the change in the target federal funds rate you recommended in answering question 1? 3. Illustrate your response to question 1 with a graph of the money market showing the impact of the policy you recommended to prevent inflation. Answers: 1. In an effort to reduce inflationary pressure in the economy, the Fed Open Market Committee should set a higher target level for the federal funds rate. Doing so will slow the economy down and reduce the upward pressure on wages and prices of goods and services. 2. In practice, the Fed Open Market Committee will sell U.S. Treasury bills to raise the actual federal funds rate until it equals the higher target federal funds rate. 3. 185 186 module 38(74) monetary policy and the interest rate Web Resources The following website provides data for selected interest rates provided by the Federal Reserve: http://www.federalreserve.gov/releases/h15/ Consider using the Federal Reserve’s Fed Challenge competition as the basis for a class activity. Information and resources are available on the New York Fed’s website: http:// www.newyorkfed.org/education/index.html