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Chapter
TwentySeven:
The Federal
Reserve and
Monetary Policy
Monetary Policy
Table 27.1: A Simplified Balance Sheet of the
Federal Reserve
Table 27.2: An Open Market Purchase of
Government Bonds by the Fed
Table 27.3: A Loan by ABC Bank Becomes a
Deposit in XYZ Bank
The Theory of Money, Interest Rates,
and Aggregate Demand
Figure 27.1a: The Market for Federal Funds
Federal Funds Rate
Supply of
Federal Funds
6%
E
Demand for
Federal Funds
Quantity of Federal Funds Borrowed and Lent
Figure 27.1b: An Open Market Purchase Lower the
Federal Funds Rate
Federal Funds Rate
Original Supply of
Federal Funds
New Supply of
Federal Funds
6%
5%
E0
E1
Demand for
Federal Funds
Quantity of Federal Funds Borrowed and Lent
Figure 27.2: Maintaining the Federal Funds Target Rate
Supply of Federal
Funds
Federal Funds Rate
A
E0
E1
Target Rate
5%
B
Demand for
Federal Funds
Quantity of federal funds borrowed and lent
Figure 27.3: The Federal Fund and Prime Rates
10
9
Interest Rate (%)
8
7
Prime Rate
6
5
4
3
2
1
Fed Funds Rate
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Federal Reserve Board, monthly data
Interest rate (r )
Figure 27.4: The Intended Investment Schedule
r0
r1
II
II0
II1
Intended Investment (II )
Interest rate (r )
Figure 27.5: An Increase in Investor Confidence
r
II’
II
I*
Intended Investment (II )
I**
Expansionary
monetary policy
Lowers
interest rates
Investment is
encouraged
Aggregate
demand rises
Equilibrium
GDP rises
Aggregate Demand and Output
Figure 27.6: Expansionary Monetary Policy and the
AD Curve
AD1 (with new, lower
E1
interest rate, r1)
AD0 (with old
interest rate, r0)
E0
45
Y0
Income
Y1
Monetary Policies in Practice
Figure 27.7a: Monetary Policy and Investment, 2000-2012
Federal Funds Rate (%)
7
6
5
4
3
2
1
0
2000
2002
2004
2006
2008
2010
2012
Figure 27.7b: Monetary Policy and Investment, 2000-2012
Private Fixed Investment
(billions of 2005 chained dollars)
1,800
Nonresidential Investment
1,600
1,400
1,200
1,000
800
Residential Investment
600
400
200
0
2000
2002
2004
2006
2008
2010
2012
Figure 27.8: Expansionary Monetary Policy in an
Environment of Pessimism
Interest rate (r )
II’
II
A
Original Target Rate
8%
B
5%
New Target Rate
I**
I*
Intended Investment (II)
Appendices
Price of Bonds (and
interest rate)
Figure 27.9a: The Market for Government Bonds
$ 100 (i = 5%)
Supply of
Bonds
E
Demand for
Bonds
Quantity of Bonds
Price of Bonds (and interest rate)
Figure 27.9b: The Market for Government Bonds
Supply of
Bonds
E1
$103 (i = 2%)
$ 100 (i = 5%)
E0
New Demand for Bonds
Original Demand for Bonds
Quantity of Bonds
Figure 27.10: The Federal Funds and Three-Month
Treasury Bill Rates, 2000-2012
7
Interest Rate (%)
6
5
3-month T-Bill
4
Fed Funds Rate
3
2
1
0
2000
2002
2004
2006
2008
2010
2012