Download Module 31 Lecture Notes

Module 31 Lecture Notes—
Module 31 builds on what you learned from Modules 28 and 29. In those units you learned how the models of
the money market and the loanable fund market are consistent and related. Specifically- in the short run the
interest rate is determined in the money market and loanable funds market adjusts in response to changes in the
money market.
However- we now will look at the LONG RUN. In the long run the interest rate is determined by matching
the supply and demand of loanable funds when real GDP equal potential output. We can use these models
to explain how the FED can use monetary policy to stabilize the economy in the short run.
Quick review: An increase in the money supply by
the Fed to M2 shifts MS curve to the right. This leads to a fall in interest rate from r1 to r2. The new interest rate
is now the only rate people are willing to hold the quantity of money supplied. The opposite happens when you
reverse the process. So, by adjusting the money supply up or down the FED can set the interest rate.
The FED uses the ∆MS to change the interest rate.
The Federal Open Market Committee sets the interest in between its next meetings. To move the interest rate
and stabilize the economy- they set a target federal funds rate. The target is enforced by the FOMC Bank of
New York which adjusts MS through open market operations.
*****The Federal Reserve of New York buys or sells Treasury bills until the actual federal funds rate equal the
target rate.*********
Usually the Fed adjusts the money supply to target a specific federal funds rate.
If the current federal funds rate is higher than the target, the Fed will increase the money supply so that the rate
falls to the target.
If the current federal funds rate is lower than the target, the Fed will decrease the money supply so that the rate
rises to the target.
If the economy is facing a recession, what might the FED do to combat it?
Expansionary Monetary Policy chain of events
The Fed observes that the economy is in a recessionary gap.
The Fed increases the money supply.
The interest rate falls.
Investment and consumption increase.
AD shifts to the right.
Real GDP increases, unemployment rate decreases, the aggregate price level rises.
What happens if the FED introduced Contractionary Monetary Policy? Can you draw the two models and
explain the sequence of events?
The Fed is not only concerned with the level of real GDP and whether the economy is producing a
full employment, but the Fed is also concerned with price stability.
The Fed also monitors inflation so that the economy doesn’t suffer unexpected spikes in the inflation rate.
In practice, this simply means that the Fed’s goals and policies are multifaceted. Some economists have
suggested that the Fed (and other central banks) operates with a monetary “rule” that dictates monetary policy.
The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the
inflation rate and the output gap.
The rule Taylor originally suggested was as follows:
Federal funds rate = 1 + (1.5 inflation rate) + (0.5 output gap)
Example: inflation is 3% and real GDP is 4% below potential GDP
FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 %
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One major difference between inflation targeting and the Taylor rule is that inflation targeting is forward- -looking rather than backward- -- looking. That is, the Taylor rule adjusts monetary policy in response to past
inflation, but inflation targeting is based on a forecast of future inflation.
****Advocates of inflation targeting argue that it has two key advantages, transparency and accountability.
*Transparency: Economic uncertainty is reduced because the public knows the objective of inflation -- targeting
central bank.
*Accountability: The central bank’s success can be judged by seeing how closely actual inflation rates have
matched the inflation target, making central bankers accountable.
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Monetary Policy and Aggregate Demand
Just as fiscal policy is used to stabilize the economy, monetary policy (changes in money supply or the interest
rate or both) can do the same thing.
Inflation targeting happens when the FED set an explicit target for the inflation rate and then sets monetary
policy in order to hit that target.
Study by Christina and David Romer shows that from 1952 and 1984 the unemployment rate (orange), and
identifies 5 dates on which the FED decided it wanted a recession to tame inflation (red lines). In 4 out 5 cases
the decision by the FED to contract the economy was followed by a rise in unemployment. On average the
unemployment rate rises by 2% after the FED decides that it needs to go up. The Fed does influence the
economy.