Download Ch. 14

Frank & Bernanke
3rd edition, 2007
Ch. 14: Stabilizing the
Economy: The Fed
1
What is Demand for Money?

Demand for Money (Liquidity Preference)
The amount of wealth an individual chooses
to hold in the form of money.
 The portfolio allocation decision is made by
comparing return relative to risk.
 Risk can be reduced by diversifying the
portfolio.
 Most people choose to hold some wealth as
money.
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The Demand for Money
Money (currency + checking deposits)
is one of the assets a person, a
household, a business holds.
 The benefit of money is its acceptability
in paying debts (liquidity).
 The cost of money is the opportunity
cost of losing a return on other assets
one could hold.
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Demand for Money by K’s Restaurant
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Currently holding $50,000/day; Interest rate = 6%
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Two ways to reduce cash holdings:
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Increase cash pickups costing $500/yr; reduce cash holdings
by $10,000.
Use a computerized cash management service costing $800/yr
plus more cash pickups of $500/yr; reduce cash holdings by
$20,000
Benefit: .06(10,000) or .06(20,000)
Cost: $500 or $1,300.
What is the cash holdings? How do they change
when i = 8%?
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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
•Demand for money = $1,280
•To hold more money
•Sell stocks
•Credit card cash advance
$3,030
•To hold less money
•Buy stocks
•Reduce her credit card balance
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The Demand for Money

If the opportunity cost of holding money
increases, less money will be held in
portfolio.

The higher the nominal interest rate, the lower
is the demand for money.
The more the income, the more will be the
amount kept in money form: the higher will
be the demand for money.
 The higher the price level, the higher will
be the demand for money.
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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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Shifts in Money Demand
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Businesses hold more than half of the total
money stock.
Changes in real income (real GDP).
Changes in price level.
Technological change and sophisticated financial
markets have reduced the demand for money in
the U.S.
Changes in foreign holdings of USD.
Between 1960 and 2004 M1 as a percent of GDP
fell from 28% to 12%.
Psychological changes.
Seasonal changes.
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Foreign Holdings of USD
 More
than $300 billion in currency
circulating outside the U.S.
 Foreign citizens will hold dollars to
avoid the impact of high inflation.
 Foreign citizens will hold dollars to
protect against political instability.
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FOMC Decision
On March16, 2004 the FOMC declared that it
will keep the federal funds rate at 1.00%.
 On March 22, 2005, the FOMC raised the
federal funds rate to 2.75%.
 On March 21, 2007 the FOMC announced
 How does the Fed keep the federal funds
rate constant or lower or higher? What is the
connection of this interest rate to the money
supply?
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Money Supply
By engaging in open market operations,
the Fed increases (buy bonds) or
decreases (sell bonds) the amount of
money in the system.
 If the demand for money remains the
same, the action of the Fed affects the
federal funds rate.
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S up; D same => P down
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Equilibrium in the Market for Money
Explain how and why the market reaches equilibrium.
12
Equilibrium in the Market for Money
If at the existing interest rate, supply
exceeds demand, that means people
would like to hold less money than there is.
 How do people adjust their portfolios?
 They buy other assets with the excess
money in their checking accounts.
 The price of bonds (non-money assets)
goes up: interest rate goes down.
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Fed’s Control of Nominal Interest Rate
By buying or selling bonds, the Fed
increases or decreases the supply of
money in the system.
 Shifting the supply curve to the right or to
the left, lowers or raises the nominal
interest rate.
 The Fed directly affects the federal funds
rate.
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15
http://www.federalreserve.gov/newsevents/press/monetary/20090203a.htm
The Federal Funds Rate, 1970-2004
http://research.stlouisfed.org/publications/mt/page9.pdf
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The Fed Wants to Raise i
Fed sells bonds
 The money supply falls
 Creates a shortage of money
 People sell non-money assets
 Non-money asset prices fall and the
interest rate increases
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Interest Rates and Money Supply
The Fed cannot set the interest rate and
the money supply independently.
 The Fed controls the money supply by
controlling bank reserves.
 Bank reserves influence the federal funds
rate.
 Therefore, the federal funds rate reflects
the impact of open market operations.
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The Fed and Money Supply
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Second Way : Discount Window Lending
The lending of reserves by the Federal Reserve
to commercial banks
 Discount Rate (primary credit rate): The interest
rate that the Fed charges commercial banks to
borrow reserves.
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The Fed and Money Supply
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Third Way: Changing Reserve Requirements
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Set by the Fed
The minimum values of the ratio of bank deposits that
commercial banks are allowed to maintain
Lowering the reserve ratio increases the ability of banks
to make loans and therefore expand the money supply.
Increasing the reserve ratio reduces the ability of banks
to make loans and create money.
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The New Tools
http://www.federalreserve.gov/monetarypolicy/default.htm
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Fed Funds Rate vs. Prime

If Fed can affect the federal funds rate, why
should we care?
We might be interested in the interest rates on
CDs, mortgage rates, credit card interest
rates?
 Usually, interest rates all go hand in hand.
 When the Fed increases the federal funds rate,
banks increase their prime rates, too.
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Real and Nominal Interest Rates
If the amount of savings and
investments in an economy determine
the real interest rate, and real interest
rate is more important for the decisions
that will affect the wealth of the society,
why should we care what the Fed does?
 Because in the short run, prices are
constant, so inflation does not increase:
any change in nominal interest rates is
reflected in the real interest rate.
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Real and Nominal Interest Rates
Remember the Fisher Effect:
i=r+p
 If the expected inflation hasn’t changed but
the Fed has increased i, then r is also
increased.
 In the long run p adjusts and it is the savings
and investments that determine the real rate
of interest.
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The Federal Reserve
and Interest Rates
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Can the Fed Control the Real Interest
Rate?
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Long-run impact of Fed policy
 Prices
adjust to changing economic conditions.
 The real interest rate is determined by the balance
of savings and investment.
 The Fed has less effect on spending in the long
run.
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How much control does the Fed
have over spending?
The Fed has direct control over the federal
funds rate.
 The federal funds rate may influence, but
does not control other interest rates which
influence spending.
 The inability of the Fed to precisely control
other interest rates complicates monetary
policy.
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Aggregate Expenditures and the
Real Interest Rate
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Real interest rates and consumption
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Real interest rates and investment spending
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High real interest rates increases the incentive to save.
If savings increase, consumption decreases.
High real interest rates reduces consumption.
High real interest rates increases the cost of investment
spending.
The increased cost reduces profitability of investment
spending and investment falls.
High real interest rates reduces investment spending.
Real interest rates and NX
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R up => $ up => NX down
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Real Interest Rates and
Aggregate Demand
Y = C + I + G + NX
 C = 400 + 0.8(Y-T) - 200r
 I = 300 - 600r
 G = 250; T = 200; NX = 10
 Explain in words how this economy
operates.
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Solving for the Unknowns
If the real interest rate is 3%, find the
values of C, I, and Y for the previous
economy and draw the Keynesian cross
to show the Y.
 If the Fed has increased the real
interest rate to 5%, find the values of C,
I, and Y and show the new AD curve on
your graph.
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Fighting Recession
The Fed reduced the fed funds rate 11
times in 2001-2002.
 In the second half of 2000, the rate
stayed at 6.5%.
 In 2002, it had been 1.75% until Nov. 6
and the Fed decided to lower it further.
 What was the effect of Fed’s lowering of
interest rates on AD?
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The Fed Fights A Recession
Expenditure
line (r = 1%)
Planned aggregate expenditure PAE
• Multiplier = 5
• Output gap = 200
• Fed wants to
increase PAE by
200/5 = 40
• C = 1,010 – 1,000r
• 1% change in r will
change C by 10
• Reduce r to 0.01
Y = PAE
Expenditure line
(r = 5%)
F
A reduction in r shifts the
expenditure line upward
E
Recessionary gap
4,800
5,000
Y*
Output Y
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Fighting Inflation
From the middle of 1999 to the middle
of 2000, the Fed raised the fed funds
rate from 4.75% to 6.50%.
 At the beginning of 1977 the fed funds
rate was 4.5%. By the end of 1978 it
was 10%. A year later it was 13.75%.
By April 1980, it reached 17.6%.
 What happens to AD?
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Raising Interest Rates
From June 2004 to June 2005 the Fed
Funds Rate rose from 1.0% to 3.25%.
 Real GDP growth of nearly 6% in late
2003 and 4.4% in 2004 and a falling
unemployment rate to 5.6% in June 2004
indicated the possible emergence of an
expansionary gap.
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The Fed Fights Inflation
Planned aggregate expenditure PAE
Y = PAE
Expenditure
line (r = 5%)
E
G
Expenditure line
(r = 9%)
An increase in r shifts the
expenditure line downward
Expansionary gap
4,600 4,800
Y*
Output Y
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Inflation and the Stock Market
Inflation is watched very closely by the Fed.
 Any sign of inflation makes Fed increase
interest rates.
 Higher real interest rates slow down the
economy and lower future profits.
 Higher real interest rates lower the price of
bonds and shift the demand away from
stocks to bonds, lowering stock prices.
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Policy Reaction Function
If there is a pattern of policies adopted
under the same economic circumstances,
then we have a policy reaction function.
 For example, if there is a correlation
between low unemployment rates and lax
immigration policies and high
unemployment rates and strict
immigration policies, this can be shown
with an equation.
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Taylor Rule
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Taylor explained the behavior of the Fed as a
reaction to output gap and inflation.
If there is a positive, recessionary output gap,
the Fed wants to stimulate the economy.
If there is a negative, expansionary gap, the
Fed wants to slow down the economy.
The Fed also reacts to higher inflation by
raising the real interest rate and slowing
down the economy.
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Taylor Rule
r = 0.01 –0.5 [(Y* - Y)/Y*] + 0.5 π
How does the Fed react when inflation rises?
How does the Fed react when output gaps appear?
What will the real and nominal interest rates be given
different values?
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A Monetary Policy Reaction
Function for the Fed
Rate of inflation, p
Real interest rate set by Fed, r
0.00 (= 0%)
0.02 (= 2%)
0.01
0.03
0.02
0.04
0.03
0.05
0.04
0.06
Assume : r  0.04  1.0(p  0.02)
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An Example of a Fed
Policy Reaction Function
Real interest rate set by Fed, r
0.06
Fed’s monetary policy
reaction function
0.05
0.04
0.03
0.02
0.01
0.02
0.03
Inflation p
0.04
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