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Macroeconomics: Principles, Applications, and Tools
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O’Sullivan, Sheffrin, Perez
6/e.
Macroeconomics: Principles, Applications, and Tools
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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O’Sullivan, Sheffrin, Perez
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O’Sullivan, Sheffrin, Perez
Macroeconomics: Principles, Applications, and Tools
The Federal Reserve and
Monetary Policy
Little did Ben S. Bernanke know when he
took over the reins as chairman of the
Federal Reserve on February 1, 2006, that
he would face a novel and complex crisis
brought on by the fall in housing prices and
its reverberations throughout the entire
financial system in 2007 and 2008.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
APPLYING THE CONCEPTS
1
Why did the Federal Reserve introduce new mechanisms
for institutions to borrow money from it?
New Ways to Borrow from the Fed
2
What happens to interest rates when the economy
recovers from a recession?
Rising Interest Rates during an Economic Recovery
3
Is it better for decisions about monetary policy to be
made by a single individual or by a committee?
The Effectiveness of Committees
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14.1
THE MONEY MARKET
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
• money market
The market for money in which the
amount supplied and the amount
demanded meet to determine the
nominal interest rate.
The Demand for Money
INTEREST RATES AFFECT MONEY DEMAND
• transaction demand for money
The demand for money based on
the desire to facilitate transactions.
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14.1
THE MONEY MARKET
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
The Demand for Money
P R I N C I P L E O F O P P O RT U N I T Y C O S T
The opportunity cost of something is what you sacrifice to get it.
 FIGURE 14.1
Demand for Money
As interest rates increase
from r0 to r1, the quantity of
money demanded falls from
M0 to M1.
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14.1
THE MONEY MARKET
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
The Demand for Money
THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income— its purchasing
Macroeconomics: Principles, Applications, and Tools
power—not the face value of money or income.
 FIGURE 14.2
Shifting the
Demand for Money
Changes in prices
and real GDP shift
the demand for
money.
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14.1
THE MONEY MARKET
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
The Demand for Money
OTHER COMPONENTS OF MONEY DEMAND
• illiquid
Not easily transferable to money.
• liquidity demand for money
The demand for money that represents
the needs and desires individuals and
firms have to make transactions on short
notice without incurring excessive costs.
• speculative demand for money
The demand for money that arises
because holding money over short
periods is less risky than holding
stocks or bonds.
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14.2
HOW THE FEDERAL RESERVE CAN
CHANGE THE MONEY SUPPLY
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
Open Market Operations
• open market operations
The purchase or sale of U.S.
government securities by the Fed.
• open market purchases
The Fed’s purchase of government
bonds from the private sector.
• open market sales
The Fed’s sale of government
bonds to the private sector.
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14.2
HOW THE FEDERAL RESERVE CAN
CHANGE THE MONEY SUPPLY
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
Other Tools of the Fed
CHANGING RESERVE REQUIREMENTS
If the Fed wishes to increase the supply of money, it can reduce banks’ reserve
requirements so they have more money to loan out.
CHANGING THE DISCOUNT RATE
• discount rate
The interest rate at which banks
can borrow from the Fed.
• federal funds market
The market in which banks borrow
and lend reserves to and from one
another.
• federal funds rate
The interest rate on reserves
that banks lend each other.
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APPLICATION
1
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
NEW WAYS TO BORROW FROM THE FED
APPLYING THE CONCEPTS #1: Why did the
Federal Reserve introduce new mechanisms
for institutions to borrow money from it?
Banks might need funds but be reluctant to borrow
from the Fed, because the Fed is also their regulator and could become concerned
about the banks’ solvency. These concerns limit the amount banks wanted to borrow
from the Fed.
To provide more liquidity directly to the banking system, the Fed developed a number
of new ideas. The first was the Term Auction Facility, in which the Fed auctioned off
loans in the market to banks and other eligible depository institutions.
The next was a Term Securities Lending Facility that provided loans to 20 different
banks and financial institutions that were major dealers in government securities.
As a response to the deepening of the financial crisis in October 2008, the Fed also
developed two additional means of providing funding to the economy. The
Commercial Paper Funding Facility allows the Fed to indirectly purchase short term
corporate debt—commercial paper—from firms. In addition, the Fed developed the
Money Market Investor Funding Facility to provide a mechanism to support money
market funds that came under stress during the financial crisis in 2008.
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14.3
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
HOW INTEREST RATES ARE
DETERMINED: COMBINING THE
DEMAND AND SUPPLY OF MONEY
 FIGURE 14.3
Equilibrium in the
Money Market
Equilibrium in the money
market occurs at an
interest rate of r*, at
which the quantity of
money demanded equals
the quantity of money
supplied.
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.3
HOW INTEREST RATES ARE
DETERMINED: COMBINING THE
DEMAND AND SUPPLY OF MONEY
 FIGURE 14.4
Federal Reserve and Interest Rates
Changes in the supply of money will change interest rates.
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
14.3
HOW INTEREST RATES ARE
DETERMINED: COMBINING THE
DEMAND AND SUPPLY OF MONEY
Interest Rates and Bond Prices
HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT
BOND PRICES
Bond prices rise as interest rates fall.
GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR
BOND PRICES
Increased money demand will increase interest rates.
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
APPLICATION
2
RISING INTEREST RATES DURING AN
ECONOMIC RECOVERY
APPLYING THE CONCEPTS #2: What
happens to interest rates when the economy
recovers from a recession?
Economists have often noticed that as an economy recovers from a recession,
interest rates start to rise.
Some observers think this is puzzling because they associate higher interest rates
with lower output. Why should a recovery be associated with higher interest rates?
The simple model of the money market helps explain why interest rates can rise
during an economic recovery. One key to understanding this phenomenon is that the
extra income being generated by firms and individuals during the recovery will
increase the demand for money. Because the demand for money increases while the
supply of money remains fixed, interest rates rise.
Another factor is that the Federal Reserve itself may want to raise interest rates as
the economy grows rapidly to avoid overheating the economy. In this case, the Fed
cuts back on the supply of money to raise interest rates. In both cases, however, the
public should expect rising interest rates during a period of economic recovery and
rapid GDP growth.
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
 FIGURE 14.5
The Money Market and Investment Spending
The equilibrium interest rate r* is determined in the money market.
At that interest rate, investment spending is given by I*.
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
Macroeconomics: Principles, Applications, and Tools
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6/e.
C H A P T E R 14
The Federal Reserve
and Monetary Policy
 FIGURE 14.6
Monetary Policy and Interest Rates
As the money supply increases, interest rates fall from r0 to r1. Investment spending increases
from I0 to I1.
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
Macroeconomics: Principles, Applications, and Tools
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6/e.
C H A P T E R 14
The Federal Reserve
and Monetary Policy
 FIGURE 14.7
Money Supply and Aggregate Demand
When the money supply is increased, investment spending increases, shifting the AD curve to
the right. Output increases and prices increase in the short run.
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 14
The Federal Reserve
and Monetary Policy
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
Monetary Policy and International Trade
• exchange rate
The rate at which currencies
trade for one another in the
market.
• depreciation of a currency
A decrease in the value of a
currency.
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14.4
INTEREST RATES AND HOW THEY CHANGE
INVESTMENT AND OUTPUT (GDP)
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
Monetary Policy and International Trade
• appreciation of a currency
An increase in the value of a
currency.
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14.5
MONETARY POLICY CHALLENGES
FOR THE FED
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
Lags in Monetary Policy
Inside lags are the time it takes for policymakers to recognize and
implement policy changes. Outside lags are the time it
takes for policy to actually work.
Influencing Market Expectations: From the Federal
Funds Rate to Interest Rates on Long-Term Bonds
It is important to recognize that the Fed directly controls only very
short-term interest rates in the economy, not long-term interest rates.
For the Fed to control investment spending, it must also somehow
influence long-term rates. It can do this indirectly by influencing shortterm rates.
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The Federal Reserve
and Monetary Policy
APPLICATION
3
THE EFFECTIVENESS OF COMMITTEES
APPLYING THE CONCEPTS #3: Is it better for decisions
about monetary policy to be made by a single individual or
by a committee?
When Professor Alan Blinder returned to teaching after serving as vice-chairman of the
Federal Reserve from 1994 to 1996, he was convinced that committees were not
effective for making decisions about monetary policy. With another researcher, Blinder
developed an experiment to determine whether in fact individuals or groups make better
decisions.
The results of the experiment showed that committees make decisions as quickly as,
and more accurately than, individuals making decisions by themselves. Moreover, it
was not the performance of the individual committee members that contributed to the
superiority of committee decisions—the actual process of having meetings and
discussions appears to have improved the group’s overall performance.
In later research, Blinder also found that it did not really matter whether the committee
had a strong leader. His findings suggest it is the wisdom of the group, not its leader,
that really matters. And to the extent the leader has too much power—and the
committee functions more like an individual than a group—monetary policy will actually
be worse!
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14.5
MONETARY POLICY CHALLENGES
FOR THE FED
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 14
The Federal Reserve
and Monetary Policy
Looking Ahead: From the Short Run to the Long Run
Monetary policy can affect output in the short run
when prices are largely fixed, but in the long run
changes in the money supply affect only the price
level and inflation.
In the long run, the Federal Reserve can only
indirectly control nominal interest rates, and it can’t
control real interest rates—the rate after inflation is
figured in.
In the next part of the book, we will explain how
output and prices change over time, and how the
economy makes the transition by itself from the
short to the long run regardless of what the Fed
does.
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KEY TERMS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 14
The Federal Reserve
and Monetary Policy
appreciation of a currency
federal funds market
depreciation of a currency
federal funds rate
discount rate
illiquid
exchange rate
liquidity demand for money
money market
open market operations
open market purchases
open market sales
speculative demand for money
transaction demand for money
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