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Chapter 8
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Introduction
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Focus of this chapter is monetary policy
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Examine how the central bank sets interest rates in order to
control aggregate demand
Begin with a description of the operation of central bank
policy (who, what, why, when, and how)
Central bank moves interest rates in response to deviations of
output and inflation from desired levels
 the Taylor rule
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Finally, discuss how the central bank decides how much
to move interest rates
8-2
The “Who” of Policy
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Both fiscal and monetary policy can be used to fine tune
the economy
Most short-run fine tuning is done with monetary policy
The “who” of stabilization policy = central bank
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In the U.S., the central bank is the Federal Reserve Bank
Formally, U.S. monetary policy is established by vote of the
Fed’s Open Market Committee (FOMC)
UK: interest rates by the Monetary Policy Committee of Bank
of England
BoE Governor has the casting vote in case of a tie
8-3
The “What” of Policy
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The CB sets the interest rate
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Base rate (UK) or Federal Funds Rate (US)
Rate at which banks borrow overnight from CB
Lower interest rates encourage greater investment
spending and greater spending on some consumption
goods, thus increasing AD
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Monetary policy works through AD
Monetary policy has little influence on AS
8-4
The “Why” of Policy
Central bank’s goals:
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2.
Maintain low inflation rates
Promote economic activity
Obvious conflict between these goals  Phillips Curve
Also conflict between CB’s preferences and capabilities
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Boosting economic activity does much more to enhance
economic welfare than does controlling inflation (except at
high inflation rates)
CB can stimulate economic activity in the SR but this only
causes inflation in the LR
This is because of different slopes of the SRAS and LRAS
Central banks focus on maintaining low inflation while
stabilizing economic activity around Y*  inflation targeting
8-5
“When” Policy Is Made
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FOMC meets every six weeks
BoE MPC: every month
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8 members, BoE Governor has tie-breaking vote
8-6
“How” Policy Is Implemented
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CB “sets” the interest rate
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Lowering interest rates means increasing the money supply
The increased money supply results, eventually, in increased
prices
 Chapter 10: money supply moves and the LM curve
8-7
Policy as a Rule
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Monetary policy rule: setting the interest rate reflecting
the current economic situation
Taylor Rule:
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
Yt  Yt  (1)


it  r   t   ( t   )   100 
*
Yt 

i → nominal interest rate
r* → real, “natural” rate of interest, corresponding to the real
interest rate we would observe if the economy were at the full
employment level of output
* → CB’s target rate of inflation
*
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*
8-8
Policy as a Rule
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

Y

Y
*
*
t
t

it  r   t   ( t   )   100 
*
Yt 

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If α and β are large, then the monetary rule dictates
aggressive responses to excess inflation and to businesscycle fluctuations
If α is large relative to β, then the monetary authority will
respond much more aggressively to inflation than it will
to the level of economic activity
The case of β=0 corresponds to pure inflation targeting
8-9
Interest Rates and Aggregate Demand
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Higher interest rates raise the
opportunity cost of purchasing
goods for investment and
consumption → reducing
demand
Ignoring all other elements that
affect aggregate demand, we
can write:
[Insert Figure 8-1 here]
Y  C (i )  I (i )  G  NX  AD(i ) (2)
 If the Fed raises interest rates, the
AD curve shifts to the left, as
shown in Figure 8-1
 Higher interest rates lower prices,
but also reduce economic activity
8-10
Calculating How to Hit the Target
[Insert Box 8-3 here]
8-11