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Slide 14 - 0 Stabilizing Aggregate Demand: The Role of the Fed Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 1 Usefulness of Monetary Policy Monetary policy Can be changed quickly Is more flexible and responsive than fiscal policy Therefore, monetary policy is used more actively than fiscal policy to stabilize the economy Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 2 Money Supply and Interest Rates Changing the money supply Changes interest rates Nominal interest rate is the “price” of money Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 3 Forms of Money Money Refers to a set of assets Cash and checking accounts Is a type of financial asset Is a way of holding wealth Cash, government bonds, rare stamps, etc. Portfolio allocation decision The decision about the forms in which to hold one’s wealth Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 4 Demand for Money Demand for money The amount of wealth an individual chooses to hold in the form of money Businesses must also must decide how much money to hold Businesses hold more than half of the total money stock Cost-benefit criterion tells us that an individual should increase money holdings if the benefit of doing so exceeds the cost Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 5 Benefits of Holding Money Benefits of holding money Usefulness in making transactions Factors that affect the demand for money (note that credit cards have decreased the demand for money) Income Technological and financial innovation Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 6 Costs of Holding Money Costs of holding money Opportunity costs The interest that could have been earned by holding interest-bearing assets Bonds and stocks pay a positive nominal return Most forms of money pay little or no interest Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 7 Macroeconomic Factors Affecting Money Demand Nominal interest rate Affects the cost of holding money Real output Affects the benefits of money Price level Affects the benefits of money Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 8 Nominal Interest Rate A nominal interest rate (i) Determines the opportunity cost of holding money The higher the nominal interest rate The greater the opportunity cost of holding money and the less money demanded The nominal interest rate Some average measure of interest rates Thousands of different assets each with their own rate of return, or interest rate Rates tend to rise and fall together Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 9 Real Income or Output Y Real income or Output (Y) An increase in real income raises the quantity of goods and services that people and businesses want to buy and sell Higher transactions require more money to be held, increasing the demand for money Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 10 The Price Level (P) The higher the prices of goods and services, the more dollars that are needed to make a given set of transactions Higher transactions require more money to be held, thereby increasing the demand for money Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 11 Money Demand Curve Money demand curve Relates the aggregate quantity of money demanded M to the nominal interest rate i Because an increase in the nominal interest rate increases the opportunity cost of holding money, the money demand curve slopes downward Reducing the quantity of money demanded Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 12 Fig. 14.1 The Money Demand Curve Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 14.2 A Shift in the Money Demand Curve Slide 14 - 13 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 14 Equilibrium in the Money Market Federal Reserve System controls the U.S. money supply Quantity of money (M) is set by the Fed Equilibrium Occurs at the intersection of supply and demand Price is the nominal interest rate (i) Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 15 Fig. 14.3 Equilibrium in the Market for Money Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 16 Reaching Equilibrium Recall the inverse relationship between interest rates and bond prices If the nominal interest rates were too low The public’s quantity demanded for money is greater than the quantity supplied The public wants to hold more money So, they sell some of the interest-bearing assets Which depresses the price of bonds Which increases interest rates (i) As interest rates rise the quantity demanded of money falls and equilibrium results Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 17 How the Fed Controls the Nominal Interest Rate When the Fed changes the money supply The equilibrium nominal interest rate changes The Fed’s primary tool Open-market operations Buying bonds in order to increase the money supply Selling bonds in order to decrease the money supply Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 14.4 The Fed Lowers the Nominal Interest Rate Slide 14 - 18 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 14.5 The Fed Stabilizes the Interest Rate After an Increase in Money Demand Slide 14 - 19 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 20 Can the Fed Control the Real Interest Rate? By controlling the money supply The Fed controls the nominal interest rate However, important economic decisions depend on the real interest rate Decisions to save and invest Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 21 Controlling the Real Interest Rate Most economists believe the Fed can control the real interest rate Definition of the real interest rate: r=i–p The Fed can control the nominal interest rate (i) quite precisely Inflation (p) changes relatively slowly after policy changes Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 22 Controlling the Real Interest Rate in the LR Because inflation changes slowly Changing nominal interest rates causes real interest rates to change by the same amount However, in the long-run the real interest rate is determined by Balance of saving and investment Several years or more Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 23 Fig. 14.6 The Federal Funds Rate, 1970-2000 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 24 Federal Funds Rate The Fed targets the federal funds rate Interest rates tend to move together This causes other interest rates to change in the same direction There is not an exact relationship The Fed’s control of other interest rates is somewhat less precise than its control of the federal funds rate Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 25 Monetary Policy on the Economy Aggregate demand depends on the real interest rate A lower real interest rate encourages higher spending As the Fed changes the real interest rate it changes aggregate demand in the desired direction, thereby changing aggregate output and employment Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 26 AD and the Real Interest Rate Higher real interest rate Increases the reward for saving Increases in saving S Decreases consumption spending C Increases the cost of borrowing Decreases consumption spending C Cars cost more Decreases investment I Buying new machinery and homes cost more Lower real interest rates have the opposite effect Decreasing financing costs Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 27 Fed Fights a Recession Facing a recessionary gap Fed reduces real interest rates Stimulating C and I Increasing AD Increasing output and employment Expansionary monetary policy or monetary easing A reduction in interest rates by the Fed, made with the intention of reducing a recessionary gap Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 28 Fig. 14.7 The Fed Fights a Recession Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 29 Fed Fights Inflation Facing an expansionary gap Fed increases real interest rates Reducing C and I Decreasing AD Decreasing output and employment Contractionary monetary policy or monetary tightening An increase in interest rates by the Fed, made with the intention of reducing an expansionary gap Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 30 Fig. 14.8 The Fed Fights Inflation Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 31 Fed’s Policy Reaction Function Policy reaction function describes how the action a policymaker takes depends on the state of the economy Ideally policymakers should try to react in such a way as to optimize economic performance Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 14.9 An Example of a Fed Policy Reaction Function Slide 14 - 32 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 14 - 33 Art or Science? Manipulating the models overstates the precision of monetary policy The real world is complex and our knowledge of the economy is imperfect Fed policymakers only have an approximate idea of the effect of a given change in the real interest rate on AD, output, and employment The Fed proceeds cautiously avoiding large changes at any one time Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.