Download ($Billions) i

Outline:
•How does the Fed change the interest rate?
•The monetary “transmission mechanism”
•Potential breakdowns of the transmission
mechanism.
•Brief review of the Fed policy record
Open Market Operations and the
Money Market
Interest
Rate
6%
Ms 1
Ms 2
E
F
4%
Fed open
market
operations bid
up the prices
of bonds, and
drive yields
down.
Md
0
500
800
Money
($Billions)
Fed “Pulls the String”
Interest
Rate
6%
Ms 1
Ms 2
E
F
4%
Fed open
market sale
depresses
bond prices,
and drives
yields upward.
Md
0
500
800
Money
($Billions)
Question: How is Fed policy
“transmitted” to macroeconomic
variables such as real GDP,
employment, and the general
price level?
Fed Open Market Purchase of Securities
Increase in the Money Supply
Decrease in the interest rate
Increase in components of spending that are
sensitive to interest rates—specifically,
investment and consumer durable goods
Multiplier Effect
Real GDP
Diagrammatic explanation of
the transmission mechanism
1
Y  (a  I ) 
1 b
p
i
6%
Ms 1
Ms 2
AE
a  I
AE2
AE1
p
4%
Md
0
450
M
0
Y1
Y2
Y
Breakdowns in the
Transmission Mechanism
Breakdowns include:
Some economists
(notably
Keynesians) are
skeptical about the
effectiveness of
expansionary
monetary policy
•
Non-responsiveness of
aggregate expenditure (AE) to
changes in the rate of interest.
•
The liquidity trap
Not interest-sensitive
i
The FED may be
successful in decreasing
interest rates. But what if
investment spending fails to
respond?
6%
4%
I2
I1
70 74
95
Investment
($Billions)
Interest
Rate
i*
0
Ms 1
Ms 2
At an interest rate
equal to or below i*,
wealth holders wish to
hold ALL money and
NO bonds.
Md
Money
($Billions)
The FOMC sets a
target for the “federal
funds” rate, which is
the rate that banks
charge other banks for
“borrowed” reserves.
The Fed pulled on the
string big time
beginning in 1979—it
was an anti-inflation
strategy under
Chairman Paul Volcker
20
Recessions are shaded
18
16
14
12
10
8
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
20
Recessions are shaded
Conventional 30 year
18
16
14
12
10
8
6
80
82
www.economagic.com
84
86
88
Mortgage Interest Rates
90
92
Monthly payments on a $110,000
30 year mortgage note
Mortgage
rate
Monthly
Payment1
8%
$807.14
10%
$965.33
12%
$1,131.47
14%
$1,303.36
16%
$1,479.23
1 Does
not include prorated insurance or
property taxes.
2400
Recessions are shaded
Data in thousands of units
2000
1600
1200
800
400
80
www.economagic.gov
82
84
86
88
Monthly Housing Starts
90
92
More recently, the
Fed raised the
federal funds rate six
times between May
99 and May 2000—
from 4.75% to 6.5
%.
The Fed reversed
course at the
beginning of 2001
7.0
6.5
6.0
5.5
5.0
4.5
99:01
99:07
00:01
Federal Funds
00:07
01:01