Download ch25 - Index of

Economics: Theory Through Applications
25-1
This work is licensed under the
Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License.
To view a copy of this license,
visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to
Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA
25-2
Chapter 25
Understanding the Fed
25-3
Learning Objectives
•
When and why was the Federal Reserve System created in the U. S.?
•
Is the Federal Reserve System independent of the Executive and
Legislative Branches of the U.S. government?
•
How does our study of monetary policy apply to other Central Banks
around the world?
•
What is the link between the actions of the Fed and the state of the
economy?
•
What interest rate does the Fed target?
•
What components of aggregate spending depend upon the interest rate?
25-4
Learning Objectives
•
How do prices adjustment in the economy?
•
What are the effects of monetary policy on prices and inflation?
•
What is the Taylor Rule?
•
How does monetary policy operate in an open economy?
•
How does monetary policy in other countries influence the U.S. economy?
•
What do banks do?
•
What are the tools of the Fed?
25-5
Learning Objectives
•
What monetary policy did the Fed pursue during the Great Depression?
•
Why is stabilization of the economy through monetary policy so difficult?
25-6
Figure 25.1- The Links between Monetary
Policy and the State of the Economy
25-7
Figure 25.2 - The Monetary Transmission
Mechanism
25-8
Figure 25.3 - Target and Actual Federal
Funds Rate, 1971 - 2005
25-9
Figure 25.4 - Short-Term and Long-Term
Interest Rates
25-10
From Nominal Interest Rates to Real Interest
Rates
real interest rate  nominal interest rate  inflation rate
25-11
Figure 25.5 - Real and Nominal Interest
Rates
25-12
Figure 25.6 - Real Interest Rates and
Spending on Durable Goods
25-13
Table 25.1 - Return on Investment
25-14
Discounted Present Value and Spending on
Durable Goods
discounted present value  year 1 profits 
year 2 profits
nominal interest factor
500
1.05
 500  476
 976.
 500 
25-15
Figure 25.7 - The Relationship between the Real
Interest Rate and Spending on Durable Goods
25-16
Figure 25.8 - Aggregate Spending Depends
Positively on Income
25-17
Figure 25.9 - An Increase in Real Interest
Rates Reduce Real GDP
25-18
Figure 25.10 - The Relationship between the
Real Interest Rate and Real GDP
25-19
Figure 25.11 - The Fed’s Influence on the Economy Depends
on the Real Interest Rate–Real GDP Relationship
25-20
Price Adjustment and Inflation
inflation rate  autonomous inflation  inflation sensitivity  output gap
output gap  potential real GDP  actual real GDP
25-21
Figure 25.12 - Price Adjustment
25-22
Figure 25.13 - Interactions among Interest
Rates, Output, and Inflation
25-23
Figure 25.14 - Completing the Circle of
Monetary Policy
25-24
Figure 25.15 - The Taylor Rule
25-25
Figure 25.16 - The Adjustment of Inflation
over Time
25-26
Figure 25.17
25-27
Figure 25.18 - The Market for Government
Bonds
25-28
Figure 25.19 - Intervention by the Federal
Reserve
25-29
Figure 25.20 - Intervention by the Federal
Reserve
25-30
Figure 25.21- An Increase in the Discount Rate
25-31
Figure 25.22- An Increase in Reserve Requirements
25-32
Figure 25.23 - Controlling the Economy
25-33
What Should the Fed Do When Its Goals Are
in Conflict?
1
1
real interest rate       output gap       inflation rate  4percent 
2
2
25-34
Key Terms
•
Monetary transmission mechanism: The monetary transmission
mechanism explains how the actions of the Federal Reserve Bank affect
aggregate economic variables, and in particular real GDP
•
Nominal interest rate: The nominal interest rate is the number of
additional dollars that must be repaid for every dollar that is borrowed
•
Real interest rate: The rate of return specified in terms of goods not
money
•
Investment: Investment is the purchase of new goods that increase the
capital stock, allowing an economy to produce more output in the future
25-35
Key Terms
•
Durable goods: Durable goods are goods purchased by households which
have long lifespan, such as cars and kitchen appliances
•
Arbitrage: Arbitrage is the act of buying and then selling an asset to make
a profit
– Arbitrage is usually carried out across two markets to profit from any
difference in prices
– The strict definition of arbitrage refers to buying and selling where there is no
risk
– A weaker meaning of arbitrage allows there to be risk associated with the
process
25-36
Key Terms
•
Maturity: The term in which an asset comes due
•
Fisher equation: According to the Fisher equation, the real interest rate
is approximately equal to the nominal interest rate minus the rate of
inflation
•
Discounted present value: Discounted present value is a device for
measuring flows that occur over time
– It tells you the value of something you will receive in the future, discounted
back to the present
•
Aggregate expenditure model: The aggregate expenditure framework
studies the relationship between planned spending and output
25-37
Key Terms
•
Multiplier: The multiplier equals one divided by one minus the marginal
propensity to spend and is key to understanding how a change in
autonomous spending effects output in the aggregate expenditures model
•
Inflation rate: The growth rate of the price index from one year to the
next is a measure of the inflation rate
•
Price level: The price level is a measure of average prices in the economy
•
Price adjustment equation: The price-adjustment equation described
how prices adjustment in response to the output gap, given autonomous
inflation
25-38
Key Terms
•
Output gap: The output gap is the difference between potential and
actual output
•
Deflation: A sustained decrease in the price level
•
Taylor rule: A rule for monetary policy in which the target real interest
rate increases when inflation is too high and decreases when output is too
low
25-39
Key Terms
•
Foreign exchange market: A foreign exchange market is where one
currency is traded for another
•
Exchange rate: An exchange rate is the price of one currency in terms of
another
•
Net exports: Net exports equals exports minus imports
25-40
Key Terms
•
Reserves: Deposits received by a bank that it must set aside rather than
loan to firms and households
•
Reserve requirements: The reserve requirements are the deposits
received by a bank that it must set aside rather than loan to firms and
households
•
Open market operations: Open market operations are purchases and
sales of government debt by a central bank
•
Discount rate: The discount rate is the interest rate paid by banks on
loans from the Fed
25-41
Key Takeaways
•
The Federal Reserve System of the United States was created in 1913
– A key motivation for the creation of a Central Bank was to manage the stock of
currency and thus influence the state of the aggregate economy, particularly
output and prices
•
In the United States, the Central Bank is independent: decisions about
monetary policy are made within the Federal Reserve System
– Still members of the Board of Governors of the Federal Reserve System
(http://www.federalreserve.gov/aboutthefed/section%2010.htm) are
nominated by the President and approved by the Senate
25-42
Key Takeaways
•
There are Central Banks around the world, conducting monetary policy
with essentially the same tools with the same basic model of the
aggregate economy in mind
•
The monetary transmission mechanism describes the links between the
actions of the Fed and the state of the aggregate economy
•
The Fed targets a short-term nominal interest rate that called the federal
funds rate
– The Fed does not set this rate directly but rather uses its tools to influence
this interest rate
25-43
Key Takeaways
•
The main components of spending that depend on the real interest rate
are spending by households on durable goods and investment
– When these components of spending are sensitive to the interest rate, then the
Fed can influence the economy through small variations in its target federal
funds rate
•
The price adjustment equation describes the dependence of price changes
(inflation) on the output gap, given the autonomous rate of inflation
•
Given prices, monetary policy influences the output gap
– Over time, prices adjust in response to the effects of monetary policy on the
output gap
25-44
Key Takeaways
•
The Taylor rule describes the dependence of the interest rate targeted by
the Fed on the rate of inflation and the output gap
•
In an open economy, interest rate changes induced by monetary policy
influence exchange rates and thus net exports
•
Actions by monetary authorities in other countries influence the net
exports of the U.S. through exchange rate changes and through the level
of aggregate spending on the U.S. by households in other countries
•
Banks act as intermediaries, taking the deposits of households and making
loans to firms and households who wish to borrow
– Banks also borrow from other banks and from the Fed
25-45
Key Takeaways
•
The main tools of the Fed are: (i) open market operations, (ii) lending at
the discount rate to member banks and (iii) setting the reserve
requirements on member banks
•
Despite the large reduction in aggregate economy activity and the
deflation during the Great Depression, the Fed did not pursue a very
aggressive policy
– The effectiveness of the Fed was hampered by the unwillingness of households
to deposit funds in banks and the unwillingness of banks to make loans
25-46
Key Takeaways
•
The conduct of monetary policy is made difficult by uncertainty over the
current state of the economy and the inexact nature of the effects of
interest rates on real GDP and prices
25-47