Frank & BernankeFrank & Bernanke

Ch. 14: Stabilizing Aggregate Demand: The Role of the Fed

http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040316/default.htm

FOMC DecisionFOMC DecisionOn March16, 2004 the FOMC declared that

it will keep the federal funds rate at 1.00%.On March 22, 2005, the FOMC raised the

federal funds rate to 2.75%.How does the Fed keep the federal funds

rate constant or lower or higher? What is the connection of this interest rate to the money supply?

Money SupplyMoney SupplyBy engaging in open market operations, the

Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system.

If the demand for money remains the same, the action of the Fed affects the federal funds rate.

The Demand for MoneyThe Demand for MoneyMoney (currency + checking deposits) is

one of the assets a person, a household, a business holds.

The benefit of money is its acceptability in paying debts (liquidity).

The cost of money is the opportunity cost of losing a return on other assets one could hold.

The Demand for MoneyThe Demand for MoneyIf the opportunity cost of holding money

increases, less money will be held in portfolio.– The higher the nominal interest rate, the lower is

the demand for money.The more the income, the more will be the

amount kept in money form: the higher will be the demand for money.

The higher the price level, the higher will be the demand for money.

The Demand for MoneyThe Demand for MoneyNominal interestrate

Quantity of Money

Shifts in Money DemandShifts in Money DemandChanges in real income (real GDP).Changes in price level.Technological/institutional changes.Changes in foreign holdings of USD.Psychological changes.Seasonal changes.

Equilibrium in the Market for Equilibrium in the Market for MoneyMoney

Explain how and why the market reaches equilibrium.

Equilibrium in the Market for Equilibrium in the Market for MoneyMoney

If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is.

How do people adjust their portfolios?They buy “bonds” with the excess money in

their checking accounts.The price of bonds goes up: interest rate goes

down.

Fed’s Control of Nominal Fed’s Control of Nominal Interest RateInterest Rate

By buying or selling bonds, the Fed increases or decreases the supply of money in the system.

Shifting the supply curve to the right or to the left, lowers or raises the nominal interest rate.

The Fed directly affects the federal funds rate.

Fed Shifts the Money SupplyFed Shifts the Money Supply

Fed Funds Rate vs. PrimeFed Funds Rate vs. PrimeIf Fed can affect the federal funds rate, why

should we care because we might be interested in the interest rates on CDs, mortgage rates, credit card interest rates?

Usually, interest rates all go hand in hand.When the Fed increases the federal funds

rate, banks increase their prime rates, too.

Real and Nominal Interest Real and Nominal Interest RatesRates

If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does?

Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate.

Real and Nominal Interest Real and Nominal Interest RatesRates

Remember the Fisher Effect:i = r + f the expected inflation hasn’t changed but the

Fed has increased i, then r is also increased.In the long run adjusts and it is the savings

and investments that determine the real rate of interest.

Real Interest Rates and Real Interest Rates and Aggregate DemandAggregate Demand

Y = C + I + G + NXC = 400 + 0.8(Y-T) - 200rI = 300 - 600rG = 250; T = 200; NX = 10Explain in words how this economy

operates.

Solving for the UnknownsSolving for the UnknownsIf the real interest rate is 3%, find the values

of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y.

If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph.

Fighting Recession Fighting Recession

The Fed reduced the fed funds rate 11 times in 2001-2002.

In the second half of 2000, the rate stayed at 6.5%.

In 2002, it has been 1.75% until Nov. 6 and the Fed decided to lower it further.

What was the effect of Fed’s lowering of interest rates on AD?

Fighting InflationFighting Inflation

From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4.75% to 6.50%.

At the beginning of 1977 the fed funds rate was 4.5%. By the end of 1978 it was 10%. A year later it was 13.75%. By April 1980, it reached 17.6%.

What happens to AD?

Inflation and the Stock MarketInflation and the Stock Market

Inflation is watched very closely by the Fed.Any sign of inflation makes Fed increase

interest rates.Higher real interest rates slow down the

economy and lower future profits.Higher real interest rates lower the price of

bonds and shift the demand away from stocks to bonds, lowering stock prices.

Policy Reaction FunctionPolicy Reaction FunctionIf there is a pattern of policies adopted

under the same economic circumstances, then we have a policy reaction function.

For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation.

Taylor RuleTaylor Rule Taylor explained the behavior of the Fed as a

reaction to output gap and inflation. If there is a positive, recessionary output gap, the

Fed wants to stimulate the economy. If there is a negative, expansionary gap, the Fed

wants to slow down the economy. The Fed also reacts to higher inflation by raising

the real interest rate and slowing down the economy.

Taylor RuleTaylor Ruler = 0.01 –0.5 [(Y* - Y)/Y*] + 0.5 π

How does the Fed react when inflation rises?

How does the Fed react when output gaps appear?

What will the real and nominal interest rates be givendifferent values?