ModuleMonetaryPolicy and the Interest Rate

KRUGMAN'SMACROECONOMICS for AP*

31

Margaret Ray and David Anderson

What you will learnWhat you will learn

in thisin this ModuleModule::

• How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output

• Why monetary policy is the main tool for stabilizing the economy

Jim Cramer’s Pleas to Ben Bernanke

The Fed Reverses Course

Monetary Policy and the Interest Monetary Policy and the Interest Rate: Targeting the Fed Funds RateRate: Targeting the Fed Funds Rate

Expansionary Monetary PolicyExpansionary Monetary Policy

The EconomyThe Economy

The Money Market

The Money Market

Contractionary Monetary PolicyContractionary Monetary Policy

The EconomyThe Economy

The Money Market

The Money Market

Fed Policy Fed Policy andand the Output Gap the Output Gap

• The Federal Reserve engages in expansionary monetary policy (they lower the interest rate) when the output gap (the difference between potential RGDP and actual GDP) becomes negative.

• The Federal Reserve engages in contractionary monetary policy (they raise the interest rate) when the output gap becomes positive. Stanford Economist, John Taylor

Fed Policy Fed Policy andand the Inflation Rate the Inflation Rate

• The Federal Reserve engages in expansionary monetary policy (they lower the interest rate) when the inflation rate falls.

• The Federal Reserve engages in contractionary monetary policy (they raise the interest rate) when the inflation rate rises. Stanford Economist, John Taylor

Monetary Policy in PracticeMonetary Policy in Practice

• Stanford economist John Taylor proposes that the Fed follow a rule

• Fed Funds = ...

• 1+(1.5 X π%)+(0.5 X Output Gap)

**(π%) represents the inflation rate

Stanford Economist, John Taylor

Monetary Policy in PracticeMonetary Policy in Practice

• In practice it appears that the Fed does follow the Taylor rule.

• The Taylor rule reflects more closely what the Fed actually does with the Federal Funds rate

Stanford Economist, John Taylor

Inflation TargetingInflation Targeting

•The Fed tries to keep inflation low but positive

•The Fed does not explicitly commit itself to a particular rate of

inflation

•Inflation Targeting (setting a target inflation rate or range) is

the policy of other countries’ central banks

•Pros of inflation targeting argue that it makes Fed policy more

transparent and keeps the Fed accountable

•Opponents argue that it limits the Fed to dealing only with

inflation when there may be other concerns