C h a p t e r fourteen © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn.

c h a p t e rc h a p t e r

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© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed.

Prepared by: Fernando & Yvonn Quijano

Monetary Policy

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What Is Monetary Policy?

Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives.

The Goals of Monetary Policy

The Fed has set four monetary policy goals that are intended to promote a well-functioning economy:

1. PRICE STABILITY

2. HIGH EMPLOYMENT

3. ECONOMIC GROWTH

4. STABILITY OF FINANCIAL MARKETS AND INSTITUTIONS

LEARNING OBJECTIVE1

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The Goals of Monetary Policy

PRICE STABILITY

What Is Monetary Policy?

14 - 1The Inflation Rate, 1952-2004

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Monetary Policy Targets

The Demand for Money

The Money Market and the Fed’s Choice of Targets

LEARNING OBJECTIVE2

14 - 2The Demand for Money

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Shifts in the Money Demand Curve

The Money Market and the Fed’s Choice of Targets

14 - 3Shifts in the Money Demand Curve

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How the Fed Manages the Money Supply: A Quick Review

Equilibrium in the Money Market

The Money Market and the Fed’s Choice of Targets

14 - 4The Impact on the InterestRate When the Fed Increasesthe Money Supply

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Equilibrium in the Money Market

The Money Market and the Fed’s Choice of Targets

14 - 5The Impact on Interest Rates When the Fed Decreasesthe Money Supply

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The Relationship between Treasury Bill Prices and Their Interest Rates

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LEARNING OBJECTIVE2

What is the price of a Treasury bill that pays $1,000 in one year, if its interest rate is 4 percent? What is the price of the Treasury bill if its interest rate is 5 percent?

4 100 x 000,1$

P

P

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A Tale of Two Interest Rates

Choosing a Monetary Policy Target

The Importance of the Federal Funds Rate

Federal funds rate The interest rate banks charge each other for overnight loans.

The Money Market and the Fed’s Choice of Targets

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The Importance of the Federal Funds Rate

The Money Market and the Fed’s Choice of Targets

14 - 6Federal Funds Rate Targeting, January 1995- July 2005

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How Interest Rates Affect Aggregate Demand

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways:

Consumption

Investment

Net exports

Monetary Policy and Economic Activity

LEARNING OBJECTIVE3

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Monetary Policy and Economic Activity

The Effects of Monetary Policy on Real GDP and the Price Level

Expansionary monetary policy The Federal Reserve’s increasing the money supply and decreasing interest rates in order to increase real GDP.

Can the Fed Eliminate Recessions?

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Monetary Policy and Economic Activity

Using Monetary Policy to Fight Inflation

Contractionary monetary policy The Fed’s adjusting the money supply to increase interest rates to reduce inflation.

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Monetary Policy and Economic Activity

A Summary of How Monetary Policy Works

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Monetary Policy and Economic Activity

Can the Fed Get the Timing Right?

14 - 9The Effect of a Poorly Timed Monetary Policy on the Economy

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The Taylor Rule

Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables.

Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap

A Closer Look at the Fed’sSetting of Monetary Policy Targets

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Should the Fed Target Inflation?

Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

A Closer Look at the Fed’sSetting of Monetary Policy Targets

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The Case for Fed Independence

The Case against Fed Independence

Is the Independence of theFederal Reserve a Good Idea?

LEARNING OBJECTIVE5

14 - 11The More Independent the Central Bank, the Lower the Inflation Rate

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Contractionary monetary policy

Expansionary monetary policy

Federal funds rate

Inflation targeting

Monetary policy

Taylor rule