11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 14: Stabilizing the Ch. 14: Stabilizing the Economy: The FedEconomy: The Fed

22

What is Demand for Money?What is Demand for Money?Demand for Money (Liquidity Preference)Demand for Money (Liquidity Preference)

The amount of wealth an individual chooses The amount of wealth an individual chooses to hold in the form of money.to hold in the form of money.

The portfolio allocation decision is made by The portfolio allocation decision is made by comparing return relative to risk.comparing return relative to risk.

Risk can be reduced by diversifying the Risk can be reduced by diversifying the portfolio.portfolio.

Most people choose to hold some wealth as Most people choose to hold some wealth as money.money.

33

The Demand for MoneyThe Demand for Money

Money (currency + checking deposits) Money (currency + checking deposits) is one of the assets a person, a is one of the assets a person, a household, a business holds.household, a business holds.

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

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

44

Demand for Money by K’s RestaurantDemand for Money by K’s Restaurant Currently holding $50,000/day; Interest rate = 6%Currently holding $50,000/day; Interest rate = 6%

Two ways to reduce cash holdings:Two ways to reduce cash holdings: Increase cash pickups costing $500/yr; reduce cash holdings Increase cash pickups costing $500/yr; reduce cash holdings

by $10,000.by $10,000. Use a computerized cash management service costing $800/yr Use a computerized cash management service costing $800/yr

plus more cash pickups of $500/yr; reduce cash holdings by plus more cash pickups of $500/yr; reduce cash holdings by $20,000$20,000

Benefit: .06(10,000) or .06(20,000)Benefit: .06(10,000) or .06(20,000) Cost: $500 or $1,300.Cost: $500 or $1,300.

What is the cash holdings? How do they change What is the cash holdings? How do they change when i = 8%?when i = 8%?

55

Consuelo’s Balance SheetConsuelo’s Balance SheetAssets Liabilities

Cash $80 Student loan $3,000

Checking account 1,200 Credit card balance 250

Shares of stock 1,000

Car (market value) 3,500

Furniture 500

Total $6,280 $3,250

Net Worth $3,030

•Demand for money = $1,280•To hold more money

•Sell stocks•Credit card cash advance

•To hold less money•Buy stocks•Reduce her credit card balance

66

The Demand for MoneyThe Demand for Money

If the opportunity cost of holding money If the opportunity cost of holding money increases, less money will be held in increases, less money will be held in portfolio.portfolio.The higher the nominal interest rate, the lower The higher the nominal interest rate, the lower

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

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

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

77

A Shift In The Money Demand CurveA Shift In The Money Demand Curve

Money M

No

min

al in

tere

st r

ate

i

MD

MD’

Shifts in MD• Changes in Y & P

• MD will increase if Y or P increase

• Technological changes• Foreign demand

88

Shifts in Money DemandShifts in Money Demand Businesses hold more than half of the total Businesses hold more than half of the total

money stock. money stock. Changes in real income (real GDP).Changes in real income (real GDP). Changes in price level.Changes in price level. Technological change and sophisticated financial Technological change and sophisticated financial

markets have reduced the demand for money in markets have reduced the demand for money in the U.S.the U.S.

Changes in foreign holdings of USD.Changes in foreign holdings of USD. Between 1960 and 2004 Between 1960 and 2004 MM11 as a percent of GDP as a percent of GDP

fell from 28% to 12%.fell from 28% to 12%. Psychological changes.Psychological changes. Seasonal changes.Seasonal changes.

99

Foreign Holdings of USDForeign Holdings of USDMore than $300 billion in currency More than $300 billion in currency

circulating outside the U.S.circulating outside the U.S.Foreign citizens will hold dollars to Foreign citizens will hold dollars to

avoid the impact of high inflation.avoid the impact of high inflation.Foreign citizens will hold dollars to Foreign citizens will hold dollars to

protect against political instability.protect against political instability.

1010

FOMC DecisionFOMC DecisionOn March16, 2004 the FOMC declared that it On March16, 2004 the FOMC declared that it

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

federal funds rate to 2.75%.federal funds rate to 2.75%.On March 21, 2007 the FOMC announcedOn March 21, 2007 the FOMC announcedHow does the Fed keep the federal funds How does the Fed keep the federal funds

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

1111

Money SupplyMoney Supply

By engaging in open market operations, By engaging in open market operations, the Fed increases (buy bonds) or the Fed increases (buy bonds) or decreases (sell bonds) the amount of decreases (sell bonds) the amount of money in the system.money in the system.

If the demand for money remains the If the demand for money remains the same, the action of the Fed affects the same, the action of the Fed affects the federal funds rate.federal funds rate.S up; D same => P downS up; D same => P down

1212

Equilibrium in the Market for MoneyEquilibrium in the Market for Money

Explain how and why the market reaches equilibrium.

1313

Equilibrium in the Market for MoneyEquilibrium in the Market for Money If at the existing interest rate, supply If at the existing interest rate, supply

exceeds demand, that means people exceeds demand, that means people would like to hold less money than there is.would like to hold less money than there is.

How do people adjust their portfolios?How do people adjust their portfolios?They buy other assets with the excess They buy other assets with the excess

money in their checking accounts.money in their checking accounts.The price of bonds (non-money assets) The price of bonds (non-money assets)

goes up: interest rate goes down.goes up: interest rate goes down.

1414

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

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

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

The Fed directly affects the federal funds The Fed directly affects the federal funds rate.rate.

1515

http://www.federalreserve.gov/newsevents/press/monetary/20090203a.htm

1616

The Federal Funds Rate, 1970-2004The Federal Funds Rate, 1970-2004

http://research.stlouisfed.org/publications/mt/page9.pdf

1717

The Fed Wants to Raise The Fed Wants to Raise iiFed sells bondsFed sells bondsThe money supply fallsThe money supply fallsCreates a shortage of moneyCreates a shortage of moneyPeople sell non-money assetsPeople sell non-money assetsNon-money asset prices fall and the Non-money asset prices fall and the

interest rate increasesinterest rate increases

1818

Interest Rates and Money SupplyInterest Rates and Money SupplyThe Fed cannot set the interest rate and The Fed cannot set the interest rate and

the money supply independently.the money supply independently.The Fed controls the money supply by The Fed controls the money supply by

controlling bank reserves.controlling bank reserves.Bank reserves influence the federal funds Bank reserves influence the federal funds

rate.rate.Therefore, the federal funds rate reflects Therefore, the federal funds rate reflects

the impact of open market operations.the impact of open market operations.

1919

The Fed and Money SupplyThe Fed and Money Supply

Second Way : Discount Window LendingSecond Way : Discount Window LendingThe lending of reserves by the Federal Reserve The lending of reserves by the Federal Reserve

to commercial banksto commercial banksDiscount Rate (primary credit rate): The interest Discount Rate (primary credit rate): The interest

rate that the Fed charges commercial banks to rate that the Fed charges commercial banks to borrow reserves.borrow reserves.

2020

The Fed and Money SupplyThe Fed and Money Supply

Third Way: Changing Reserve RequirementsThird Way: Changing Reserve Requirements Set by the FedSet by the Fed The minimum values of the ratio of bank deposits that The minimum values of the ratio of bank deposits that

commercial banks are allowed to maintaincommercial banks are allowed to maintain Lowering the reserve ratio increases the ability of banks Lowering the reserve ratio increases the ability of banks

to make loans and therefore expand the money supply.to make loans and therefore expand the money supply. Increasing the reserve ratio reduces the ability of banks Increasing the reserve ratio reduces the ability of banks

to make loans and create money.to make loans and create money.

2121

The New ToolsThe New Toolshttp://www.federalreserve.gov/monetarypolicy/default.htm

2222

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

should we care? should we care? We might be interested in the interest rates on We might be interested in the interest rates on

CDs, mortgage rates, credit card interest CDs, mortgage rates, credit card interest rates?rates?

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

banks increase their prime rates, too.banks increase their prime rates, too.

2323

Real and Nominal Interest RatesReal and Nominal Interest Rates

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

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

2424

Real and Nominal Interest RatesReal and Nominal Interest RatesRemember the Fisher Effect:Remember the Fisher Effect: i = r + i = r + f the expected inflation hasn’t changed but f the expected inflation hasn’t changed but

the Fed has increased i, then r is also the Fed has increased i, then r is also increased.increased.

In the long run In the long run adjusts and it is the adjusts and it is the savings and investments that determine the savings and investments that determine the real rate of interest.real rate of interest.

2525

The Federal ReserveThe Federal Reserveand Interest Ratesand Interest Rates

Can the Fed Control the Real Interest Can the Fed Control the Real Interest Rate?Rate?Long-run impact of Fed policyLong-run impact of Fed policy

Prices adjust to changing economic conditions.Prices adjust to changing economic conditions.The real interest rate is determined by the balance The real interest rate is determined by the balance

of savings and investment.of savings and investment.The Fed has less effect on spending in the long The Fed has less effect on spending in the long

run.run.

2626

How much control does the Fed How much control does the Fed have over spending?have over spending?

The Fed has direct control over the federal The Fed has direct control over the federal funds rate.funds rate.

The federal funds rate may influence, but The federal funds rate may influence, but does not control other interest rates which does not control other interest rates which influence spending.influence spending.

The inability of the Fed to precisely control The inability of the Fed to precisely control other interest rates complicates monetary other interest rates complicates monetary policy.policy.

2727

Aggregate Expenditures and the Aggregate Expenditures and the Real Interest RateReal Interest Rate

Real interest rates and consumptionReal interest rates and consumption High real interest rates increases the incentive to save.High real interest rates increases the incentive to save. If savings increase, consumption decreases.If savings increase, consumption decreases. High real interest rates reduces consumption.High real interest rates reduces consumption.

Real interest rates and investment spendingReal interest rates and investment spending High real interest rates increases the cost of investment High real interest rates increases the cost of investment

spending.spending. The increased cost reduces profitability of investment The increased cost reduces profitability of investment

spending and investment falls.spending and investment falls. High real interest rates reduces investment spending.High real interest rates reduces investment spending.

Real interest rates and NXReal interest rates and NX R up => $ up => NX downR up => $ up => NX down

2828

Real Interest Rates and Real Interest Rates and Aggregate DemandAggregate Demand

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

operates.operates.

2929

Solving for the UnknownsSolving for the Unknowns

If the real interest rate is 3%, find the If the real interest rate is 3%, find the values of C, I, and Y for the previous values of C, I, and Y for the previous economy and draw the Keynesian cross economy and draw the Keynesian cross to show the Y.to show the Y.

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

3030

Fighting Recession Fighting Recession

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

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

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

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

3131

The Fed Fights A RecessionThe Fed Fights A Recession

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

Y = PAE

5,000

Recessionary gap

E

Expenditure line (r = 5%)

4,800Y*

Expenditure line (r = 1%)

F

A reduction in r shifts the expenditure line upward

• Multiplier = 5• Output gap = 200• Fed wants to

increase PAE by 200/5 = 40

• C = 1,010 – 1,000r• 1% change in r will

change C by 10• Reduce r to 0.01

3232

Fighting InflationFighting Inflation

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

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

What happens to AD?What happens to AD?

3333

Raising Interest RatesRaising Interest Rates

From June 2004 to June 2005 the Fed From June 2004 to June 2005 the Fed Funds Rate rose from 1.0% to 3.25%.Funds Rate rose from 1.0% to 3.25%.

Real GDP growth of nearly 6% in late Real GDP growth of nearly 6% in late 2003 and 4.4% in 2004 and a falling 2003 and 4.4% in 2004 and a falling unemployment rate to 5.6% in June 2004 unemployment rate to 5.6% in June 2004 indicated the possible emergence of an indicated the possible emergence of an expansionary gap.expansionary gap.

3434

The Fed Fights InflationThe Fed Fights Inflation

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

Expenditure line (r = 5%)

Y = PAE

4,800

Expansionary gap

E

4,600Y*

G

Expenditure line (r = 9%)

An increase in r shifts the expenditure line downward

3535

Inflation and the Stock MarketInflation and the Stock Market Inflation is watched very closely by the Fed.Inflation is watched very closely by the Fed.Any sign of inflation makes Fed increase Any sign of inflation makes Fed increase

interest rates.interest rates.Higher real interest rates slow down the Higher real interest rates slow down the

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

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

3636

Policy Reaction FunctionPolicy Reaction Function If there is a pattern of policies adopted If there is a pattern of policies adopted

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

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

3737

Taylor RuleTaylor Rule

Taylor explained the behavior of the Fed as a Taylor explained the behavior of the Fed as a reaction to output gap and inflation.reaction to output gap and inflation.

If there is a positive, recessionary output gap, If there is a positive, recessionary output gap, the Fed wants to stimulate the economy.the Fed wants to stimulate the economy.

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

The Fed also reacts to higher inflation by The Fed also reacts to higher inflation by raising the real interest rate and slowing down raising the real interest rate and slowing down the economy.the economy.

3838

Taylor RuleTaylor Rule

r = 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?

3939

A Monetary Policy ReactionA Monetary Policy ReactionFunction for the FedFunction for the Fed

0.00 (= 0%) 0.02 (= 2%)

0.01 0.03

0.02 0.04

0.03 0.05

0.04 0.06

Rate of inflation, Real interest rate set by Fed, r

)02.0(0.104.0 :Assume r

4040

An Example of a Fed An Example of a Fed Policy Reaction FunctionPolicy Reaction Function

Rea

l in

tere

st r

ate

set

by

Fed

, r

0.01

0.02

0.03

0.04

0.05

0.06

0.02 0.03 0.04

Fed’s monetary policy reaction function

Inflation