Pump PrimerPump Primer::

• Define monetary policy.

31

ModuleMonetaryPolicy and the Interest Rate

KRUGMAN'SMACROECONOMICS for AP*

31

Margaret Ray and David Anderson

Biblical Integration:Biblical Integration:

• Stabilization is a crafty word. It is defined by Webster as: "to become stable, firm, or steadfast." In 1 Cor. 15:58 God talks about our labor not being in vain. However, we need to be steadfast and immoveable in our work for the Lord. How is your stability?

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

Monetary Policy and the Interest Monetary Policy and the Interest Rate:Rate:

We are ready to use the model of the money market to explain how the Federal Reserve can use monetary policy to stabilize the economy in the short run. Suppose the Fed took steps to increase the money supply. This will usually be the result of an open market operation to buy Treasury bills from large commercial banks. The increase in the money supply causes short-term interest rates to fall in the money market.

Monetary Policy and the Interest Monetary Policy and the Interest Rate:Rate:Now suppose the Fed took steps to decrease the money supply. This will usually be the result of an openmarket operation to sell Treasury bills to large commercial banks. The decrease in the money supply causes short-term interest rates to rise in the money market. Usually, the Fed adjusts the money supply to target a specific federal funds rate.

Monetary Policy and the Interest Monetary Policy and the Interest Rate:Rate:

If the current federal funds rate is higher than the target, the Fed will increase the money supply, so that the rate falls to the target.

If the current federal funds rate is lower than the target, the Fed will decrease the money supply, so that the rate rises to the target.

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

Expansionary and Contractionary Expansionary and Contractionary Monetary PolicyMonetary Policy

We have seen how fiscal policy can be used to stabilize the economy. Now we will see how monetary policy can play the same role.

Expansionary and Contractionary Expansionary and Contractionary Monetary PolicyMonetary Policy

Investment spending is usually quite sensitive to changes in the interest rate.

When interest rates fall, we see an increase in investment spending. Some types of consumption spending also increase when the interest rate falls.

Examples: car/truck buying, college educations, real estate.

Expansionary and Contractionary Expansionary and Contractionary Monetary PolicyMonetary Policy

Since both investment spending and consumption spending are important components of aggregate demand, it would therefore make sense that when the interest rate falls, AD should rise.

Note: the instructor can draw the AD/AS graph with AD to the left of potential output. Ask the students,

“What could the Fed do about this recession”?

Expansionary Monetary PolicyExpansionary Monetary Policy

Expansionary Monetary Policy chain of events

• The Fed observes that the economy is in a recessionary gap.

• The Fed increases the money supply.• The interest rate falls.• Investment and consumption

increase.• AD shifts to the right.• Real GDP increases, unemployment

rate decreases, the aggregate price level rises.

Expansionary Monetary PolicyExpansionary Monetary Policy

The EconomyThe Economy

The Money Market

The Money Market

Contractionary Monetary PolicyContractionary Monetary Policy

“What could the Fed do about this inflation”?Contractionary Monetary Policy chain of

events

• The Fed observes that the economy is in an inflationary gap.

• The Fed decreases the money supply.• The interest rate rises.• Investment and consumption decrease.• AD shifts to the left.• Real GDP decreases, unemployment

rate increases, the aggregate price level falls.

Contractionary Monetary PolicyContractionary Monetary Policy

The EconomyThe Economy

The Money Market

The Money Market

Monetary Policy in PracticeMonetary Policy in Practice• The Fed is not only concerned

with the level of real GDP and whether the economy is producing a full employment, but also with price stability. The Fed also monitors inflation, so that the economy doesn’t suffer unexpected spikes in the inflation rate.

• In practice, this simply means that the Fed’s goals and policies are multifaceted. Some economists have suggested that the Fed (and other central banks) operates with a monetary “rule” that dictates monetary policy.

Stanford Economist, John Taylor

Monetary Policy in PracticeMonetary Policy in Practice

The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap.

• The rule Taylor originally suggested was as follows:

• Federal funds rate = 1 + (1.5 × inflation rate) + (0.5 ×output gap)

1+(1.5 X π%)+(0.5 X Output Gap)

• Example Inflation is 3% and real GDP is 4% below potential GDP

• FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 %

Inflation TargetingInflation Targeting

Other nations have adopted a policy of keeping interest rates at a level that creates a specific level of price inflation, or at least attempts to keep inflation rates within an acceptable range.

One major difference between inflation targeting and the Taylor rule is that inflation targeting is forward looking rather than backward-looking. That is, the Taylor rule adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation.

Inflation TargetingInflation TargetingAdvocates of inflation targeting argue that it

has two key advantages, transparency and accountability.

Transparency: Economic uncertainty is reduced because the public knows the objective of an inflation-targeting central bank.

Accountability: The central bank’s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable.