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KW_Macro_Ch_14_Sec_02_Money_and_Interest_Rates - chapter 14...

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>> Monetary Policy Section 2: Money and Interest Rates chapter 14 “The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 2 3 / 4 %.” So reads the first sentence of the press release from the FOMC after its meeting of March 22, 2005. (A basis point is equal to 0.01 percentage point. So the statement says that the Fed raised the target from 2.50% to 2.75%.) We learned about the federal funds rate in Chapter 13: it’s the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight-times-a-year meetings, the Federal Open Market Committee sets a target value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells Treasury bills to achieve that target. Other short-term interest rates, such as the rates on bank loans to businesses, move with the federal funds rate. So when the Fed raised its target for the federal funds rate from 2.50% to 2.75% in March 2005, all short-term interest rates rose as well by about a quarter of a percentage point.
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2 C H A P T E R 1 4 S E C T I O N 2 : M O N E Y A N D I N T E R E S T R AT E S How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all? The Equilibrium Interest Rate Recall that, for simplicity, we’ve assumed that there is only one interest rate paid on non- monetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 14-4, which illustrates the liquidity pref- erence model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 14-4 combines the nominal money demand curve, MD, with the money supply curve, MS, which shows how the nominal quantity of money supplied by the Federal Reserve varies with the inter- est rate. (From now on we will drop the word nominal with the understanding that MD and MS represent nominal quantities). In Chapter 13 we learned how the Federal Reserve can increase or decrease the money supply by buying or selling Treasury bills. Let’s assume for simplicity that the Fed simply chooses the level of the money supply that they believe will achieve their interest rate target. Then the money supply curve is a vertical line, MS in Figure 14-4, with a horizontal intercept corresponding to the money supply chosen by the Fed, M __ . The money market equilibrium is at E, where MS and MD cross.
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