Ch014 - b Chapter 14 Stabilizing the Economy The Role of...

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1. Chapter 14 Stabilizing the Economy: The Role of the Fed Overview This chapter looks at the second of the two major types of stabilization policy: monetary policy. It discusses how the Fed uses its ability to control the money supply to influence the real and nominal interest rates. It then looks at the economic effects of changes in interest rates. The chapter builds on the basic Keynesian model presented in Chapter 25 to show that monetary policy, in the short-run, achieves its effects by influencing aggregate demand and thus short-run equilibrium output. Coverage of the other major effects of monetary policy, including changes in the inflation rate, is deferred to the next chapter. The chapter has an appendix covering algebraic analysis of monetary policy in the basic Keynesian model. Core Principles Cost-Benefit Principle - the chapter applies this principle to the individual's decision to hold money. The concept of opportunity cost is also used to explain the cost of holding money instead of another interest-paying asset. Equilibrium Principle – though there is no icon on this page, the chapter looks at equilibrium in the money market. Important Concepts Covered Portfolio allocation decision Money demand Federal funds rate Expansionary and contractionary monetary policy Policy reaction function Answers to Text Questions and Problems Answers to Review Questions 1. The demand for money is the amount of money that an individual or other wealth- holder chooses to hold; the economy-wide demand for money is the amount of money held by all wealth-holders taken together. Because a higher nominal interest rate increases the opportunity cost of holding money (funds not held in the form of money could be earning interest), the demand for money falls when the nominal interest rate 221
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1. rises. Increases in the price level or income tend to increase the dollar volume of transactions, increasing the benefit of holding money and thus the demand for money. 2. Equilibrium in the market for money is shown in Figure 27.3. The nominal interest rate is determined at the intersection of the downward-sloping demand for money curve and the vertical supply curve for money (as established by the Fed). The Fed can affect the nominal interest rate by changing the supply of money and thus shifting the supply curve of money (Figure 27.4). An increase in the supply of money shifts the vertical supply curve for money to the right, lowering the nominal interest rate, while a reduction in the money supply shifts the supply curve to the left and raises the nominal interest rate. The real interest rate is the nominal interest rate minus the rate of inflation; because the rate of inflation adjusts relatively slowly, the Fed can control the real interest rate in the short run. In the long run, the real interest rate is determined by the equality of saving and investment. 3.
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Ch014 - b Chapter 14 Stabilizing the Economy The Role of...

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