But the prime rate moves almost perfectly in parallel

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Unformatted text preview: al funds rate because lending to a business customer always involves some risk of nonpayment. But the prime rate moves almost perfectly in parallel with the federal funds rate. The last interest rate in Figure 14-7 is the rate on 30-year mortgages—loans that many people use to buy homes. As you can see, this rate didn’t move nearly as much in synch with the federal funds rate as did the prime rate. This illustrates a point we mentioned earlier in this chapter: long-term interest rates don’t always move closely together with short-term rates. Still, mortgage rates did fall significantly as the Fed cut the federal funds rate repeatedly in 2001. And the fall in mortgage rates helped start a housing boom, which had an expansionary effect on the economy. Housing starts—the number of new homes on which construction has begun—rose by one-third, from 1.2 million in 2000 to 1.6 million in 2004. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 14-2 1. Assume that there is an increase in the demand for money. Using a diagram, show what effect this will have on the interest rate for a given money supply. 2. Now assume that the Fed is following a policy of targeting the federal funds rate. What will the Fed do in the situation described in Question 1 to keep the federal funds rate unchanged? Illustrate with a diagram. Solutions appear at back of book. Monetary Policy and Aggregate Demand In Chapter 12 we saw how fiscal policy can be used to stabilize the economy. Now we will see how monetary policy—changes in the money supply or the interest rate, or both—can play the same role. Expansionary and Contractionary Monetary Policy As we have just seen, the Fed moves the interest rate up or down by increasing or decreasing the money supply. Changes in the interest rate, in turn, change aggregate demand. Other things equal, a fall in the interest rate leads to a rise in investment UNCORRECTED Preliminary Edition CHAPTER 14 and consumer spending and so to a rise in aggregate demand. And, other things equal, a rise in the interest rate leads to a fall in investment and consumer spending and so to a fall in aggregate demand. As a result, monetary policy, like fiscal policy, can be used to close either a recessionary gap or an inflationary gap. Figure 14-8 shows the case of an economy facing a recessionary gap, where aggregate output is below potential output. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial short-run macroeconomic equilibrium, E1, aggregate output is Y1, below potential output, YE. Suppose the Fed would like to increase aggregate demand, shifting the aggregate demand curve rightward to AD2. This would increase aggregate output to potential output. The Fed can accomplish that goal by increasing the money supply, which drives the interest rate down. A lower interest rate, in turn, leads to...
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This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

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