Chapter 14 Notes

Chapter 14 Notes - Ch. 14 “4" 3m; Wows-a...

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Unformatted text preview: Ch. 14 “4" 3m; Wows-a Monetary Foiiey «7‘3 Liz-Vi. omeeofiw 'c \w‘w’ What is Monetary Foiiey‘? A. Tire {ioais of Monetary Poiicy 0 Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue its macroeconomic policy objectives. The Fed has set four monetary policy goals: 1. Price Stability. Rising prices erode the value of money as a medium of exchange and a store of value. 2. High Employment or a Low Rate of Unemployment. Unemployed workers and underused factories and office buildings reduce GDP below its potential level. 3. Economic Growth. Stable economic growth allows households and firms to plan accurately and encourages the long-run investment that is needed to sustain growth. 4. Stability of Financial Markets and Institutions. The Fed promotes the stability of financial markets and institutions to ensure an efficient flow of funds fiom savers to borrowers. a ' 3. fa“ y‘\. l K} . Ian-«‘1 an a; tame A» were: .- w a 3., 4,. 2“ ~.. wig”? \J a_...o: : “t :- -.. Mr.“ Tim Money Market and tiie Fed’s {Iiioiee of Monetary Poiiey “forgets 1%. Monetary Foiiey Targets o The Fed’s objective in setting monetary policy is to use policy tools to achieve its monetary policy goals. o The Fed uses variables called monetary policy targets to keep both the unemployment and inflation rates low. ‘1 if ‘r'y' o The two main monetary policy targets are the money supply and the interest rate. if“ -':: a" yogi“;- SQLJEELBEZERAE o The Fed typically uses the interest rate as its policy target. B, The Bemeed for Money o The demand curve for money slopes downward because lower interest rates cause households and firms to switch from financial assets like U.S. Treasury bills to money. a When interest rates on Treasury bills and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high. G The opportunity cost of holding money is the interest rate. e2: . “a . f? a — 5 , E‘Sfiggé: Via/“3’ M3 fl“ _,= ("QQ‘L‘ an??? Harts} - h} VJHA L x“ 5\ x ’q \H\ m {i 3‘64: “\N \XK “N. at} “a We i ijf‘a , .2. E, Shifts in the Money Demand £arve 0 The two most important variables that cause the money demand curve to shift are real GDP and the price level.. n A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. Price ‘1 Ext—6E ’ #46; MM, ‘61); f} é ‘E V‘a‘fijé 5;} i B, flew the Fed Manages the Mersey Snppiy: A Quick heview 0 Eight times per year, the F OMC meets in Washington, DC. 0 If the FOMC decides to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to purchase US. Treasury securities. 0 The seilers of these securities deposit the fimds they receive from the Fed in banks, which increases the banks’ reserves. t The banks loan out most of their reserves, which creates new checking account deposits and expands the money supply. 0 If the FOMC decides to decrease the money supply, it orders the trading desk to sell Treasury securities, which decreases banks’ reserves and contracts the money supply. LE. quiiihrium in the Meney Market s Equilibrium in the money market occurs where the money demand curve crosses the money supply curve. 0 When the Fed increases the money supply, the short-term interest rate must fail until it reaches a level at which households and firms are willing to hold the additional money. We!” 4:801“ /? Wk? ’TG ' Mi) F. A Tale of Two interest Rates 0 We need two models of the interest rate because the loanable funds model is concerned with the long-term real rate of interest, and the money-market model is concerned with the short-term nominal rate qt interest. it The long-run real rate of interest is the interest rate that is most relevant when savers consider purchasing a long-term financial investment such as a corporate bond. 0 When conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because it is the interest rate most affected by increases and decreases in the money supply. G. {Zhoostng a Monetary Foliey ’l‘arget The F ed chooses the money supply or the interest rate as its monetary policy target. a The Fed has generally focused more on the interest rate than on the money supply. c There are many interest rates in the economy but for purposes of monetary policy, the Fed has targeted the interest rate known as the federal funds rate. a, m+ere§+ rat/“tees; wanes; 4— a 153%3xM D o; . war l x A ‘ « iv‘u w" l5 ,, . , a 4 .. 44 was 5 a i flair w W {.3 :3 , H. Tine importance of the Federai Funds Rate 0 Banks receive no interest on their reserves, so they have an incentive to invest reserves above the 10 percent minimum. a When banks need additional reserves, they borrow in the federal funds market from banks that have reserves available. The federal funds rate is the interest rate banks charge each other for overnight loans. The federal funds rate is not set administratively by the Fed. The rate is determined by the supply of reserves relative to the demand for them. The FOMC announces a target for the federal funds rate afier each of its meetings. Neither households nor firms, except banks, can borrow or lend in the federal funds market. However, changes in the federal funds rate usually result in changes in interest rates on other short-term financial assets, such as Treasury bills, and changes in interest rates on long-term financial assets, such as corporate bonds and mortgages. Monetary hoiiey and Eeonernii: detivity A. tine; interest Rates Attest Aggregate fiemand - Changes in interest rates affect aggregate demand, which is the total level of spending in the economy. 0 Changes in interest rates will not affect government purchases, but will affect consumption, investment, and net exports in the following ways: ‘ f , fi‘a . . . . M's? é / 4‘0 1. Consumption: Lower Interest rates lead to mcreased spending on durables and reduced returns to saving, leading households to save less and spend more. 7 .\ v '. ...1 . a -. -‘ in. s. 4 . ‘Si/ i my @gfifirifi r“ :‘agfi-“rt t" “an; Ha? ‘1} ? 3 V i 4K: 2. Investment: Lower interest rates make it less expensive for firms to borrow, so they will V undertake more investment projects. Lower interest rates can also increase investment through their impact on stock prices. \‘ 3. Net exports: If interest rates in the United States decline relative to interest rates in other countries, the value of the dollar will fall and net exports will rise. #- ‘5’“ m tits“: fl -- J i ' m . - reg~ihhé M933» mi: '3. ‘ . .0: M slinging-i 19" _ \i’ innvsxsa ; :2 v E. The Effects of Menetary leoliey on Real Q3? and the Price travel: Ara initial we}: II The Federal Reserve carries out an expansionary monetary policy by increasing the money supply and decreasing interest rates to increase real GDP. 0 Contractionary monetary policy refers to the Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation. 9:39 ‘5 x. m ‘ w . 2‘ q 5 =. L43. “‘3’ fi-rfifimfigigmfifi’lfa “OCH E51414 “it? glfi“; ‘ ,1 1 g a a; v” :3 its as. 3% s. ’l‘lie Effects of slonetary l’elicy en Real 3‘33? asset the Price Leyel: A More fiomplete Account o The Fed can use monetary policy to affect aggregate demand and change the price level and the level of real GDP. a The economists at the Federal Reserve closely monitor the coonomy and continually update forecasts of future levels of real GDP and prices. B, E, hen the Fed Eliminate Recessions? Although the Fed was able to use expansionary monetary policy successfully to reduce the severity of the 2001 recession, it was unable to eliminate it entirely. The Fed does not have a realistic hope of “fine—tuning” the economy to eliminate the business cycle and achieve absolute price stability. «— MC: , 39qu wag, Mai; iising Monetary Policy to Fight inflation In addition to using monetary policy to reduce the severity of recessions, the Fed can also use a contractionaly monetary policy to keep aggregate demand fi‘om expanding so rapidly that the inflation rate begins to increase. ' 8X Smilfiicm enamaeia on. lessen. ii a gammai‘y of lien; Monetary ?ciicy Worhs When the FOMC follows an expansionary policy: The money supply increases and interest rates fall; investment, consumption, and net exports all increase; The AD curve shifts to the right; Real GDP and the. price level rise. When the FOMC follows a contractionary policy: The money supply decreases and interest rates rise; Investment, consumption, and net exports all decrease; The AD curve shifts to the left; Real GDP and the price level fall. [consign fan the Fed flat the Timing Right? The Fed has the ability to quickly recognize the need for a change in monetary policy. If the Fed is late recognizing that a recession has began 01' that the inflation rate is increasing, it may not be able to implement a new policy soon. The economy may be destabilizing if the Fed implements a policy too late. The National Bureau of Economic Research (NBER) announces dates for the beginning and A9. ES : ran-.959 Om ‘ ‘? C, a: If“: 'f'g‘f * .5} .. WT} ending of recessions. A floser their at the Fed’s Setting of Monetary Folio}; Targets Pi. dhonld the Fed Target the hioney Supply? 0 Some economists argue that rather than use an interest rate as its monetary policy target, the Fed should use the money supply. 0 These economists belong to a school of thought known as monetarism. - Monetan'sts favor replacing monetary policy with a monetary growth rule. 0 When the economy is in recession, the Fed reduces interest rates and when inflation is increasing, the Fed raises interest rates. 0 A monetary growth rule, in contrast, is a plan for increasing the money supply at a constant rate that does not change in response to economic conditions. 0 Monetarists believe that keeping the money supply growing at a constant rate would increase economic stability. 0 Although some economists and politicians favored adopting a monetary growth rule in the 19705, most of the pressure to do so has disappeared recently. 0 A key reason for this is that the relationship between movements in the money supply and movements in real GDP and the price level has become much weaker. _po-r dong. aged ‘7 . -.J Why Boesn’t the Fed Pi‘arget Both the Money Supply and the interest Rate? 3:: 0 The Fed can’t target both the interest rate and the money supply at the same time. o The Fed controls the money supply, but it does not control money demand. a Money demand is determined by decisions of households and firms as they weigh the trade-off between the convenience of money and its low interest rate compared with other financial assets. 3. The Taylor hale 9 The Taylor rule is a rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. a {I . 7‘ g‘g-E. D r-‘n‘zukwccm'a‘. Hmmu-{w m .«a;«w~=~ £321" 59"} ‘ (103‘? hm. bG’r‘m 0 According to the Taylor rule, the Fed should set the target for the federal funds rate so that it is equal to the sum of the inflation rate, the equilibrium real federal funds rate, and two additional terms. 1. The difference between current inflation and a target rate, known as the inflation gap. 2. The percentage difference between real GDP and potentiai real GDP, known as the output gap. The inflation gap and output gap are each given weights that reflect their influence on the federal funds target rate. With weights of 1/2 for both gaps, we have the following Taylor rule: Tamil 6*“ . . . . . fl) 2 f?) Federal funds target rate = Current inflation rate + Real equrhbnurn federal funds rate + (1/2) x Ination gap + (1/2) x Output gap 9 The Taylor rule has accurately predicted changes in the federal funds target during the period of Alan Greenspan’s leadership of the Federal Reserve. 0 The Taylor rule does not account for changes in the target inflation rate or the equilibrium interest rate, but many economists view the rule as a convenient way to analyze the federal funds target. i}. ghenid the Fed Target inflation? 0 Some nations’ central banks have adopted inflation targeting as a framework for conducing monetary policy. 0 Inflation targeting refers to conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. Arguments in favor of the Federal Reserve adopting an inflation targeting policy focus on four points: 1. In the long run, real GDP returns to its potentiai level and potential real GDP is not affected by monetary policy. 2. By announcing an inflation target, the Fed would make it easier for households and fnms to form accurate expectations of future inflation, improving their planning and the efficiency of the economy. An announced inflation target would help institutionalize good U.S. monetary policy. 4. An inflation target would promote accountability for the Fed by providing a yardstick against which its performance could be measured. La) Arguments against inflation targeting focus on three points: ‘rv‘ A1 (FAKE I \ r ‘ {H :3 z, 16) “rd-".3 i l. 2. A numerical target for inflation reduces the flexibility of monetary policy to address other policy goals. I . Inflation targeting assumes the Fed can accurately forecast future mflatlon rates. :5 Holding the Fed accountable only for an inflation goal may make it less likely that the Fed will achieve other important policy goals The Federal Reserve Responds tn the Financial {Irisis Marital; A. ’i‘he fihanging Mortgage Market A financial asset — such as a stock or bond — is considered a security if it can be sold in a financial market. When an asset is first sold, the sale takes place in the primary market. Subsequent sales take place in the secondary market. Prior to 1970, most mortgages were not considered securities because they Were rarely resold in a secondary market. Congress, however, wanted to create a secondary market in mortgages to increase home ownership. Congress created the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) to sell bonds to investors and use the funds to purchase mortgages from banks and savings and loans. By the 19905, a large secondary market existed in mortgages with funds flowing from investors through Fannie Mae and Freddie Mac to banks and savings and loans and, ultimately, to families borrowing money to buy houses. The Role of investment Earths By the 20065, investment banks became significant participants in the secondary market for mortgages. investment banks do not take in deposits and rarely lend to households, but concentrate on providing advice to firms issuing stocks and bonds and considering mergers with other firms. Investment banks began buying mortgages, bundling them together as mortgage-backed securities and reselling them. At the height of the housing bubble in 2005 and 2006, lenders loosened the standards for obtaining a mortgage loan. By 2005, mortgages were being issued to “suhprime” borrowers with flawed credit histories. In addition, new types of mortgages were created that allowed borrowers to pay to pay a low interest rate for the first few years of the mortgage before paying higher rates in later years. Borrowers and lenders were apparently anticipating that housing prices would continue to rise, which would reduce the chance that borrowers would default on the mortgages and make it easier to convert to more traditional mortgages in the future. Unfortunately, the decline in housing prices ted to rising defanit rates among subprime borrowers. When borrowers began defaulting on their mortgages, the value of many mortgage-backed securities declined sharpiy. Because many commercial and investment banks owned these secarities, the decline in the value of the securities caused the banks to suffer heavy losses. Many investors refused to buy mortgage-backed securities and some investors would only buy bonds issued by the US. Treasury. ii. The sad and the Treasury Department Respond Fed Chairman Ben Bernanke and 15.8. Treasury Secretary Henry Paulson responded to the financial crisis in several unprecedented ways. The Fed decided. to make primary dealer-Sm firms that participate in open market operations with the Fed —- eligible for discount loans. In addition, the Fed began lending to non-financial corporations by purchasing commercial paper. The Fed and the Treasury urged Congress to pass the Emergency Economic Stabiiization Act of 2008, which authorized the Treasury to purchase mortgage-backed securities from banks. The not also authorized the Treasury to increase the financial strength of banks by buying their stocks. The Fed and the Treasury aiso took direct action to keep large financiai institutions from bankruptcy. In March 2008, they helped JP Morgan Chase acquire the investment bank Bear Stearns. The Fed agreed that if J? Morgan Chase acquired Bear Stearns, the Fed would guarantee any losses JP Morgan Chase suffered on Bear Stearns holdings of mortgage-backed securities, up to $29 billion. In September, the Fed agreed to provide an $85 billion loan to the American international Group (AIG) insurance company in exchange for an 80 percent ownership stake. Finally, in September the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were each provided with up to $108 billion in exchange for 80 percent ownership of the firms. In September, Lehman Brothers declared bankruptcy, Merrill Lynch sold itself to Bank of America and Goldman Sachs and Morgan Stanley received approval to convert themselves to bank holding companies; this allowed them to set up commercial banking operations. The era of large, stand-alone Wall Street investment banks appeared to come to an end. - ‘- ' r a?) "an ""4 ifll a I“ . _ W,77 , _ ' a U q 1 ii a H‘ p s: -’ xi ,2 ILL,,QE.(3C3d,,&,¢ , V2} 99; , , , g i A \ 7 g ‘ ‘éh': r‘: i. ,, ,EGDP. F).."U‘Xflfffiilflkfifii".Lfififi‘f __ __.\).€\2,m;éagwwiggmy;a: ...
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This note was uploaded on 02/21/2011 for the course ECON 2010 taught by Professor Roussel during the Spring '08 term at LSU.

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Chapter 14 Notes - Ch. 14 “4" 3m; Wows-a...

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