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THE FED AND INTEREST RATES CHAPTER OBJECTIVES 1. This chapter explains how the Fed measures the money supply, and introduces the monetary aggregates—M1 and M2. Having learned the components of the monetary base in Chapter 2, students must now grasp the difference between the “monetary base” and the “money supply”. 2. The chapter explains how the Fed influences interest rates, and introduces the Fed Funds Rate. Students must appreciate how the Fed Funds Rate is determined and why it is important. 3. The chapter explains why the Fed manipulates the money supply and interest rates by describing the linkages between these financial sector variables and economic activity in the real sector. The chapter compares and contrasts two basic schools of thought about monetary policy—Monetarists and Keynesians., and discusses complications encountered by the Fed as it pursues its goals. CHANGES FROM THE LAST EDITION Tables, exhibits, and data have been updated. CHAPTER KEY POINTS 1. The “monetary base” and the “money supply” are not the same thing. The monetary base comprises Federal Reserve Notes in circulation and deposits of financial institutions with the Fed. The money supply reflects both monetary policy and private transactions: M1 = currency, coin and travelers checks in circulation + demand checking deposits or checking accounts + “NOW” accounts and similar interest-on-checking accounts M2 = M1 + savings deposits and money market deposit accounts + overnight repurchase agreements + Eurodollars + noninstitutional or “retail” MMMFs + small time deposits (under $100,000) MZM = M2 – small time deposits + institutional MMMFs 2. By controlling the monetary base, the Fed substantially influences the money supply. To meet reserve requirements, depository institutions deal in monetary base assets by depositing reserves with the Fed or holding adequate quantities of Federal Reserve Notes in their vaults. Either way, they earn no interest. The more they exceed requirements, the more interest income they lose. Excess reserves appear as the Fed buys securities on the open market, lends at the Discount Window, or cuts reserve requirements. As depository institutions lend or invest excess reserves, they increase M1 and finance spending in the real sector. By expanding or contracting the monetary base, the Fed increases or decreases excess reserves, raising or lowering incentive to lend or invest to encourage or discouraging expansion in the real sector. 3. To influence interest rates, the Fed targets but does not set the ed Funds Rate. The Fed Funds Market is a Fed-sponsored system in which depository nstitutions lend and borrow excess reserves among themselves. The interest rate on these ansactions—the Fed Funds Rate—is set by market forces. The FFR is a “benchmark” rate n the financial system—it normally represents the lowest possible cost of loanable funds. The Fed influences the FFR by controlling overall availability f reserves. 31
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This note was uploaded on 02/23/2011 for the course FINA 4090 taught by Professor S during the Spring '11 term at Toledo.

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