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Chapter 31 - 742-767_CH31_Econ.qxp 3:12 PM Page 742 31 What...

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742 >> Monetary Policy chapter 31 HEN THE FOMC TALKS , PEOPLE listen. Eight times a year, econo- mists and investors around the world wait anxiously for word from the dozen men and women who make up the Federal Open Market Committee of the Federal Reserve. The FOMC controls the federal funds rate, the interest rate changed on reserves that banks lend each other to meet reserve re- quirements. What the world wants to know is the FOMC’s decision—whether it has de- cided to increase the federal funds rate, re- duce it, or leave it unchanged. Financial market analysts also carefully read the committee’s accompanying statement and wait anxiously for the official minutes of the meeting, released three weeks later. Why such a high degree of scrutiny? Be- cause the statements of the FOMC, al- though usually written in jargon, offer EIGHT TIMES A YEAR w The FOMC’s decision about interest rates is anxiously watched by traders like these, and by investors around the world. John Gress/Reuters/Landov Denni Brack/Bloomberg News/Landov clues to the future stance of monetary pol- icy. A careful reading of FOMC statements, where seemingly minor changes in wording can be highly significant, can help predict whether monetary policy will be relatively expansionary (or loose), leading to a fall in interest rates, or relatively contractionary (or tight), leading to a rise in interest rates. For example, the FOMC statement in De- cember 2003 said, as it had after the past several meetings, that “policy accommoda- tion can be maintained for a considerable period.” The phrase “policy accommoda- tion” means “keeping interest rates low.” But in January 2004 these words were replaced with slightly different wording: “The Com- mittee believes that it can be patient in re- moving its policy accommodation.” The new wording suggested that the FOMC would soon begin raising the federal funds rate, and stocks and bonds plunged at this news. What you will learn in this chapter: What the money demand curve is Why the liquidity preference model determines the interest rate in the short run How the Federal Reserve can move interest rates How monetary policy affects ag- gregate output in the short run A deeper understanding of the adjustment process behind the savings–investment spending identity Why economists believe in mon- etary neutrality —that monetary policy affects only the price level, not aggregate output, in the long run 742-767_CH31_Econ.qxp 10/31/05 3:12 PM Page 742
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The Demand for Money In Chapter 30 we saw that M1, the most commonly used definition of the money supply, consists of currency in circulation (cash) plus checkable bank deposits plus traveler’s checks. M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. We also saw why peo- ple hold money—to make it easier to purchase goods and services. Now we’ll go deeper, examining what determines how much money individuals and firms want to hold at any given time.
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