Lecture_Notes_16B - Fiscal and Monetary Policy Effects...

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Fiscal and Monetary Policy Effects CHAPTER 16B
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When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Describe the Federal Reserve’s monetary policy process and explain the effects of monetary policy.
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THE FEDERAL RESERVE AND MONETARY POLICY You’ve now seen how fiscal stabilization policy works, and you’ve seen that it has some pretty severe limitations. Automatic stabilizers help, but discretionary actions are very hard to get right. Fortunately, fiscal policy isn’t the only tool available for seeking to stabilize the business cycle. Monetary policy is also available. We’re now going to see how monetary policy works and how the Fed’s actions ripple through the economy to influence real GDP and the price level.
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THE FEDERAL RESERVE AND MONETARY POLICY Influencing the Interest Rate When the FOMC announces a policy change, its press release talks about the federal funds rate, the interest rate at which banks borrow reserves from each other, or the discount rate, the interest rate at which banks borrow reserves from the Fed. The press release does not talk about the quantity of money or the size of the open market operations it plans to conduct. This focus on interest rates makes it appear as though the Fed determines interest rates rather than the quantity of money. But this impression is misleading because the Fed only influences the nominal and real interest rates by its actions. Other factors that play a major role in determining interest rates are saving supply and investment demand in domestic and global financial markets.
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THE FEDERAL RESERVE AND MONETARY POLICY The Fed Raises Its Interest Rate Target Suppose that the Fed fears inflation and decides that it must take action to decrease aggregate demand. The FOMC announces that it will raise its short-term interest rate target. How does the Fed achieve its goal of a higher interest rate? The FOMC instructs the New York Fed to sell securities in the open market. This action mops up bank reserves. Some banks are short of reserves and seek to borrow reserves from other banks. The federal funds rate rises. With fewer reserves, the banks make a smaller quantity of new loans each day until the quantity of loans outstanding has fallen to a level that is consistent with the new lower level of reserves. The quantity of money decreases.
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THE FEDERAL RESERVE AND MONETARY POLICY The demand for money determines the quantity of money that will achieve the FOMC’s interest rate target. The Fed could, if it chose, fix the quantity of money and let the interest rate adjust to its equilibrium level. Or the Fed can, and does, fix the interest rate and adjust the quantity of money to the level that makes the chosen interest rate the equilibrium rate.
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THE FEDERAL RESERVE AND MONETARY POLICY Suppose, for example, that the short-term nominal interest rate is 5 percent a year and the FOMC decides that it needs to rise to 6 percent a year. Figure 16.6(a) illustrates what the Fed must do. The
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Lecture_Notes_16B - Fiscal and Monetary Policy Effects...

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