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1303135393014_Chapter18_Instructor_Notes - CHAPTER 18...

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______________________________________________________________________________________ 373 CHAPTER 18: MONETARY POLICY: USING INTEREST RATES TO STABILIZE THE DOMESTIC ECONOMY A. T HE B ASICS Chapter 18 begins an analysis, extending through the end of the text, of how modern central banks use the interest rate to stabilize the economy. Thus, much of the remaining focus is on Core Principle 5: stability improves economic welfare. Furthermore, the policy instrument of choice, an overnight interest rate (the federal funds rate in the U.S. and the overnight cash rate in the euro area), has several advantages. It is observed easily, widely reported, and satisfies, at least in the very short term, the feature that central bank policy be both transparent and accountable. Overnight loan markets are traded actively, interest rates are observable by the minute, and comparison between the observed interest rate and the stated target is immediate. Finally, by taking aim directly at ultimate goal variables, such as an inflation target, policy transparency is also enhanced since nearly all agents have easily accessible information on inflation rates. All they have to do is occasionally watch the evening news or read headlines on their favorite, general- information Internet websites. Of course, the stability that is especially important is longer-run stability in the economy, often expressed in terms of goals like the variance of GDP or inflation. Central banks, by targeting a key interest rate, influence the present value of spending on durable goods, which alters economic growth. For example, suppose you are considering buying capital (even human capital, such as your college education) that will raise your income by $1,000 per month. A lower interest rate can be thought of as raising the value of that capital in two ways. First, the lower interest rate makes financing of the capital cheaper (lower student loan rates, for example). Second, the lower rate raises the present value of the extra $1,000 per month and so makes the capital purchase more attractive. Either way, investment is encouraged, which helps economic growth. While there is much more to come on just how markets in the economy determine GDP and its growth rate, for now it is enough to appreciate the direct link between the interest rate and economic activity that is, that the interest rate affects economic stability, the object of Core Principle 5. B. S OLIDIFY Y OUR K NOWLEDGE DISCUSSION/EXTENSIONS OF THE BASICS The Real Interest Rate, Revisited : In chapter 4 of the text, and with some added technical detail in chapter 4 of this study guide, you learned about the real interest rate. At the end of this chapter, you are going to encounter a simple, descriptive, and effective way to think about monetary policy: the Taylor rule. Since the Taylor rule builds on the
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Chapter 18: Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy ______________________________________________________________________________________ 374 nominal/real interest rate distinctio n, let’s first recall that the relationship between the se two (the Fisher equation) is expressed simply as t t t r i where i t is the nominal interest rate, r t
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