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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 longerrun 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
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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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 Spring '05
 Staff
 Interest Rates, Monetary Policy, Fed

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