Class 24 Revised 11-14-2011 Discussion Outline for FED Policy

Class 24 Revised 11-14-2011 Discussion Outline for FED Policy

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Class 24 Chap 17 parts & Chap 18 Taylor rule on FED Policy Review of the S & D analysis: a) The current or actual state of the economy [‘temporary’ state] is always given b) Given the inflation expected in the economy and the sustainable [‘potential’ state] of the economy, SRAS intersects LRAS at π e . (The expectations that allow SRAS to be consistent with potential or LRAS. c) The sustainability (stability) of the current state is determined by whether or not AD is at this current intersection on the LRAS. a. If it is, is will be stable or sustainable. b. If it is not, changes in the economy will occur that brings the intersection to a point on the LRAS. c. We examine the ‘forces’ that bring about this change. (a) (b)
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(c) The answer to A14 is given here where the actual equals the potential, the expected or desired state of the economy. I. Monetary Policy.
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Monetary policy is now viewed as choosing an inflation target--plus a response to shocks to achieve this target at full employment. What is not stated clearly is sometimes the “supply shock” or the “demand shock” is often a response to previous monetary policy! The Taylor Rule is a way of understanding monetary policy. The basic indicator of monetary policy position by the FED is their decision on the FED funds target rate which indicates the FED’s position with respect to reserves and the resulting money supply. 1. Increases in FF T indicates a “tightening” monetary policy with the goal of preventing rising inflation. 2. Decreases in FF T indicates a “easing” monetary policy with the goal of preventing a recession. Therefore, the “rule” guiding monetary policy, stated by Taylor, examines the gap of actual inflation from target inflation and the gap of actual output from potential output and adjust the FED funds target rate accordingly. The Taylor rule: FF T = FF A + ½ * Inflation Gap + ½ Output Gap The inflation gap = π a – π T The output gap = Y A – Y P . The intuition for this “rule” is that the target Fed Funds rate should rise fast enough to reduce AD enough to choke inflation but not to hinder growth. This Taylor rule is a general “rule of thumb” foundation of monetary policy. There is no corollary “rule of thumb” for fiscal policy because the fiscal side of the economy is so laden with political negotiation that no simplified “rule” can be specified. For
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This note was uploaded on 02/22/2012 for the course MANEC 453 taught by Professor Jerrynelson during the Winter '10 term at BYU.

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Class 24 Revised 11-14-2011 Discussion Outline for FED Policy

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