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Section14 - UNIVERSITY OF CALIFORNIA BERKELEY Department of...

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UNIVERSITY OF CALIFORNIA, BERKELEY Dorian Carloni Department of Economics ECON 100B, Fall 2011 SECTION 14: Monetary Policy and Aggregate Demand 14.1. The Federal Reserve and Monetary Policy ° Central banks use nominal short-term interest rates as their primary policy tool. { In the U.S., the Federal Reserve conducts monetary policy by setting a target for the federal funds rate (a nominal rate!). It does so through open market operations, which allow the Fed to control the amount of reserves in the banking system and, thus, the fed funds rate. ° Central banks control short-term nominal interest rate but it is real interest rates that matter for real economic activity. { Changes in the nominal interest rate will a°ect the real interest rate only if expected in±ation remains unchanged in the short-run. { This is true if prices are sticky (i.e. in the short run), in which case changes in monetary policy that a°ect short-term nominal interest rates will not have an immediate e°ect on either actual or expected in±ation. { The ability of central banks to control real interest rates in the short-term does not imply that they can control them in the long-run (when all prices are ±exible). ° The monetary policy curve, MP, represents the positive relationship between the real interest rate that
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