ShortRunB - The Economy in the Short Run - Part B...

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1 The Economy in the Short Run - Part B Stabilizing the Economy: The Role of the Fed I. Overview The Fed has a big role in stabilization policy. It is for this reason that the public scrutinizes the Fed and Bernanke. We will begin by reviewing and discussing in more detail money supply and money demand. We will then link the Fed’s actions to our short-run model.
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2 II. The Federal Reserve and Interest Rates What matters to the economy is interest rates. The Fed sets of target for interest rates and changes reserves and the money supply to achieve it. A. Review of Money Demand Benefit: Cost: Facilitates transactions Opportunity cost of holding money is the interest rate M M 1 31 31 1 Avg M = 1/2Y, interest = 0 Avg. M = 1/4Y, int. = ix(1/4)Y
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3 A. Review of Money Demand - continued i M/P As i rises, the opportunity cost of holding money grows, so you want to hold less in your portfolio.
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4 B. Supply of Money and Money Market Equilibrium The most common method for changing reserves and the money supply is through open market operations. To increase reserves in the banking system, the Fed buys bonds from the Public. Increases the money supply. To decrease reserves the Fed sells bonds. To increase reserves in the banking system, the Fed buys bonds. To decrease reserves in the banking system, the Fed sells bonds. i M/P MD MS (M/P)^S
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5 C. How the Fed controls the nominal interest rate Show effects of change in M i M/P (M/ P)D (M/ P)S Note that Fed cannot control both M and i at same time. Once it determines one, the other is determined. In practice, Fed sets target for I and changes M to achieve. To decrease I, the Fed should increase reserves which increases money supply. Fed cannot control the money supply and interest rates at the same time. Once it determines one, the other is determined. Typically Fed sets a target for the interest rate (i) and changes money supply to achieve it.
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Recall that the fed funds rate is the interest rate that commercial banks charge each other for very short-term loans. By affecting the fed funds rate, the Fed affects other interest rates. Federal Funds Rate – the rate on overnight loans made between
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This note was uploaded on 04/07/2008 for the course GENERAL ED MMW 1,2; E taught by Professor Vandehey during the Spring '08 term at UCSD.

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ShortRunB - The Economy in the Short Run - Part B...

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