expectations about what’s going to happen to short-term rates in the future. 3. EXPANSIONARY MONETARY POLICY reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. CONTRACTIONARY MONETARY POLICY raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run. 4. The Federal Reserve and other central banks try to stabilize the economy, limiting fluctuations of actual output around potential output, while also keeping inflation low but positive. Under a TAYLOR RULE FOR MONETARY POLICY , the target federal funds rate rises when there is high inflation and either a positive output gap or very low unemployment; it falls when there is low or negative inflation and either a negative output gap or high employment. Some central banks engage in INFLATION TARGETING , which is a forward looking policy rule, whereas the Taylor rule method is a backward-looking policy rule. Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the
preferred policy tool for stabilizing the economy. Because interest rates cannot fall below zero- the ZERO LOWER BOUND FOR INTEREST RATES - the power of monetary policy is limited. 5. In the long run, changes in the money supply affects the aggregate price level but not real GDP or the interest rate. Data show that the concept of MONETARY NEUTRALITY holds: changes in the money supply have no real effect on the economy in the long run. MONEY DEMAND CURVE: A graphical representation of the relationship between the interest rate and the quantity of money demanded. The money demand curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money. SHORT-TERM INTEREST RATES: The interest rate on financial assets that mature within less than a year. LONG-TERM INTEREST RATES: The interest rate on financial assets that mature a number of years into the future. LIQUIDITY PREFERENCE MODEL OF THE INTEREST RATE: A model of the market for money in which the interest rate is determined by the supply and demand for money. SUPPLY CURVE: A graphical representation of the supply schedule, showing the relationship between quantity supplied and price. TARGET FEDERAL FUNDS RATE: The Federal Reserve’s desired level for the federal funds rate. The Federal Reserve adjusts the money supply through the purchase and sale of Treasury bills until the actual rate equals the desired rate. EXPANSIONARY MONETARY POLICY: Monetary policy that, through the lowering of the interest rate, increase aggregate demand and therefore output. CONTRACTIONARY MONETARY POLICY: Monetary policy that, through the raising of the interest rate, reduces aggregate demand and therefore output.
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