Monetary Policy and the Interest Rate

Fed Goals ● Fed Goals: Economic growth and price stability (inflation control) ● When the Fed wants to lower interest rates, they engage in expansionary monetary policy ● When the Fed wants to raise interest rates, they engage in contractionary monetary policy.

Expansionary Monetary Policy ● The Fed observes that the economy is in a recessionary gap. ● The Fed buys bonds--increases the money supply. ● The interest rate falls. ● Investment and consumption increase. ● AD shifts to the right. ● Real GDP increases, unemployment rate decreases, the aggregate price level rises

Contractionary Monetary Policy ● The Fed observes that the economy is in a recessionary gap. ● The Fed buys bonds--increases the money supply. ● The interest rate falls. ● Investment and consumption increase. ● AD shifts to the right. ● Real GDP increases, unemployment rate decreases, the aggregate price level rises

Monetary Policy & Interest Rate ● Usually the Fed adjusts the money supply to target a specific federal funds rate. ● If the current federal funds rate is higher than the target, the Fed will increase the money supply so that the rate falls to the target. ● If the current federal funds rate is lower than the target, the Fed will decrease the money supply so that the rate rises to the target.

Interest Rate Graph

Real v. Nominal Interest Rate Real interest rate = Nominal interest rate — Inflation rate ● Nominal interest rate is the rate actually paid for a loan ● Real interest rate is nominal interest rate adjusted for inflation ● For borrowers, the true cost of borrowing is the real interest rate. ● For lenders, the true payoff to lending is the real interest rate.