1 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy CHAPTER 14 Monetary Policy Fernando Quijano Prepared by:

2 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy What Is Monetary Policy? 1.price stability 2.high employment 3.promote stable long-run economic growth 4.ensure the stability of financial markets and institutions The Fed has four monetary policy goals that are intended to promote a well-functioning economy: Define monetary policy and describe the Federal Reserve’s monetary policy goals LEARNING OBJECTIVE The Monetary Policy Goals of the Fed Monetary policy The actions the Federal Reserve takes to manipulate the money supply or the interest rate to pursue macroeconomic objectives.

3 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy What Is Monetary Policy? GOAL # 1: Price Stability Figure 14-1 The Inflation Rate, January 1952–July 2009 For most of the 1950s and 1960s, the inflation rate in the United States was 4 percent or less. During the 1970s, the inflation rate increased, peaking during 1979–1981, when it averaged more than 10 percent. After 1992 the inflation rate was usually less than 4 percent, until increases in oil prices pushed it above 5 percent during summer The effects of the recession caused several months of deflation—a falling price level—during early Note: The inflation rate is measured as the percentage change in the consumer price index (CPI) from the same month in the previous year. Define monetary policy and describe the Federal Reserve’s monetary policy goals LEARNING OBJECTIVE

4 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy What Is Monetary Policy? GOAL # 2: High Employment The goal of high employment extends beyond the Fed to other branches of the federal government. Define monetary policy and describe the Federal Reserve’s monetary policy goals LEARNING OBJECTIVE When financial markets and institutions are not efficient in matching savers and borrowers, resources are lost. GOAL # 3: Promote Stable Long-Run Economic Growth Policymakers aim to encourage stable long-run economic growth because stable growth allows households and firms to plan accurately and encourages the long-run investment needed to sustain growth. GOAL # 4: Ensure the Stability of Financial Markets and Institutions

5 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets The Fed tries to keep both the unemployment and inflation rates low, but it can’t affect either of these economic variables directly. The Fed has two intermediate targets of monetary policy. The Fed can directly affect these variables, and in turn, these variables affect the Fed’s policy goals, such as real GDP, employment, and the price level. INTERMEDIATE TARGET # 1: the nominal M1 money supply INTERMEDIATE TARGET # 2: short-term nominal interest rates The Intermediate Policy Targets of the Fed Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

6 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets The Demand for Money Figure 14-2 The Demand for Money The money demand curve slopes downward because lower interest rates cause households and firms to switch from financial assets such as U.S. Treasury bills to money. A fall in the interest rate from 4 percent to 3 percent will increase the quantity of money demanded from $900 billion to $950 billion. An increase in the interest rate will decrease the quantity of money demanded. Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

7 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets Shifting the Money Demand Curve Figure 14-3 Shifts in the Money Demand Curve Changes in real GDP (Y) or the price level (P) cause the money demand curve to shift. Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

8 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets Equilibrium in the Money Market Figure 14-4 The Impact on the Interest Rate When the Fed Increases the Money Supply Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

9 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets Figure 14-5 The Impact on Interest Rates When the Fed Decreases the Money Supply Equilibrium in the Money Market Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

10 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets A Tale of Two Interest Rates Why do we need two models of the interest rate? The answer is that the loanable funds model is concerned with the long-term real rate of interest, and the money market model is concerned with the short-term nominal rate of interest. Choosing an Intermediate Target There are many different interest rates in the economy. For purposes of monetary policy, since the 1980s, the Fed has targeted the interest rate known as the federal funds rate. Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

11 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets The Importance of the Federal Funds Rate Federal funds rate The interest rate banks charge each other for overnight loans. Usually just called the “fed funds” rate Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

12 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Money Market and the Fed’s Choice of Monetary Policy Targets The Importance of the Federal Funds Rate Figure 14-6 Federal Funds Rate Targeting, January 1998– July 2009 The Fed does not set the federal funds rate, but its ability to increase or decrease bank reserves quickly through open market operations keeps the actual federal funds rate close to the Fed’s target rate. The orange line is the Fed’s target for the federal funds rate, and the jagged green line represents the actual value for the federal funds rate on a weekly basis. Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate LEARNING OBJECTIVE

13 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy and Economic Activity consumption (C) investment (I) net exports (NX) How Interest Rates Affect Aggregate Demand Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand : Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE

14 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy and Economic Activity Expansionary monetary policy The Federal Reserve’s increasing the money supply and decreasing interest rates to increase real GDP. The Effects of Monetary Policy on Real GDP and the Price Level Contractionary monetary policy The Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation. Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE

15 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary policy in the simple (static) AD-LRAS-SRAS model Figure 14-7 Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE

16 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Too Low for Zero: The Fed Tries "Quantitative Easing” Making the Connection The Fed pushed interest rates to very low levels during 2008 and Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE

17 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy and Economic Activity Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do. Can the Fed Eliminate Recessions? Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE

18 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy and Economic Activity Figure 14-8 The Effect of a Poorly Timed Monetary Policy on the Economy The upward-sloping straight line represents the long-run growth trend in real GDP. The curved red line represents the path real GDP takes because of the business cycle. If the Fed is too late in implementing a change in monetary policy, real GDP will follow the curved blue line. The Fed’s expansionary monetary policy results in too great an increase in aggregate demand during the next expansion, which causes an increase in the inflation rate. Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE Can the Fed Eliminate Recessions?

19 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy and Economic Activity A Summary of How Monetary Policy Works Table 14-1 Expansionary and Contractionary Monetary Policies Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level LEARNING OBJECTIVE

20 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy in the Dynamic Aggregate Demand and Aggregate Supply Model Figure 14-9 An Expansionary M.P. Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy LEARNING OBJECTIVE Monetary policy in the dynamic AD-LRAS-SRAS model

21 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Monetary Policy in the Dynamic Aggregate Demand and Aggregate Supply Model Figure A Contractionary M.P. Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy LEARNING OBJECTIVE Monetary policy in the dynamic AD-LRAS-SRAS model

22 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy YEARPOTENTIAL GDPREAL GDPPRICE LEVEL 2012$14.9 trillion $15.3 trillion$15.2 trillion112 The hypothetical information in the table shows what the values for real GDP and the price level will be in 2013 if the Fed does not use monetary policy. The Effects of Monetary Policy Solved Problem 14-4 Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy LEARNING OBJECTIVE

23 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Solved Problem 14-4 The Effects of Monetary Policy (continued) Use the dynamic aggregate demand and aggregate supply model to analyze monetary policy LEARNING OBJECTIVE

24 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy A Closer Look at the Fed’s Setting of Monetary Policy Targets Some economists have argued that rather than use an interest rate as its monetary policy target, the Fed should use the money supply. Many of the economists who make this argument belong to a school of thought known as monetarism. The leader of the monetarist school was Nobel Laureate Milton Friedman. Friedman and his followers favored replacing monetary policy with a monetary growth rule. Rules vs Discretion Debate 1: Should the Fed Target the Money Supply Instead? Discuss the Fed’s setting of monetary policy targets LEARNING OBJECTIVE

25 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy A Closer Look at the Fed’s Setting of Monetary Policy Targets Why Doesn’t the Fed Just Target Both the Money Supply and the Interest Rate? Figure The Fed Can’t Target Both the Money Supply and the Interest Rate Discuss the Fed’s setting of monetary policy targets LEARNING OBJECTIVE

26 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy A Closer Look at the Fed’s Setting of Monetary Policy Targets Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. Rules vs Discretion Debate 2: The Taylor Rule Federal funds target rate = = current inflation rate + real equilibrium federal funds rate + (1/2) * inflation gap + (1/2) * output gap Discuss the Fed’s setting of monetary policy targets LEARNING OBJECTIVE

27 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy A Closer Look at the Fed’s Setting of Monetary Policy Targets Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. Discuss the Fed’s setting of monetary policy targets LEARNING OBJECTIVE Rules vs Discretion Debate 3: Should the Fed Target the Inflation Rate?

28 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Making the Connection How Does the Fed Measure Inflation? The Fed excludes food and energy prices from its main measure of inflation. Discuss the Fed’s setting of monetary policy targets LEARNING OBJECTIVE

29 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Fed Policies During the Recession The Inflation and Deflation of the Housing Market “Bubble” Figure The Housing Bubble Sales of new homes in the United States went on a roller-coaster ride, rising by 60 percent between January 2000 and July 2005, before falling by 76 percent between July 2005 and January Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE

30 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Fed Policies During the Recession The Changing Mortgage Market The Role of Investment Banks Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors through Fannie Mae and Freddie Mac to banks and, ultimately, to individuals and families borrowing money to buy houses. By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury.

31 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Making the Connection The Wonderful World of Leverage Making a very small down payment on a home mortgage leaves a buyer vulnerable to falling house prices. RETURN ON YOUR INVESTMENT FROM... DOWN PAYMENT A 10 PERCENT INCREASE IN THE PRICE OF YOUR HOUSE A 10 PERCENT DECREASE IN THE PRICE OF YOUR HOUSE 100% 10% -10% Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE During the housing boom, many people purchased houses with down payments of 5 percent or less. In this sense, borrowers were highly leveraged, which means that their investment in their house was made mostly with borrowed money.

32 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Fed and the Treasury Department Respond Initial Fed and Treasury Actions Fed Policies During the Recession Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE First, although the Fed traditionally made loans only to commercial banks, in March 2008 it announced the “Primary Dealer Credit Facility”, under which primary dealers—firms that participate in regular open market transactions with the Fed—are eligible for discount window loans. Second, also in March, the Fed announced the “Term Securities Lending Facility”, under which the Fed will loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities (this is QE1—the Fed buys up all the toxic assets). Third, once again in March, the Fed and the Treasury helped JPMorgan Chase acquire the investment bank Bear Stearns, which was on the edge of failing. Finally, in early September, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac (which are now going bankrupt).

33 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy The Fed and Treasury Department Respond Responses to the Failure of Lehman Brothers Fed Policies During the Recession Discuss the policies the Federal Reserve used during the recession LEARNING OBJECTIVE In October 2008, Congress passed the “Troubled Asset Relief Program” (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock. Taking partial ownership positions in private commercial banks was an unprecedented action for the federal government. Clearly, the recession of 2007–2009, and the accompanying financial crisis, had led the Fed and the Treasury to implement new approaches to policy. Many of these new approaches were controversial because they involved partial government ownership of financial firms, implicit guarantees to large financial firms that they would not be allowed to go bankrupt, and unprecedented intervention in financial markets.

34 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy ECB Chief Says Boost in Stimulus Not Needed The European Central Bank’s monetary policy has been less aggressive than the Federal Reserve’s. Housing Market Affects the United States and Europe Differently AN INSIDE LOOK >>

35 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 14: Monetary Policy Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule KEY TERMS