Lecture 11 Federal Reserve and the Macroeconomy (Chapter 14 And Chapter 15) Ch. 12 & 13 in 4 th Edition

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The supply of money determines the interest rate, given the demand for money.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The Demand for Money  Money is an asset, and is used for transactions.  Money is a store of value, and is used for holding wealth.  People must decide how to hold their wealth, or make portfolio allocation decisions.  There are many ways to hold wealth: Cash, Checking, Bonds, Stocks

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The Demand for Money  The portfolio allocation decision is made by comparing return relative to risk.  Risk can be reduced by diversifying the portfolio.  Most people choose to hold some wealth as money.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Demand for Money (Liquidity Preference)  The amount of wealth an individual chooses to hold in the form of money.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Example  Louis’ wealth = $10,000 Holds $10,000 in cash His demand for money = $10,000 If he allocates his wealth to:  $1,000 cash  $2,000 checking account  $2,000 government bonds  $5,000 rare stamps His demand for money = $3,000

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The Demand for Money  How much money to hold (demand for money) is determined by the cost-benefit principle. Benefit of holding money used to make transactions Cost of holding money; the opportunity cost of foregone interest vs.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Macroeconomic Factors that Affect the Demand for Money  Cost of holding money The nominal interest rate (i)  The quantity of money demanded is inversely related to the nominal interest rate

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Macroeconomic Factors that Affect the Demand for Money  Benefit of holding money Real income or output (Y)  An increase in real income will increase the demand for money and vice versa The price level (P)  The higher the price level, the greater the demand for money and vice versa

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Money Demand Curve Money M Nominal interest rate i MD Demand for money is inversely related to the nominal interest rate (i)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. A Shift In The Money Demand Curve Money M Nominal interest rate i MD MD’ Shifts in MD Changes in Y & P MD will increase if Y or P increase Technological changes Foreign demand

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The Supply of Money and Money Market Equilibrium  The Fed controls the supply of money with open-market operations.  An open-market purchase of bonds by the Fed will increase the money supply.  An open-market sale of bonds by the Fed will decrease the money supply.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Equilibrium in the Market for Money Money Money demand curve, MD E Money supply curve, MS M i M1M1 i1i1 If interest = i 1 Q md > Q ms People sell interest bearing assets to hold more money Price of financial assets falls and interest rates rise Nominal interest rate

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Fed Lowers the Nominal Interest Rate Nominal interest rate MD E MS M Money i M’ I’ F MS’ The Fed wants to lower i Fed buys bonds The money supply increases Creates a surplus of money People buy interest bearing assets Non-money asset prices rise and interest rates fall

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The Supply of Money and Money Market Equilibrium  The Fed wants to raise i Fed sells bonds The money supply falls Creates a shortage of money People sell non-money assets Non-money asset prices fall and the interest rate increases

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates How the Fed Controls the Nominal Interest Rate  The Fed cannot set the interest rate and the money supply independently.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates The Advantages of Targeting the Interest Rate  The effects of monetary policy are exerted through interest rates  Public familiarity with interest rates  Interest rates can be monitored easily

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Federal Funds Rate  The interest rate that commercial banks charge each other for very short-term (usually overnight) loans  Because the Fed frequently sets its policy in the form of a target for the federal funds rate, this rate is closely watched in financial markets

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Can the Fed Control the Real Interest Rate?  The real interest rate = nominal interest - inflation

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Can the Fed Control the Real Interest Rate?  The Fed controls the nominal interest rate.  Inflation adjusts slowly to changing economic conditions.  Therefore, if the Fed changes the nominal interest rate, the real rate will generally change by the same amount in the short run.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Can the Fed Control the Real Interest Rate?  Short-run impact of Fed policy Prices do not vary greatly in the short run. Changes in the money supply can change nominal and real interest. Real interest influences consumption and investment. Fed’s ability to influence spending is strongest in the short run.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates Can the Fed Control the Real Interest Rate?  Long-run impact of Fed policy Prices adjust to changing economic conditions. The real interest rate is determined by the balance of savings and investment. The Fed has less effect on spending in the long run.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Reserve and Interest Rates How much control does the Fed have over spending?  The Fed has direct control over the federal funds rate.  The federal funds rate may influence, but does not control other interest rates which influence spending.  The inability of the Fed to precisely control other interest rates complicates monetary policy. New efforts to change this.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy The Fed can control i and r in the short run. PAE is influenced by r.  Lower r increases PAE  Higher r reduces PAE The Fed can stabilize output and employment.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy Planned Aggregate Expenditure and the Real Interest Rate  Real interest rates and consumption High real interest rates increases the incentive to save. If savings increase, consumption decreases. High real interest rates reduces consumption.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy Planned Aggregate Expenditure and the Real Interest Rate  Real interest rates and investment spending High real interest rates increases the cost of investment spending. The increased cost reduces profitability of investment spending and investment falls. High real interest rates reduces investment spending.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy Example  Assume: C = (Y – T) – 500r  -500r – a 1% increase in r reduces C by 5 units I P = 800 – 400r  -400r – a 1% increase in r reduces I by 4 units G = 800 NX = 85 T = 650

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy Example  PAE = C + I P + G + NX Autonomous spending depends on rInduced spending depends on Y

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Example  The real interest rate and short-run equilibrium output Assume the Fed sets the r at 0.05 (5 percent) The Effects of Federal Reserve Actions on the Economy

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Example  Equilibrium occurs when Y = PAE Y = 20,550 The Effects of Federal Reserve Actions on the Economy

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy Example  The Fed fights a recession  Assume

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Fed Fights A Recession Output Y Planned aggregate expenditure PAE Y = PAE 20,820 Recessionary gap E Expenditure line (r = 5%) 20,550 Y* Expenditure line (r = 2%) F A reduction in r shifts the expenditure line upward Multiplier = 10 Output gap = 270 Fed wants to increase PAE by 270/10 =27 C = 1, (Y-T) – 500r I = 800 – 400r 1% change in r will change C by 5 and I by 4 Reduce r to 0.02 to increase C and I by 27 total

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Fed Fights Inflation Output Y Planned aggregate expenditure PAE Expenditure line (r = 5%) Y = PAE 20,550 Expansionary gap E 20,280 Y* G Expenditure line (r = 8%) An increase in r shifts the expenditure line downward

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy An example of a monetary policy reaction function:

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. A Monetary Policy Reaction Function for the Fed 0.00 (= 0%)0.02 (= 2%) Rate of inflation,  Real interest rate set by Fed, r

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. An Example of a Fed Policy Reaction Function Real interest rate set by Fed, r Fed’s monetary policy reaction function Inflation 

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. A General Monetary Policy Reaction Function Real interest rate set by Fed, r MPRF Inflation  r* Slope = g ** A

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of Federal Reserve Actions on the Economy The Fed  A determinant of the Fed’s policy reaction function is its objective for inflation.  The slope of the reaction function indicates how aggressive the Fed will pursue its target.

Inflation, Aggregate Supply, and Aggregate Demand (Chapter 15)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Introduction The Keynesian model assumes that producers meet demand at preset prices. The shortcoming of their assumption is that it does not explain the behavior of inflation.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Introduction The aggregate demand/aggregate supply model will allow us to see how macroeconomic policy affects inflation and output.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Aggregate Demand (AD) Curve  Shows the relationship between short-run equilibrium output Y and the rate of inflation,   The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Aggregate Demand (AD) Curve  Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward- sloping

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Aggregate Demand Curve Output Y AD Aggregate Demand Curve An increase in  reduces Y (all other factors held constant) Inflation 

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Inflation, the Fed, and the AD Curve  A primary objective of the Fed is to maintain a low and stable inflation rate.  Inflation is likely to occur when Y > Y*.  To control inflation, the Fed must keep Y from exceeding Y*.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Inflation, the Fed, and the AD Curve  The Fed can reduce autonomous expenditure by raising the interest rate.  increases r increases autonomous spending decreases Y decreases (AD curve)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Aggregate Demand Curve and the Monetary Policy Reaction Function Output Y Inflation  Real interest rate set by the Fed, r A A 11 r1r1 11 B B 22 r2r2 22

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Other Reasons for the Downward Slope of the AD Curve  Real value of money  Distributional effects  Uncertainty  Prices of domestic goods and services sold abroad

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Effect of An Increase In Exogenous Spending Output Y AD Exogenous Spending: spending unrelated to Y or r Fiscal policy Technology Foreign demand AD’ An increase in exogenous spending shifts AD to AD’ and vice versa Inflation 

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. A Shift in the Fed’s Monetary Policy Reaction Function Real interest rate set by Fed, r Output Y Inflation  Fed “tightens” monetary policy – shifting reaction curve The new Fed policy increases r and AD shifts to AD’ Old monetary policy reaction function AD A A r* 1*1* New monetary policy reaction function AD’ B B 2*2*

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Movements Along the AD Curve   and Y are inversely related  Changes in  cause a change in Y or a movement along the AD curve   increases r increases planned spending decreases Y decreases (stationary monetary policy reaction function)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation, Spending, and Output: The Aggregate Demand Curve Shifts of the AD Curve  Any factor that changes Y at a given  shifts the AD curve.  Shifts of the AD curve can be caused by: Changes in exogenous spending. Changes in the Fed’s policy reaction function.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply Three factors that can increase the inflation rate  Output gap  Inflation shock  Shock to potential output

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply Long-term Wage and Price Contracts  Union wage contracts set wages for several years.  Contracts setting the price of raw materials and parts for manufacturing firms also cover several years.  These long-term contracts reflect the inflation expectations at the time they are signed.

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Output Gap and Inflation Relationship of output to potential outputBehavior of inflation 1. No output gapInflation remains unchanged Y = Y* 2. Expansionary gapInflation rises Y > Y*  3. Recessionary gapInflation falls Y < Y* 

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply The Output Gap and Inflation  If Y* = Y An increase in exogenous spending creates and expansionary gap (Y > Y*) -- inflation increases A decrease in exogenous spending creates a recessionary gap (Y < Y*) -- inflation decreases

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply The Aggregate Demand—Aggregate Supply Diagram  Long-run aggregate supply (LRAS) A vertical line showing the economy’s potential output Y*

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply The Aggregate Demand—Aggregate Supply Diagram  Short-run Aggregate Supply (SRAS) A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply The Aggregate Demand—Aggregate Supply Diagram  Short-run Equilibrium A situation in which inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Output Nominal interest rate i Aggregate demand, AD Long-run aggregate supply, LRAS A Y*Y Short-run aggregate supply, SRAS Short-run equilibrium Y: SRAS(  ) = AD Y < Y* -- recessionary gap  and Y adjust to the gap  decreases & Y increases Long-run equilibrium AD, SRAS (  *), LRAS (Y*) will intersect at the same point

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply The Aggregate Demand—Aggregate Supply Diagram  Long-run Equilibrium A situation in which actual output equals potential output and the inflation rate is stable Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inflation and Aggregate Supply A Review of the Adjustment Process to a Recessionary Gap  Firms that are selling less than they want to will start to lower prices.  As  falls the Fed lowers r and AD increases.  Falling  reduces uncertainty which also increases AD

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. AD LRAS A Y SRAS 1  SRAS 2 SRAS 3 The Adjustment of Inflation When a Recessionary Gap Exists Output Inflation Y* SRAS Final B ’’

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Adjustment of Inflation When A Expansionary Gap Exists Output Inflation LRAS A AD Y*Y SRAS  B Short-run Eq. Y Expansionary gap Y > Y*  rises, AD falls – Y falls Long-run equilibrium at Y*,  * ’’ SRAS Final SRAS 3 SRAS 2

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Sources of Inflation Excessive Aggregate Spending Inflation Shocks Shocks to Potential Output

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. War and Military Buildup As A Source of Inflation Output Inflation Output Inflation AD LRAS A Y* SRAS LRAS A Y* SRAS   ’’ SRAS Final C  increases shifting SRAS to SRAS Final Long-run equilibrium back to Y* with  * SRAS 3 SRAS 2 Y B AD’ Y B Increase in military spending causes AD to increase Creates an expansionary gap -- Y > Y*

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Sources of Inflation Inflation Shock  A sudden change in the normal behavior of inflation, unrelated to the nation’s output gap

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Sources of Inflation Inflation Shock -- Examples  OPEC embargo of 1973  Drop in oil prices in 1986

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of an Adverse Inflation Shock Output Inflation AD’ C No policy --  falls; long-run eq. at A With policy--AD shifts to AD’; Y = Y*;  rises to  * AD LRAS A Y*Y* SRAS A--Y* = Y  Y’ B SRAS’ Inflation shock,  increases to  ‘ (SRAS’) Short-run eq. At B, Y < Y*; recessionary gap and higher inflation (stagflation) ’’

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Effects of a Shock To Potential Output Output Inflation AD LRAS A Y*Y* SRAS Equilibrium at A -- Y* = Y  Y*’ B SRAS’ LRAS’ Y* falls to Y*’ Y > Y* -- expansionary gap  increases--SRAS rises to SRAS’ Equilibrium at B Y = Y*’  increased to  ‘ Decline in output is permanent ’’