F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez Monetary Policy

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 2 of 23 money market The market for money in which the amount supplied and the amount demanded meet to determine the nominal interest rate. transaction demand for money The demand for money based on the desire to facilitate transactions. THE MONEY MARKET 17.1 The Demand for Money INTEREST RATES AFFECT MONEY DEMAND

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 3 of 23 THE MONEY MARKET 17.1 INTEREST RATES AFFECT MONEY DEMAND The Demand for Money  FIGURE 17.1 Demand for Money

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 4 of 23 THE MONEY MARKET 17.1 The Demand for Money THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND  FIGURE 17.2 Shifting the Demand for Money

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 5 of 23 THE MONEY MARKET 17.1 The Demand for Money OTHER COMPONENTS OF MONEY DEMAND illiquid Not easily transferable to money. liquidity demand for money The demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs. speculative demand for money The demand for money that arises because holding money over short periods is less risky than holding stocks or bonds.

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 6 of 23 open market operations The purchase or sale of U.S. government securities by the Fed. HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY 17.2 Open Market Operations open market purchases The Fed’s purchase of government bonds from the private sector. open market sales The Fed’s sale of government bonds to the private sector.

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 7 of 23 discount rate The interest rate at which banks can borrow from the Fed. HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY 17.2 Other Tools of the Fed federal funds market The market in which banks borrow and lend reserves to and from one another. federal funds rate The interest rate on reserves that banks lend each other. CHANGING RESERVE REQUIREMENTS CHANGING THE DISCOUNT RATE

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 8 of 23 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 17.3  FIGURE 17.3 Equilibrium in the Money Market

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 9 of 23 HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY 17.3  FIGURE 17.4 Federal Reserve and Interest Rates

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 10 of 23 RISING INTEREST RATES DURING AN ECONOMIC RECOVERY APPLYING THE CONCEPTS #1: What happens to interest rates when the economy recovers from a recession? Economists have often noticed that interest rates start to rise: As an economy recovers from a recession. As the economy grows quickly. Why should a recovery be associated with higher interest rates? The extra income being generated by firms and individuals during the recovery will increase the demand for money. Because the demand for money increases while the supply of money remains fixed, interest rates rise. The Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy. The Fed cuts back on the supply of money to raise interest rates. The public should expect rising interest rates during a period of economic recovery and rapid GDP growth.

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 11 of 23 GETTING THE PRICE RIGHT The Fed receives economic data ahead of the general public and many Fed watchers believe that core personal consumption expenditure (PCE) data play a bigger role in the Fed’s decision-making than the CPI or PPI. The PCE data is considered to be more responsive to economic changes and thus a better measure of inflation. It is difficult to separate the different inflation measures. The PCE is compiled by the Commerce Department and uses both CPI and PPI data (compiled by the Labor Department) to adjust for inflation. The government also monitors import prices and compiles an Import Price Index that indicated import prices increased by 1.6% in May. So, what does the Fed look at? The Fed probably considers all of this information when making interest rate determinations. However, how much weight each factor carries is indeterminate since we are on the outside looking in. All the markets have the inflation jitters largely due to Ben Bernanke’s control of the Fed. Investors have yet to determine Bernanke’s likely reaction to economic news and are concerned over how the Fed might react to personal income and spending data soon to be released. If inflation appears imminent, the Fed will likely raise rates. Extra Application 4

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 12 of 23 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 17.4  FIGURE 17.5 The Money Market and Investment Spending

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 13 of 23 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 17.4  FIGURE 17.6 Monetary Policy and Interest Rates

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 14 of 23 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 17.4  FIGURE 17.7 Money Supply and Aggregate Demand

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 15 of 23 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 17.4

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 16 of 23 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 17.4 Monetary Policy and International Trade exchange rate The rate at which currencies trade for one another in the market. depreciation of a currency A decrease in the value of a currency.

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 17 of 23 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) 17.4 Monetary Policy and International Trade appreciation of a currency An increase in the value of a currency.

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 18 of 23 THE EFFECTIVENESS OF COMMITTEES APPLYING THE CONCEPTS #2: Is it better for decisions about monetary policy to be made by a single individual or by a committee? Professor Alan Blinder was convinced that committees were not effective for making decisions about monetary policy. Blinder developed an experiment to see whether individuals or groups make better decisions and who makes them more rapidly. The experiment was designed to explore how quickly individuals and groups could distinguish changes in underlying trends from random events. Example: If unemployment were to rise in one month, such a rise could be- a temporary aberration. the beginning of a recession. Problems: Changing monetary policy would be a mistake if the rise were temporary. Waiting too long to change policy would be costly if the change were permanent. Who is better at making these sorts of determinations? Committees make decisions as quickly and are more accurate than individuals making decisions by themselves.

chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 19 of 23 MONETARY POLICY CHALLENGES FOR THE FED 17.5 Lags in Monetary Policy Expectations of Inflation