Outline: How does the Fed change the interest rate? The monetary “transmission mechanism” Potential breakdowns of the transmission mechanism. Brief review of the Fed policy record

Interest Rate Money ($Billions) 0 Ms1Ms1 Ms2Ms2 MdMd E F 6% 4% Fed open market operations bid up the prices of bonds, and drive yields down. Open Market Operations and the Money Market

Interest Rate Money ($Billions) 0 Ms1Ms1 Ms2Ms2 MdMd E F 6% 4% Fed open market sale depresses bond prices, and drives yields upward. Fed “Pulls the String”

Question: How is Fed policy “transmitted” to macroeconomic variables such as real GDP, employment, and the general price level?

Fed Open Market Purchase of Securities Increase in the Money Supply Decrease in the interest rate Increase in components of spending that are sensitive to interest rates—specifically, investment and consumer durable goods Multiplier Effect Real GDP

0 0 i M AE Y % 4% Ms1Ms1 Ms2Ms2 Y1Y1 Y2Y2 AE 1 AE 2 MdMd Diagrammatic explanation of the transmission mechanism

Some economists (notably Keynesians) are skeptical about the effectiveness of expansionary monetary policy Breakdowns in the Transmission Mechanism Breakdowns include: Non-responsiveness of aggregate expenditure (AE) to changes in the rate of interest. The liquidity trap

i Investment ($Billions) I2I2 I1I1 6% 4% Not interest-sensitive The FED may be successful in decreasing interest rates. But what if investment spending fails to respond?

Ms1Ms1 Ms2Ms2 MdMd Interest Rate Money ($Billions) i* 0 At an interest rate equal to or below i*, wealth holders wish to hold ALL money and NO bonds.

The FOMC sets a target for the “federal funds” rate, which is the rate that banks charge other banks for “borrowed” reserves.

The Fed pulled on the string big time beginning in 1979—it was an anti-inflation strategy under Chairman Paul Volcker

Conventional 30 year

Mortgage rate Monthly Payment 1 8%$ %$ %$1, %$1, %$1, Does not include prorated insurance or property taxes. Monthly payments on a $110, year mortgage note

Data in thousands of units

More recently, the Fed raised the federal funds rate six times between May 99 and May 2000— from 4.75% to 6.5 %.

The Fed reversed course at the beginning of 2001