Stabilizing the Economy: The Role of the Fed Chapter 14

Chapter 14 Learning Objectives. You should be able to: Distinguish between the Federal funds rate and the discount rate. Explain how the Fed influences the interest rate. Show how a demand and supply diagram can be used to model the determination of the Federal Funds rate. Show the effect of expansionary and contractionary monetary policy on the Keynesian cross diagram.

New Fed Chair Ben Bernanke Took office February 1, 2006.

Important Distinction Federal Funds Rate -rate of interest banks charge one another for short-term loans. Money is transferred between accounts at the Fed—hence fed funds Discount Rate -rate of interest the Fed charges banks for short-term loans. Originally banks would sell loans to the Fed. The present value would be calculated using the rate of discount.

Most Important Tool of Monetary Policy Open market operations: the purchase or sale of Treasury securities by the Fed Sell Treasury securities: contractionary. Buy Treasury securities: expansionary.

The Money Demand Curve Money M Nominal interest rate i MD Demand for money is inversely related to the nominal interest rate (i)

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

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

Real vs Nominal Interest Rate Nominal rate = Real rate + Inflation rate Fed can change the real rate only in the short-run.

The Effects of Federal Reserve Actions on the Economy Policy Reaction Function –Describes how the action a policymaker takes depends on the state of the economy

Fed’s Policy Reaction Function