© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 39 Monetary Policy Define monetary policy and describe the Federal Reserve’s monetary policy goals. Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate. Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level. Assess the arguments for and against the independence of the Federal Reserve. Learning Objectives By driving down interest rates, the Fed succeeded in heading off what some economists had predicted would be a prolonged and severe recession.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 38 What we learned in our last class: Fractional reserve banking system, bank run, bank panic Organization of the Fed. How the Federal Reserve Manages the Money Supply: Monetary policy and monetary policy tools Open market operations Discount policy Reserve requirements The Fed cannot completely control the money supply: the nonbank public and banks.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 38 What we learned in our last class: The Quantity Theory of Money A theory of the connection between money and prices that assumes that the velocity of money is constant. M × V = P × Y Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output If the velocity is constant: Inflation rate = Growth rate of the money supply − Growth rate of real output In the long run, inflation results from the money supply growing at a faster rate than real GDP. Hyperinflation and how it comes.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 38 What Is Monetary Policy? Learning Objective 14.1 Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives. 1 Price stability 2 High employment 3 Economic growth 4 Stability of financial markets and institutions The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy:

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 38 What Is Monetary Policy? Learning Objective 14.1 Price Stability FIGURE 14.1 The Inflation Rate, 1952–2006 The Goals of Monetary Policy

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 38 What Is Monetary Policy? Learning Objective 14.1 High Employment The goal of high employment extends beyond the Fed to other branches of the federal government. The Goals of Monetary Policy Economic Growth Policymakers aim to encourage stable economic growth because stable growth allows households and firms to plan accurately and encourages the long-run investment that is needed to sustain growth.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 38 What Is Monetary Policy? Learning Objective 14.1 Stability of Financial Markets and Institutions When financial markets and institutions are not efficient in matching savers and borrowers, resources are lost. The Goals of Monetary Policy

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 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 uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level. Two main targets are: the money supply and the interest rate. Monetary Policy Targets

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 The Demand for Money FIGURE 14.2 The Demand for Money

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 Shifts in the Money Demand Curve FIGURE 14.3 Shifts in the Money Demand Curve

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 How the Fed Manages the Money Supply: A Quick Review Equilibrium in the Money Market FIGURE 14.4 The Impact on the Interest Rate When the Fed Increases the Money Supply

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 Equilibrium in the Money Market FIGURE 14.5 The Impact on the Interest Rate When the Fed Increases the Money Supply

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 38 A Closer Look at the Fed’s Setting of Monetary Policy Targets Learning Objective 14.4 Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? FIGURE The Fed Can’t Target Both the Money Supply and the Interest Rate

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 38 Solved Problem The Relationship between Treasury Bill Prices and Their Interest Rates Learning Objective 14.2 What is the interest rate of a Treasury bill that pays $1,000 in one year, if its price is $962? What is the interest rate of the Treasury bill if its price is $29?

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 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 a Monetary Policy Target There are many different interest rates in the economy. For purposes of monetary policy, the Fed has targeted the interest rate known as the federal funds rate.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 The Importance of the Federal Funds Rate Federal funds rate The interest rate banks charge each other for overnight loans.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 38 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 14.2 The Importance of the Federal Funds Rate FIGURE 14.6 Federal Funds Rate Targeting, January 1997–May 2007

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 Consumption Investment Net exports 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 in the following ways:

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 38 Learning Objective 14.3 The Inflation and Deflation of the Housing Market “Bubble” Making the Connection

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 38 What we learned in last class: Monetary policy Definition Four economic objectives: Price stability, High employment, Economic growth, Statility of financial markets Two targets: interest rate and the money supply. (thinking about three main tools, don't get confused !!) Money supply and money demand model

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 38 What we learned in last class: Monetary policy The relationship between Treasury bill prices and their interest rates. Two interest rates: Short-run vs. long-run, norminal vs. real, loanable funds market vs. money market The Fed targets the federal funds rate. How Interest Rates Affect Aggregate Demand: Consumption, Investment, Net exports.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 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: An Initial Look Contractionary monetary policy The Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look FIGURE 14.7 Monetary Policy

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 The Effects of Monetary Policy on Real GDP and the Price Level: A More Complete Account FIGURE 14.8 An Expansionary Monetary Policy

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 38 Learning Objective 14.3 The Fed Responds to the Terrorist Attacks of September 11, 2001 Making the Connection The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do. Can the Fed Eliminate Recessions?

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 Using Monetary Policy to Fight Inflation FIGURE 14.9 A Contractionary Monetary Policy in 2000

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 38 Solved Problem 14-3 The Effects of Monetary Policy Learning Objective 14.3 YEARPOTENTIAL REAL GDPREAL GDPPRICE LEVEL 2010$13.3 trillion $13.7 trillion$13.6 trillion142 The hypothetical information in the table shows what the values for real GDP and the price level will be in 2011 if the Fed does not use monetary policy.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 38 Solved Problem 14-3 The Effects of Monetary Policy (continued) Learning Objective 14.3

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 A Summary of How Monetary Policy Works Table 14-1 Expansionary and Contractionary Monetary Policies

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 38 Learning Objective 14.3 Why Does Wall Street Care about Monetary Policy? Making the Connection The stock market reacts when the Fed either raises or lowers interest rates.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 38 Monetary Policy and Economic Activity Learning Objective 14.3 Can the Fed Get the Timing Right? FIGURE The Effect of a Poorly Timed Monetary Policy on the Economy Don’t Let This Happen to YOU! Remember That with Monetary Policy, It’s the Interest Rates—Not the Money—That Counts

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 38 A Closer Look at the Fed’s Setting of Monetary Policy Targets Learning Objective 14.4 Should the Fed Target Inflation? Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 38 Learning Objective 14.3 How Does the Fed Measure Inflation? Making the Connection 1 The PCE is a so-called chain-type price index, as opposed to the market-basket approach used in constructing the CPI. As we saw in Chapter 20, because consumers shift the mix of products they buy each year, the market-basket approach makes the CPI overstate actual inflation. A chain-type price index allows the mix of products to change each year. 2 The PCE includes the prices of more goods and services than the CPI, so it is a broader measure of inflation. 3 Past values of the PCE can be recalculated as better ways of computing price indexes are developed and as new data become available. This allows the Fed to better track historical trends in the inflation rate. In 2000, the Fed announced that it would rely more on the PCE than on the CPI in tracking inflation. The Fed noted three advantages that the PCE has over the CPI:

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 38 Learning Objective 14.3 Making the Connection How Does the Fed Measure Inflation?

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 38 Is the Independence of the Federal Reserve a Good Idea? Learning Objective 14.5 The Case for Fed Independence FIGURE The More Independent the Central Bank, the Lower the Inflation Rate

Chapter 14: Monetary Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 38 Is the Independence of the Federal Reserve a Good Idea? Learning Objective 14.5 In democracies, elected representatives usually decide important policy matters. In the United States, however, monetary policy is not decided by elected officials. Instead, it is decided by the unelected FOMC. Because those deciding monetary policy do not have to run for election, they are not accountable for their actions to the ultimate authorities in a democracy: the voters. The Case against Fed Independence