© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. Fernando & Yvonn Quijano Prepared by: Chapter 26 Monetary Policy

© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 2 of 39 Monetary Policy, Toll Brothers, and the Housing Market 26.1Define monetary policy and describe the Federal Reserve’s monetary policy goals. 26.2Describe the Federal Reserve’s monetary policy targets and explain how expansionary and contractionary monetary policies affect the interest rate. 26.3Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level. 26.4Discuss the Fed’s setting of monetary policy targets. 26.5Discuss the steps the Federal Reserve took during 2007 and 2008 to respond to the crisis in the housing market. 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 3 of 39 What Is Monetary Policy? Learning Objective 26.1 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 4 of 39 What Is Monetary Policy? Learning Objective 26.1 Price Stability The Goals of Monetary Policy Figure 26-1 The Inflation Rate, 1952–2007

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 5 of 39 What Is Monetary Policy? Learning Objective 26.1 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 6 of 39 What Is Monetary Policy? Learning Objective 26.1 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 7 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 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, such as real GDP, employment, and the price level, that are closely related to the Fed’s policy goals. Monetary Policy Targets

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 8 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 The Demand for Money FIGURE 26-2 The Demand for Money

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 9 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 Shifts in the Money Demand Curve FIGURE 26-3 Shifts in the Money Demand Curve

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 10 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 How the Fed Manages the Money Supply: A Quick Review Equilibrium in the Money Market FIGURE 26-4 The Impact on the Interest Rate When the Fed Increases the Money Supply

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 11 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 Equilibrium in the Money Market FIGURE 26-5 The Impact on Interest Rates When the Fed Decreases the Money Supply

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 12 of 39 Solved Problem 26-2 The Relationship between Treasury Bill Prices and Their Interest Rates Learning Objective 26.2 What is the price of a Treasury bill that pays $1,000 in one year, if its interest rate is 4 percent? What is the price of the Treasury bill if its interest rate is 5 percent?

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 13 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 14 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 The Importance of the Federal Funds Rate Federal funds rate The interest rate banks charge each other for overnight loans.

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 15 of 39 The Money Market and the Fed’s Choice of Monetary Policy Targets Learning Objective 26.2 The Importance of the Federal Funds Rate Figure 26-6 Federal Funds Rate Targeting, January 1997–May 2008

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 16 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 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:

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 17 of 39 Learning Objective 26.3 The Inflation and Deflation of the Housing Market “Bubble” Making the Connection

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 18 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 19 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look FIGURE 26-7 Monetary Policy

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 20 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 The Effects of Monetary Policy on Real GDP and the Price Level: A More Complete Account FIGURE 26-8 An Expansionary Monetary Policy

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 21 of 39 Learning Objective 26.3 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 22 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do. Can the Fed Eliminate Recessions?

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 23 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 Using Monetary Policy to Fight Inflation FIGURE 26-9 A Contractionary Monetary Policy in 2000

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 24 of 39 Solved Problem 26-3 The Effects of Monetary Policy Learning Objective 26.3 YEARPOTENTIAL REAL GDPREAL GDPPRICE LEVEL 2010$13.3 trillion 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 25 of 39 Solved Problem 26-3 The Effects of Monetary Policy (continued) Learning Objective 26.3

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 26 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 A Summary of How Monetary Policy Works Table 26-1 Expansionary and Contractionary Monetary Policies

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 27 of 39 Learning Objective 26.3 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 28 of 39 Monetary Policy and Economic Activity Learning Objective 26.3 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 29 of 39 A Closer Look at the Fed’s Setting of Monetary Policy Targets Learning Objective 26.4 Some economists have argued that rather than use an interest rate as its monetary policy target, the Fed should use the money supply. Many of the economists who make this argument belong to a school of thought known as monetarism. The leader of the monetarist school was Nobel laureate Milton Friedman. Friedman and his followers favored replacing monetary policy with a monetary growth rule. Should the Fed Target the Money Supply?

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 30 of 39 A Closer Look at the Fed’s Setting of Monetary Policy Targets Learning Objective 26.4 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 31 of 39 A Closer Look at the Fed’s Setting of Monetary Policy Targets Learning Objective 26.4 Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. The Taylor Rule Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 32 of 39 A Closer Look at the Fed’s Setting of Monetary Policy Targets Learning Objective 26.4 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 33 of 39 Learning Objective 26.3 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 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 34 of 39 Learning Objective 26.3 Making the Connection How Does the Fed Measure Inflation?

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 35 of 39 The Fed Responds to the Financial Crisis Learning Objective 16.5 The Changing Mortgage Market A financial asset — such as a loan or a stock or bond — is considered a security if it can be bought and sold in a financial market. When a financial asset is first sold, the sale takes place in the primary market. Subsequent sales take place in the secondary market. By the 1990s, a large secondary market existed in mortgages with funds flowing from investors through Fannie Mae and Freddie Mac to banks and savings and loans and, ultimately, to individuals and families borrowing money to buy houses.

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 36 of 39 The Fed Responds to the Financial Crisis Learning Objective 16.5 The Role of Investment Banks Investment banks began buying mortgages, bundling large numbers of them together as bonds known as mortgage-backed securities, and reselling them to investors. At the height of the housing bubble in 2005 and early 2006, lenders began to loosen the standards for obtaining a mortgage loan. Borrowers and lenders were anticipating that housing prices would continue to rise, which would reduce the chance that borrowers would default on the mortgages. The decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks caused turmoil in the financial system.

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 37 of 39 The Fed Responds to the Financial Crisis Learning Objective 16.5 The Fed’s Response First, although the Fed traditionally made loans only to commercial banks, it decided to make primary dealers – firms that participate in regular open market transactions with the Fed – eligible for discount loans. Second, at the urging of the Fed and the Treasury, Congress passed the Emergency Economic Stabilization Act of 2008, which authorized the Treasury to purchase mortgage-backed securities and other troubled assets from banks. Third, the Fed and the Treasury took direct action to keep some large financial institutions from bankruptcy. The financial crisis of 2008 led the Fed and the Treasury to try new approaches to policy. What remains to be seen is whether these new approaches will become part of the policy toolbox or whether policy will return to more traditional approaches.

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 38 of 39 An Inside LOOK Housing Market Slowdown Affects the United States and Europe Very Differently Slowing Housing Market Isn’t Big Worry in Europe Monetary policy has been relatively more contractionary in the United States than in the euro zone during the past few years.

Chapter 26: Monetary Policy © 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 39 of 39 Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule K e y T e r m s