Chapter 8 Policy Preview

8-2 Introduction Focus of this chapter is monetary policy Examine how the central bank sets interest rates in order to control aggregate demand Begin with a description of the operation of central bank policy (who, what, why, when, and how) Central bank moves interest rates in response to deviations of output and inflation from desired levels  the Taylor rule Finally, discuss how the central bank decides how much to move interest rates

8-3 The “Who” of Policy Both fiscal and monetary policy can be used to fine tune the economy Most short-run fine tuning is done with monetary policy The “who” of stabilization policy = central bank In the U.S., the central bank is the Federal Reserve Bank Formally, U.S. monetary policy is established by vote of the Fed’s Open Market Committee (FOMC) UK: interest rates by the Monetary Policy Committee of Bank of England BoE Governor has the casting vote in case of a tie

8-4 The “What” of Policy The CB sets the interest rate Base rate (UK) or Federal Funds Rate (US) Rate at which banks borrow overnight from CB Lower interest rates encourage greater investment spending and greater spending on some consumption goods, thus increasing AD Monetary policy works through AD Monetary policy has little influence on AS

8-5 The “Why” of Policy Central bank’s goals: 1. Maintain low inflation rates 2. Promote economic activity Obvious conflict between these goals  Phillips Curve Also conflict between CB’s preferences and capabilities Boosting economic activity does much more to enhance economic welfare than does controlling inflation (except at high inflation rates) CB can stimulate economic activity in the SR but this only causes inflation in the LR This is because of different slopes of the SRAS and LRAS Central banks focus on maintaining low inflation while stabilizing economic activity around Y *  inflation targeting

8-6 “When” Policy Is Made FOMC meets every six weeks BoE MPC: every month 8 members, BoE Governor has tie-breaking vote

8-7 “How” Policy Is Implemented CB “sets” the interest rate Lowering interest rates means increasing the money supply The increased money supply results, eventually, in increased prices  Chapter 10: money supply moves and the LM curve

8-8 Policy as a Rule Monetary policy rule: setting the interest rate reflecting the current economic situation Taylor Rule: (1) i → nominal interest rate r * → real, “natural” rate of interest, corresponding to the real interest rate we would observe if the economy were at the full employment level of output  * → CB’s target rate of inflation

8-9 Policy as a Rule If α and β are large, then the monetary rule dictates aggressive responses to excess inflation and to business- cycle fluctuations If α is large relative to β, then the monetary authority will respond much more aggressively to inflation than it will to the level of economic activity The case of β=0 corresponds to pure inflation targeting

8-10 Interest Rates and Aggregate Demand Higher interest rates raise the opportunity cost of purchasing goods for investment and consumption → reducing demand Ignoring all other elements that affect aggregate demand, we can write: (2)  If the Fed raises interest rates, the AD curve shifts to the left, as shown in Figure 8-1  Higher interest rates lower prices, but also reduce economic activity [Insert Figure 8-1 here]

8-11 Calculating How to Hit the Target [Insert Box 8-3 here]