Frank & Bernanke Ch. 14: Stabilizing Aggregate Demand: The Role of the Fed

FOMC Decision On March16, 2004 the FOMC declared that it will keep the federal funds rate at 1.00%. On March 22, 2005, the FOMC raised the federal funds rate to 2.75%. How does the Fed keep the federal funds rate constant or lower or higher? What is the connection of this interest rate to the money supply?

Money Supply By engaging in open market operations, the Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system. If the demand for money remains the same, the action of the Fed affects the federal funds rate.

The Demand for Money Money (currency + checking deposits) is one of the assets a person, a household, a business holds. The benefit of money is its acceptability in paying debts (liquidity). The cost of money is the opportunity cost of losing a return on other assets one could hold.

The Demand for Money If the opportunity cost of holding money increases, less money will be held in portfolio. – The higher the nominal interest rate, the lower is the demand for money. The more the income, the more will be the amount kept in money form: the higher will be the demand for money. The higher the price level, the higher will be the demand for money.

The Demand for Money Nominal interest rate Quantity of Money

Shifts in Money Demand Changes in real income (real GDP). Changes in price level. Technological/institutional changes. Changes in foreign holdings of USD. Psychological changes. Seasonal changes.

Equilibrium in the Market for Money Explain how and why the market reaches equilibrium.

Equilibrium in the Market for Money If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is. How do people adjust their portfolios? They buy “bonds” with the excess money in their checking accounts. The price of bonds goes up: interest rate goes down.

Fed’s Control of Nominal Interest Rate By buying or selling bonds, the Fed increases or decreases the supply of money in the system. Shifting the supply curve to the right or to the left, lowers or raises the nominal interest rate. The Fed directly affects the federal funds rate.

Fed Shifts the Money Supply

Fed Funds Rate vs. Prime If Fed can affect the federal funds rate, why should we care because we might be interested in the interest rates on CDs, mortgage rates, credit card interest rates? Usually, interest rates all go hand in hand. When the Fed increases the federal funds rate, banks increase their prime rates, too.

Real and Nominal Interest Rates If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does? Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate.

Real and Nominal Interest Rates Remember the Fisher Effect: i = r +   f the expected inflation hasn’t changed but the Fed has increased i, then r is also increased. In the long run  adjusts and it is the savings and investments that determine the real rate of interest.

Real Interest Rates and Aggregate Demand Y = C + I + G + NX C = (Y-T) - 200r I = r G = 250; T = 200; NX = 10 Explain in words how this economy operates.

Solving for the Unknowns If the real interest rate is 3%, find the values of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y. If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph.

Fighting Recession The Fed reduced the fed funds rate 11 times in In the second half of 2000, the rate stayed at 6.5%. In 2002, it has been 1.75% until Nov. 6 and the Fed decided to lower it further. What was the effect of Fed’s lowering of interest rates on AD?

Fighting Inflation From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4.75% to 6.50%. At the beginning of 1977 the fed funds rate was 4.5%. By the end of 1978 it was 10%. A year later it was 13.75%. By April 1980, it reached 17.6%. What happens to AD?

Inflation and the Stock Market Inflation is watched very closely by the Fed. Any sign of inflation makes Fed increase interest rates. Higher real interest rates slow down the economy and lower future profits. Higher real interest rates lower the price of bonds and shift the demand away from stocks to bonds, lowering stock prices.

Policy Reaction Function If there is a pattern of policies adopted under the same economic circumstances, then we have a policy reaction function. For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation.

Taylor Rule Taylor explained the behavior of the Fed as a reaction to output gap and inflation. If there is a positive, recessionary output gap, the Fed wants to stimulate the economy. If there is a negative, expansionary gap, the Fed wants to slow down the economy. The Fed also reacts to higher inflation by raising the real interest rate and slowing down the economy.

Taylor Rule r = 0.01 –0.5 [(Y* - Y)/Y*] π How does the Fed react when inflation rises? How does the Fed react when output gaps appear? What will the real and nominal interest rates be given different values?