1. Nov. 13 th, 2002ECON 1 – Section 20 – Page 1GSI: R. Estopina ECON 1 – Section 20 Stabilizing Aggregate Demand: The Role of the Fed

2. ECON 1 – Section 20 – Page 2GSI: R. EstopinaNov. 13 th, 2002 Contact Details GSI: Ramon Estopina Office Hours: Thursday 1:45-3:45 PM Office: Evans 508-7 Email: estopina@haas.berkeley.eduestopina@haas.berkeley.edu Handouts (only sections 104 & 133) after class in: http://www.ocf.berkeley.edu/~jaychen/econ1/ http://www.ocf.berkeley.edu/~jaychen/econ1/ Please read: Read before downloading!.

3. ECON 1 – Section 20 – Page 3GSI: R. EstopinaNov. 13 th, 2002 Section 20 Agenda Administrative Stuff (10 min) Recap Quiz (10 min) Example 26.4 (10 min) Problem 26.8 (10 min) Problem 26.9 (10 min) Re-cap (2 min)

4. ECON 1 – Section 20 – Page 4GSI: R. EstopinaNov. 13 th, 2002 Administrative Stuff PS #4 due today !!! Leave them on the table. Remember, no class next Monday!! -Midterm. Review session probably Friday, check Econ-1 website.

5. ECON 1 – Section 20 – Page 5GSI: R. EstopinaNov. 13 th, 2002 Review of Last Lecture - 11/6 th Chapter 23 & 26: Federal Reserve (Fed) Federal Funds Rate (Federal Open Market Committee) Discount Rate Buying/Selling Bonds (Open Market Operations) Relationship between Price of Bonds and Interest rate Money D& S (equilibrium, shifts, stabilization by FED) Keynesian Model Keynesian cross, AD as function of r FED fights inflation, FED fights recession Taylor Rule

6. ECON 1 – Section 20 – Page 6GSI: R. EstopinaNov. 13 th, 2002 Recap Quiz - 1 The interest rate that commercial banks charge each other for very short-term loans is called: 1) discount rate. 2) reserve rate. 3) real interest rate. 4) federal funds rate. 5) prime rate.

7. ECON 1 – Section 20 – Page 7GSI: R. EstopinaNov. 13 th, 2002 Recap Quiz - 2 When the real interest rate rises, which of the following is true? 1) C and I p spending rise. 2) C and I p spending fall. 3) C rises while I p spending falls. 4) C falls while I p spending rises. 5) C falls while I p spending is unchanged.

8. ECON 1 – Section 20 – Page 8GSI: R. EstopinaNov. 13 th, 2002 Recap Quiz - 3 To fight a recession, the Fed should do which of the following? 1) Raise the real interest rate. 2) Lower the real interest rate. 3) Keep the real interest rate constant. 4) Allow the real interest rate to fluctuate with the market. 5) Raise the nominal interest rate.

9. ECON 1 – Section 20 – Page 9GSI: R. EstopinaNov. 13 th, 2002 Recap Quiz - 4 The Taylor rule is a(n) 1) rule the Fed is required to follow regarding monetary policy. 2) example of a policy reaction function. 3) rule that helps Congress coordinate fiscal policy with monetary policy. 4) guideline for individuals in making their portfolio allocation decisions. 5) "rule of thumb" for solving the basic Keynesian model.

10. ECON 1 – Section 20 – Page 10GSI: R. EstopinaNov. 13 th, 2002 Recap Quiz - 5 An increase in the interest rate by the Fed, made with the intention of reducing an expansionary gap, is called 1) expansionary monetary policy. 2) monetary loosening. 3) contractionary fiscal policy. 4) expansionary fiscal policy. 5) contractionary monetary policy.

11. ECON 1 – Section 20 – Page 11GSI: R. EstopinaNov. 13 th, 2002 Review Question You hear a news report that employment growth is lower than expected. How do you expect that report to affect market interest rates?

12. ECON 1 – Section 20 – Page 12GSI: R. EstopinaNov. 13 th, 2002 Review Answer Slow employment growth is indicative of a possible recessionary output gap. Typically the Fed responds to a slowing of the economy by lowering the nominal interest rate. A weaker economy also reduces the demand for money, which reduces the nominal interest rate.

13. ECON 1 – Section 20 – Page 13GSI: R. EstopinaNov. 13 th, 2002 Another Review Question The Fed faces a recessionary gap. How would you expect it to respond? How its policy change is likely to affect the economy?

14. ECON 1 – Section 20 – Page 14GSI: R. EstopinaNov. 13 th, 2002 Another Review Answer The Fed is likely to respond to a recessionary gap with an expansionary monetary policy intended to stimulate aggregate demand. The first step is an open-market purchase of government bonds, which puts additional money into circulation and lowers the nominal interest rate. The lower interest rate stimulates aggregate demand (consumption and investment spending). An increase in aggregate demand in turn raises short-run equilibrium output, as firms produce enough to meet the extra demand.

15. ECON 1 – Section 20 – Page 15GSI: R. EstopinaNov. 13 th, 2002 Important to remember: Equations of the day: The real interest affects consumption ad planned investment. Where a, b >0 and measure the strength of the interest rate effect.

16. ECON 1 – Section 20 – Page 16GSI: R. EstopinaNov. 13 th, 2002 Important to remember (2) Combined with the equations we know: Composed of: Autonomous AD, effect of r & Induced AD

17. ECON 1 – Section 20 – Page 17GSI: R. EstopinaNov. 13 th, 2002 Important to remember (3) In equilibrium Y = AD, so: Vary scary, isn ’ t it?

18. ECON 1 – Section 20 – Page 18GSI: R. EstopinaNov. 13 th, 2002 Example 26.4 (F&B page 707) In a certain economy, we have: Where r is set by the Fed = 5% Solve for the short-run equilibrium.

19. ECON 1 – Section 20 – Page 19GSI: R. EstopinaNov. 13 th, 2002 Example 26.4 (Conclusion) We know the definition of Aggregate Demand is: AD = C + I p + G + NX Substituting the components: AD = [640 + 0.8(Y-250)-400(0.05)] + [250-600(0.05)] +300+20 And finally: AD = 960 + 0.8Y In addition, from the short term equilibrium: Y=AD So the previous equation will be: Y = 960 + 0.8Y Solving for Y: Y = 960 / 0.2 = 4,800

20. ECON 1 – Section 20 – Page 20GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (F&B page 719) For the following economy, find at what rate should the Fed set the real interest rate to eliminate any output gap.

21. ECON 1 – Section 20 – Page 21GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) A) The relationship between aggregate demand and output is given by: Autonomous aggregate demand equals 23,600 the part of aggregate demand that does not depend on output nor on r.

22. ECON 1 – Section 20 – Page 22GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) To find short-run equilibrium output, use the equation Y=AD and solve for Y: Potential output Y*=40,000. To find the real interest rate consistent with no output gap, we set Y=40,000 in the equation for short- run equilibrium output and solve for r.

23. ECON 1 – Section 20 – Page 23GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) So the real interest rate that eliminates any output gap is 6%. So we have:

24. ECON 1 – Section 20 – Page 24GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) With Y*=Y as found before, now G increases to 7,600. What happens to the SR equilibrium if the Fed leaves r unchanged? What should the Fed do to keep the economy at full employment?

25. ECON 1 – Section 20 – Page 25GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) Let ’ s solve for the new value of short- run equilibrium output. Recall for this economy: Now there is an increase in government purchases from 7000 to 7600 so autonomous AD raises by 600, from 23,600 to 24,200.

26. ECON 1 – Section 20 – Page 26GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) And r = 6%, consequently: Solving for output:

27. ECON 1 – Section 20 – Page 27GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) So if the Fed keeps the interest rate at 6%, the increase in government purchases raises output above potential (an expansionary gap, remember Y*=40,000). To keep the economy at full employment (and reduce inflation), the Fed has to offset the increase in government purchases with a higher real interest rate.

28. ECON 1 – Section 20 – Page 28GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) Remember the process for contractionary monetary policy: Fed Increases interest rates by reducing money supply (selling bonds) … This will reduce C and I … Then AD Decreases … … and Decrease GDP and employment.

29. ECON 1 – Section 20 – Page 29GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) To see how much the real interest rate must rise, note that after the increase in government purchases aggregate demand is given by: Solving for output:

30. ECON 1 – Section 20 – Page 30GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) We want to know the value of r that sets Y at its full-employment level of 40,000. To find that rate, we set Y=40,000 in the previous equation and solve for r:

31. ECON 1 – Section 20 – Page 31GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (cont ’ d) So to keep the economy at full employment when government purchases increase, the Fed should raise the real interest rate from 6% to 7%. The increase in r is consistent with the effects of an increased government deficit in the market for saving and investment (Chapter 22).

32. ECON 1 – Section 20 – Page 32GSI: R. EstopinaNov. 13 th, 2002 Problem 26.8 (Conclusion) In other words, 40,000 Expenditure line (r=6%) Expenditure line (r=7%) 41,200

33. ECON 1 – Section 20 – Page 33GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (F&B page 720) Supposing the Fed follows the Taylor rule, find the real int. rate (r) and the nominal int. rate (i) that the Fed will set in each of the following situations: A) Inflation or 4% and a expansionary gap equal to 1% of potential output.

34. ECON 1 – Section 20 – Page 34GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (cont ’ d) Remember Taylor rule: Fed sets r, so it decreases as relative income gap grows, and increases as inflation increases. Fed ’ s goals: Y = Y* Low  (inflation rate)

35. ECON 1 – Section 20 – Page 35GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (cont ’ d) Taylor rule is an example of a Policy reaction function. It describes how the action a policymaker takes depends on the state of the economy Ideally policymakers should try to react in such a way as to optimize economic performance

36. ECON 1 – Section 20 – Page 36GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (cont ’ d) A) Inflation of 4% and a expansionary gap equal to 1% of potential output.  r i=r+  0.04-0.010.0350.075 4%-1%3.5%7.5%

37. ECON 1 – Section 20 – Page 37GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (cont ’ d) B) Inflation of 2% and a recessionary gap equal to 2% of potential output.  r i=r+  0.02 0.010.03 2% 1%3%

38. ECON 1 – Section 20 – Page 38GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (cont ’ d) C) Inflation of 6% and no output gap.  r i=r+  0.0600.040.10 6%0%4%10%

39. ECON 1 – Section 20 – Page 39GSI: R. EstopinaNov. 13 th, 2002 Problem 26.9 (Conclusion) D) Inflation of 2% and a recessionary gap equal to 5% of potential output.  r i=r+  0.020.05-0.050.015 2%5%-0.5%1.5% Can the Fed set a negative real interest rate? It ’ s possible for the Fed to set a negative r, by setting the nominal rate below .

40. ECON 1 – Section 20 – Page 40GSI: R. EstopinaNov. 13 th, 2002 Problems for next sections !!! For next section: Chapter 27: Problems 2, 4, 6 & 8. Remember: This is not mandatory. It won ’ t be graded. Only for those of you that need improvement in Exam grades.

41. ECON 1 – Section 20 – Page 41GSI: R. EstopinaNov. 13 th, 2002 Next class Next Class: Section 21 – Wednesday, Nov 20 th No class next Monday. Midterm Exam. Due PS#4 !!!! If you want more practice, work on Next Sections Problems (although you probably have enough). Read ch. 27. You can download handouts this afternoon. Thank you for coming on time !!! Enjoy the long weekend & C-U Wednesday !!.