1. c h a p t e r fourteen © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn Quijano Monetary Policy

2. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 2 of 30 What Is Monetary Policy? Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue its economic objectives. The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy: 1. PRICE STABILITY 2. HIGH EMPLOYMENT 3. ECONOMIC GROWTH 4. STABILITY OF FINANCIAL MARKETS AND INSTITUTIONS LEARNING OBJECTIVE 1

3. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 3 of 30 The Goals of Monetary Policy PRICE STABILITY What Is Monetary Policy? 14 - 1 The Inflation Rate, 1952-2004

4. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 4 of 30 Monetary Policy Targets The Demand for Money The Money Market and the Fed’s Choice of Targets LEARNING OBJECTIVE 2 14 - 2 The Demand for Money

5. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 5 of 30 Shifts in the Money Demand Curve The Money Market and the Fed’s Choice of Targets 14 - 3 Shifts in the Money Demand Curve

6. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 6 of 30 How the Fed Manages the Money Supply: A Quick Review Equilibrium in the Money Market The Money Market and the Fed’s Choice of Targets 14 - 4 The Impact on the Interest Rate When the Fed Increases the Money Supply

7. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 7 of 30 Equilibrium in the Money Market The Money Market and the Fed’s Choice of Targets 14 - 5 The Impact on Interest Rates When the Fed Decreases the Money Supply

8. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 8 of 30 The Relationship between Treasury Bill Prices and Their Interest Rates 14 - 1 LEARNING OBJECTIVE 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?

9. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 9 of 30 A Tale of Two Interest Rates Choosing a Monetary Policy Target The Importance of the Federal Funds Rate Federal funds rate The interest rate banks charge each other for overnight loans. The Money Market and the Fed’s Choice of Targets

10. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 10 of 30 The Importance of the Federal Funds Rate The Money Market and the Fed’s Choice of Targets 14 - 6 Federal Funds Rate Targeting, January 1995- July 2005

11. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 11 of 30 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:  Consumption  Investment  Net exports Monetary Policy and Economic Activity LEARNING OBJECTIVE 3

12. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 12 of 30 Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level Expansionary monetary policy The Federal Reserve’s increasing the money supply and decreasing interest rates in order to increase real GDP. Can the Fed Eliminate Recessions?

13. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 13 of 30 Monetary Policy and Economic Activity Using Monetary Policy to Fight Inflation Contractionary monetary policy The Fed’s adjusting the money supply to increase interest rates to reduce inflation.

14. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 14 of 30 Monetary Policy and Economic Activity A Summary of How Monetary Policy Works

15. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 15 of 30 Monetary Policy and Economic Activity Can the Fed Get the Timing Right? 14 - 9 The Effect of a Poorly Timed Monetary Policy on the Economy

16. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 16 of 30 The Taylor Rule Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap A Closer Look at the Fed’s Setting of Monetary Policy Targets

17. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 17 of 30 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. A Closer Look at the Fed’s Setting of Monetary Policy Targets

18. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 18 of 30 The Case for Fed Independence The Case against Fed Independence Is the Independence of the Federal Reserve a Good Idea? LEARNING OBJECTIVE 5 14 - 11 The More Independent the Central Bank, the Lower the Inflation Rate

19. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 14: Monetary Policy 19 of 30 Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule