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Stabilizing the Economy: The Role of the Fed Chapter 14
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Chapter 14 Learning Objectives. You should be able to: Distinguish between the Federal funds rate and the discount rate. Explain how the Fed influences the interest rate. Show how a demand and supply diagram can be used to model the determination of the Federal Funds rate. Show the effect of expansionary and contractionary monetary policy on the Keynesian cross diagram.
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New Fed Chair Ben Bernanke Took office February 1, 2006.
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Important Distinction Federal Funds Rate -rate of interest banks charge one another for short-term loans. Money is transferred between accounts at the Fed—hence fed funds Discount Rate -rate of interest the Fed charges banks for short-term loans. Originally banks would sell loans to the Fed. The present value would be calculated using the rate of discount.
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Most Important Tool of Monetary Policy Open market operations: the purchase or sale of Treasury securities by the Fed Sell Treasury securities: contractionary. Buy Treasury securities: expansionary.
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The Money Demand Curve Money M Nominal interest rate i MD Demand for money is inversely related to the nominal interest rate (i)
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A Shift In The Money Demand Curve Money M Nominal interest rate i MD MD’ Shifts in MD Changes in Y & P MD will increase if Y or P increase Technological changes Foreign demand
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The Fed Lowers the Nominal Interest Rate Nominal interest rate MD E MS M Money i M’ I’ F MS’ The Fed wants to lower i Fed buys bonds The money supply increases Creates a surplus of money People buy interest bearing assets Non-money asset prices rise and interest rates fall
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Real vs Nominal Interest Rate Nominal rate = Real rate + Inflation rate Fed can change the real rate only in the short-run.
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The Effects of Federal Reserve Actions on the Economy Policy Reaction Function –Describes how the action a policymaker takes depends on the state of the economy
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Fed’s Policy Reaction Function
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