http://unofficialtrimbletechblog.blogspot.com/
http://www.uri.edu/artsci/newecn/Classes/Art/INT1/Mac/1970s/Money.price1.html
http://stocks.about.com/od/understandingstocks/a/Bondint111004.htm
http://www.uri.edu/artsci/newecn/Classes/Art/INT1/Mac/1970s/1970sA.html
http://internationalecon.com/Finance/Fch40/F40-9.php www.econ.umd.edu/~daysal/econ305/PQ%205%20(Ch%2011).pdf
www.fiu.edu/~bidarkot/eco2013/chap16.doc
Chapter 27 Outline: Stabilizing the Economy: The Role of the Fed
I.
Introduction/Overview
1. Financial
market participants and commentators go to remarkable length to try to predict
the actions of the Federal Reserve; the "Greenspan Briefcase
Indicator" is just one example.
2. The
reason for the intense scrutiny is that the Federal Reserve’s decisions about
monetary policy, and especially the level of interest rates, have important
implications, both for financial markets and for the economy in general.
II. The
Federal Reserve and Interest Rates
A. The
Demand for Money
1. Anyone
who has wealth must determine the form in which to hold that wealth; this is
called the portfolio allocation decision
a. People
prefer assets with high return and which do not carry much risk.
b. They also
try to reduce risk through diversification.
2. The
amount of wealth that an individual chooses to hold in the form of money (cash
and checking accounts) is that individual’s demand for money.
3. An
individual must consider the costs versus the benefits of holding money.
a. The
principal benefit from holding money is its usefulness in carrying out
transactions.
b. This is
affected by the technological and financial sophistication of the society in
which she lives.
c. There
is an opportunity cost of holding money because the nominal rate of interest on
money is zero.
4. Businesses also hold money for transactions; in fact, their
holdings account for more than half of the total money stock.
B. Macroeconomic
Factors that Affect the Demand for Money
There are three factors that affect the demand for
money quite broadly:
1. the
nominal interest rate: as the opportunity cost of holding money, the higher the
rate, the lower the amount of money held
2. real
income or output: as income or output increases, people and businesses want to
buy and sell more goods and services and so need more money for transactions
3. the
price level: the higher the prices of goods and services the more money is
needed to make a given set of transactions.
C. The
Money Demand Curve
1. The
economy wide demand for money can be represented graphically by the money
demand curve, as illustrated in Figure 27.1.
2. The
curve shows an inverse relationship between the nominal interest rate and the
amount of money people want to hold (quantity).
3. Changes
in the nominal interest rate will move people up or down the curve, changing
the amount of money they wish to hold.
4. The
money demand curve can also shift due to any change that makes people want to
hold more (or less) for a given nominal interest rate.
5. The
money demand curve can also shift due to other changes that affect the cost or
benefit of holding money, such as changes in technology (like ATMs).
D. The
Supply of Money and Money Market Equilibrium
A. The
supply of money is controlled by the central bank, which in the United States,
is the Federal Reserve or Fed.
B. The
Fed’s primary tool for controlling the money supply is open-market operations
in which it buys or sells government bonds; when it buys, the money supply
increases, and when it sells the money supply decreases.
C. Equilibrium
in the market for money occurs at the intersection of the supply and demand
curves, establishing an equilibrium nominal interest rate and quantity of money
holdings.
D. Only at
that nominal rate of interest will people be content to hold the quantities of
money and other assets that are actually available in the economy.
E. How the
Fed Controls the Nominal Interest Rate
A. The Fed
can used newly-created money to buy or sell government bonds, thus increasing
and decreasing the supply of money, and decreasing or increasing the nominal
interest rate.
B. Control
of the interest rate is not separate from control of the money supply; the Fed
cannot set the two independently.
C. The
Fed, and almost every other central bank, uses a target nominal interest rate
rather than a target money supply in communicating its policy decisions to the
public because the main effects of monetary policy on both the economy and
financial markets are exerted through interest rates.
D. Interest
rates are also more familiar to the public and can be monitored continuously,
making the effects of Fed policies easy to observe.
F. A Second Way the Fed Controls the Money
Supply: Discount Window Lending
1. Lending
of reserves by the Federal Reserve to commercial banks is called discount
window lending.
2. The
interest rate that the Fed changes on these loans is the discount rate (also
known as the primary credit rate).
3. When
the Fed lends, reserves increase, and this ultimately leads to increases in
bank deposits and the money supply.
G. A Third Way the Fed Controls the Money
Supply: Change Reserve Requirements
1. Congress
granted the power to set minimum values of the ratio of total bank reserves to
total bank deposits.
2. Changes in
this reserve requirement can be used to affect the money supply, although the
Fed does not usually use them in this way.
3. An increase
in the requirement would decrease the money supply and vice versa.
H. Can the
Fed Control the Real Interest Rate?
1. Most
economists believe that the Fed can control the real interest rate, at least
for some period.
2. The
real interest rate is the nominal interest rate minus the rate of inflation.
3. The Fed
can control the nominal interest rate, and, as long as inflation adjusts
slowly, that will mean it can also change the real rate; its ability to do so
is strongest in the short run.
4. This is
not in fact a contradiction with Chapter 22 (real interest rate is determined
by S = I); that is the situation in the long run.
5. Because
interest rates tend to move together, a change in the federal funds rate tends
to cause other interest rates to change.
6. But in
practice, the Fed’s control of other interest rates may be somewhat less
precise than its control of the federal funds rate, and that is a fact that
complicates Fed policymaking.
III. The Effects of Federal Reserve Actions on the
Economy
A. Planned
Aggregate Expenditure and the Real Interest Rate
1.
The real interest rate has potentially important effects on aggregate
expenditure; it influences the behavior of both households and firms.
2.
A higher interest rate leads households to save more and consume less.
3.
A higher interest rate also discourages firms from making capital
investments and households from making residential investments.
4.
Thus both C and planned I decline when the real interest rate increases
and vice versa.
5.
Algebraically, the effect of a change in the real interest rate appears
as a change in autonomous expenditure.
B. The Fed
Fights a Recession
1. To
fight the recession, the Fed should lower the real interest rate, raising
aggregate expenditure until output reaches the full-employment level.
2. A
reduction in interest rates by the Fed, made with the intention of reducing a
recessionary gap in this way, is an example of an expansionary monetary policy
(less formally, monetary easing)
C. The Fed
Fights Inflation
1. The
procedure for getting rid of an expansionary gap is the reverse of that for
fighting a recession.
2. The
cure for an expansionary gap is to raise the real interest rate, which reduces
C and planned I by raising the cost of borrowing.
3. The
resulting fall in planned spending and leads in turn to a decline in output and
to a reduction in inflationary pressures.
4. This is called contractionary monetary policy
(monetary tightening).
D. The
Fed’s Policy Reaction Function
1. Economists
sometimes find it convenient to model the behavior of the Fed in terms of a
policy reaction function, which describes how the action the Fed takes depends
on the state of the economy.
2. Equation
27.1 illustrates the policy reaction function.
3. The Fed
will generally try to set its target for the real interest rate at the level
which sets saving equal to investment, and chooses its target inflation rate at
a level that helps to achieve the best long-run performance.
4. If
inflation rises above or falls below its target, the Fed will react by changing
the real interest rate.
5. In practice,
this process is complex; a large number of variables can be considered in the
function.
6. Also,
it is clear that the Fed can decide how aggressively it wishes to react to
inflation, which affects the function.
7. The Taylor rule is an example
of a real-world policy reaction function that provides a useful benchmark for
assessing and predicting the Fed’s actions.
| 
<
