Monetary Policy

monetary policy

actions of the central bank to manage the money supply and interest rates to pursue macro policy goals

main monetary policy goals (4)

price stability
high employment
stability of financial markets and institutions
economic growth

dual mandate of the fed

price stability and high employment

monetary policy targets

money supply
interest rate

relation of targets

higher interest rates result in a lower quantity of money demanded (holding money begins to look attractive)

shifts in money demand curve

change in the need to hold money or to engage in transactions

increase the money supply: effect of interest rates

short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money

decrease in money supply: effect on interest rates

banks are forced to offer a higher interest rate on interest-bearing accounts

money market model

concerned with the short-term nominal rate of interest
changes in money supply directly affect this interest rate

federal (policy) rate

the interest rate banks charge each other for overnight loans

federal funds rate targeting: recessions and expansions

rec: push down to encourage high employment
exp: push down to encourage price stability

floor on the fed funds rate

central bank began paying banks interest on their reserve holdings

repurchase agreements

central bank buys a security from a financial firm, which promises to buy it back the next day

reverse purchase agreements

borrowing money from that firm overnight

how interest rates affect aggregate demand

consumption: lower interest rates encourage buying on credit (sales of durables) + discourage saving
investment: lower interest rates encourage investment (cheaper to borrow ans stocks more attractive)
net exports: high interest rates attract foreign funds, raising exchange rates, causing net exports to fall

expansionary monetary policy

actions to decrease interest rates to increase real GDP
increase aggregate demand

expansionary monetary policy: when?

short-run equilibrium real GDP below potential real GDP

contractionary monetary policy

increasing interest rates to reduce inflation

contractionary monetary policy: when?

economy producing above potential GDP

liquidity trap

central banks were unable to push rates any lower to encourage investment

quantitative easing

buying securities beyond the normal short-term treasury securities

taylor rule

fed funds target = current inflation rate + equilibrium real fed funds rate + 1/2 inflation gap + 1/2 output gap

inflation targeting

framework for conducting monetary policy involves the central bank announcing its target level of inflation

how do central banks measure inflation?

core PCE (personal consumption expenditure without food and energy prices)

bubble

prices are too high relative to the underlying value of the asset

herding behaviour

failing to correctly evaluate the value of the asset and relying on other people's apparent evaluations

speculation

believing that prices will rise even higher and buying the asset intending to sell if before prices fall