ap economics: module 31 terms

how is the interest rate determined in the short run?

determined in the money market, and loanable funds market adjusts to changes in the money market

how is the interest rate determined in the long run?

determined by matching supply and demand of loanable funds when RGDP = potential output

how can the central bank set the interest rate?

adjusting the money supply

• increases in MS will decrease the IR

target federal funds rate

set by the Fed, who use OMOs to achieve this target

• OMOs are the most commonly used tool of the Fed

how does monetary policy influence aggregate demand?

by altering interest rates

expansionary monetary policy

monetary policy that increases AD

• increase in MS → decrease in IR → increase in I → increase in RGDP → increase in income → increase in C (via multiplier) → increase in AD → R shift

contractionary monetary policy

monetary policy that decreases AD

• decrease in MS → increase in IR → decrease in I → decrease in RGDP → decrease in income → decrease in C (via multiplier) → decrease in AD → L shift

goals of monetary policy

• fight recessions

• price stability (less inflation)

output gap

percentage difference between RGDP and potential output

• RGDP < Yp → r gap → exp. MP → lower IR

• RGDP > Yp → i gap → cont. MP → higher IR

Taylor rule for monetary policy

a rule for setting the federal funds rate that takes into account both the inflation rate and output gap (business cycle)

• FFR = 1 + (1.5 * inflation rate) + (0.5 * output gap)

• may not be very effective with low inflation and large negative output gap

why is monetary policy the preferred tool for stabilization policy compared to fiscal policy?

has a time lag like FP, but the central bank can enact things faster than Congress can (lower lag than FP)

inflation targeting

when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target

• economists may use this instead of Taylor rule

inflation targeting vs. Taylor rule

inflation targeting: forward looking (based on forecast of future inflation)

Taylor rule: backward looking (adjusts MP in response to past inflation)

2 advantages of inflation targeting

1. transparency: less uncertainty, since the public knows the central bank’s objective

2. accountability: central bank’s sucess is measured by the diff. between actual inflation vs. inflation target → can be held accountable for discrepancies

why do some critics believe inflation targeting is restrictive?

they think other concerns (ex: stability of the financial system) should be prioritized over a target inflation rate

the Fed’s main concerns

• the level of RGDP (r/i gap)

• producing @ full employment (no cyclical unemployment)

• price stability

• monitoring inflation (1-2%)

limited reserve market vs. ample reserve market

limited:

• Fed manages MS

• 3 tools

• small change in MS affects interest rate

ample:

• Fed supplies reserves beyond what is needed

• small change in MS doesn’t affect interest rate

• new tool —> administered rate (IOR/interest on reserves)

• 3 tools are ineffective

how does the Fed indirectly set the FFR?

OMOs

• buy → decrease FFR

• sell → increase FFR

with ample reserves, if MS shifts, IR ____ change. in the limited reserve market IR ___ change with changes in MS.

won’t, will

interest on reserves (IOR)

IR that the Fed pays commercial banks

• to decrease IR/FFR → decrease IOR w/ exp. MP (and vice-versa)

quantity based monetary policy

in limited reserves market; changes in MS influence interest rates

key difference between limited and ample reserve market

ample → maintain sufficient reserves (changes in MS don’t impact IR, only changes in IOR)

limited → influence interest rates by changing MS

reserve market graph

upper end of DR → discount rate, horizontal (banks won’t demand reserves at any IR higher than DR)

lower end of DR → IOR, horizontal (IOR acts as a floor)

middle part → as IOR decrease, demand for reserves increases