ap economics: module 31 terms

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how is the interest rate determined in the short run?

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18 Terms

1

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

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2

how is the interest rate determined in the long run?

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

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3

how can the central bank set the interest rate?

adjusting the money supply

  • increases in MS will decrease the IR

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4

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

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5

how does monetary policy influence aggregate demand?

by altering interest rates

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6

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

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7

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

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8

goals of monetary policy

  • fight recessions

  • price stability (less inflation)

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9

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

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10

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

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11

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)

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12

inflation targeting

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

  • economists may use this instead of Taylor rule

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13

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)

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14

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

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15

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

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16

the Fed’s main concerns

  • the level of RGDP (r/i gap)

  • producing @ full employment (no cyclical unemployment)

  • price stability

  • monitoring inflation (1-2%)

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17

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)

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18

how does the Fed indirectly set the FFR?

OMOs

  • buy → decrease FFR

  • sell → increase FFR

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