Monetary Policy and Phillips Curve

Monetary Policy

Decisions concerning money supply and their interest rates

Dual Mandate

The Federal Reserve Act mandates that Fed monetary policy,ust “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”

2%

Fed Inflation Goal

Setting Short-Term Interest Rates

How Fed utilizes monetary policy to satisfy dual mandate

Federal Funds Market

Banks borrow and loan reserves to each other overnight

Federal Funds Rate (FFR)

The interest rate at which banks loan reserves to one another overnight

Fractional Reserve System

When banks keep a fraction of deposits as reserves

nominal

The Fed influences ______ interest rates

Inflation = Change in Price Level = Expected Inflation + Change in Inflation + Inflation Shocks (obar)

Inflation Equation

Change in Inflation = (vbar x Ytilda) + obar

Change in Inflation Equation

Demand-Pull Inflation

An increase in demand pulls up prices; represented by vbar x Ytilda

Cost-Push Inflation

An increase in the price of something pushes up the price of other things

Supply for Market for Overnight Reserves

Banks with extra reserves

Demand for Market for Overnight Reserves

Banks in need of reserves

Open Market Operations

The Fed trades interest-bearing government bonds in exchange for currency or non-interest-bearing reserves as a way to influence the supply of reserves (and thus FFR)

Supply of reserves increases

Fed buys bonds

Supply of reserves decreases

Fed sells bonds

Interest on Reserves

When banks deposit their reserves in their Fed account, the Fed pays interest on those reserves overnight (like earning interest on a savings account); acts as a price floor, because no bank will lend reserves to another bank at lower price than the can receive from the Fed; = FFR

Yield Curve

Shows the return on the bonds of different maturities; we expect long-term bonds to carry higher return because they are higher risk

Quantitative Easing

A policy where central banks buy assets to inject money into the economy

Rt = r* + mbar(Pit - Pibar) + (nbar + Ytilda)

Taylor Rule

r*

Natural Interest Rate; = rbar, mpk

mbar

Sensitivity to inflation

nbar

Sensitivity to output

mbar = nbar = 1/2

Taylor Rule of Thumb