Chapter 15: Monetary Policy

Federal Reserve Basics

• Created to be independent of political pressures.

• Jerome Powell is the current Chair, cannot be fired by the President (term ends May 2026).

• President vs. Fed: The President may want lower interest rates to stimulate the economy, but the Fed is cautious due to stagflation risks (e.g., due to tariffs).

• Main tool of monetary policy: Open Market Operations (OMOs) to control the federal funds rate.

Money Demand & Opportunity Cost

• Holding money = convenience, but has an opportunity cost (loss of interest income from bonds, CDs, etc.).

• Higher interest rates increase the opportunity cost of holding money.

• Money demand curve: Shows inverse relationship between interest rate and quantity of money demanded.

What Shifts the Money Demand Curve?

1. Price level ↑ → Money demand ↑

2. Real GDP ↑ → Money demand ↑

3. Technology ↑ (e.g., credit cards) → Money demand ↓

4. Institutions (e.g., banking changes)

How the Fed Controls Interest Rates

• Uses the Liquidity Preference Model: Interest rate = determined by money supply and money demand.

• Money supply curve = vertical (set by the Fed).

• Open Market Operations:

  • Purchase → ↑ Reserves → ↑ Money supply → ↓ Interest rate

  • Sale → ↓ Reserves → ↓ Money supply → ↑ Interest rate

Federal Funds Market

• Banks lend to each other overnight to meet reserve requirements.

• Federal funds rate: The interest rate in this market.

  • Currently 4.25–4.5%, effective rate 4.33%.

• Fed targets this rate through OMOs.

Tools of Monetary Policy

1. Open Market Operations (OMOs)

2. Discount Rate: Rate at which banks borrow from the Fed.

3. Reserve Requirements: % of deposits banks must hold in reserve.

Expansionary vs. Contractionary Policy

Expansionary Monetary Policy

• Goal: Fight recession / ↑ Aggregate Demand (AD)

• Fed buys securities, ↓ federal funds rate

• Leads to:

  • ↑ Reserves

  • ↑ Loans

  • ↑ Money supply (via money multiplier)

  • ↓ Real interest rates

  • ↑ C (Consumption) and I (Investment)

  • ↑ Stock prices, ↓ dollar value

Contractionary Monetary Policy

• Goal: Fight inflation

• Fed sells securities, ↑ federal funds rate

• ↓ Reserves → ↓ Loans → ↓ Money supply

Time Lags in Policy

1. Data lag – Getting accurate data

2. Recognition lag – Knowing there's a problem

3. Legislative lag – Passing policy

4. Implementation lag – Enacting policy

5. Effectiveness lag – Time for policy to work

Taylor Rule (Formula-based policy)

• Suggests a federal funds rate based on:

  • Inflation rate

  • Output gap or unemployment rate

• If inflation ↑ by 1%, Fed ↑ rate by slightly more than 1%.

Limits of Monetary Policy

• Banks must be willing to lend, and people must want loans (for money multiplier to work).

• Long-term rates don’t always follow short-term ones.

• Expectations matter: Policy announcements shape behaviors (e.g., investment, spending).

Extra Concepts

• Moral hazard & Adverse selection: As economy improves, information asymmetry ↓, banks behave more responsibly.

• Aggregate Demand = C + I + G + NX