ECO3200 Chap 9

Introduction

• Monetary policy

• Examine how central bank set interest rates in order to control aggregate demand

• Central bank moves interest rates in response to deviations of output and inflation from desired levels => a notion that's summarized by the Taylor rule

• Policy and Keynesian aggregate supply (AS) curve

• Expansionary monetary policy and real money balances

The Who of Policy

• Most short run adjustment is done with monetary policy

• The who of stabilization policy= central bank

• In U.S, the central bank is the federal reserve bank

• U.S monetary policy is established by vote of Feds open market committee (FOMC)

  • In other countries, the formal decision making is solely in the governor of the central bank

The What of Policy

• What the Fed actually does is set a key interest rate in the economy => the federal funds rate

  • Raising int rates tends to cool off the econ

  • Lowering int rates tends to heat up the econ

• Lower int rates encourage greater investment spending and spending on consumption goods, increasing AD

  • Monetary policy works through AD

  • Monetary policy has little influence on AS

The Why of Policy

• Central banks choose short run policy with 2 goals in mind

  • Maintain high economic activity

  • Maintain low inflation rats

• Additional conflict between central banks preferences and capabilities

  • Except at high inflation rates, boosting economic activity does much more to enhance economic welfare than controlling inflation

  • Central banks focus on stabilizing economic activity around a sustainable goal (Y') and have moved toward inflation targeting

When policy is Made

• Fed's open market committee (FOMC) meets every 6 weeks and sets federal funds rate

• Fed tries not to "surprise" markets

  • Sends advance signals of the likely future path of interest rates

  • At each meeting appropriate language is chosen to describe the Feds thinking about the near future

  • Markets listen to these words closely and react to the signals that they send

How Policy is implemented

• Fed sets the interest rate by buying/selling Treasury bills to lower/raise the interest rate

• The Fed buys treasury bills with money it prints (electronically)

  • Lowering interest rates means increasing money supply

  • Increased money supply results in increased prices

Policy as a rule

• When central bank sets the interest rate, makes a decision on the current economic situation

• Useful to set that decision within the overall framework of a monetary policy rule

• A general format of a monetary policy rule

• r* is the real, natural rate of interest, corresponding to the real interest rate we would observe f the economy operating at full employment level of output; a inflation coefficient, B output coefficient

• Pi* is the Feds target rate of inflation

• If a and B are large, then the monetary rule requires an aggressive responses to excess inflation (pit-pi*) and to economic booms (100*(yt-yt*/yt*))

• If a is large relative to B then monetary policy makers will respond much more aggressively to inflation that it will to level of economic activity

• The case of B=0 corresponds to inflation targeting

Interest Rates and Aggregate Demand

• Higher interest rates raise the oppurtuntiy cost of purhcasing goods for investment and consumption => reduct=ing demand

• Ignoring all other elements that affect aggregate demand

• If the Fed raises interest rates, the AD curve shifts to the left

  • Higher interest rates lower prices, but also reduce economic activity

Calculating how to hit the target

• Steps taken by a policy maker are

  • Determining where output and the price level should be (pr employment and inflation)

  • Determining how much they need to shift AD and AS to hit those targets

  • Determining how large a policy change is required to move the AD pr AS the necessary distance

The economic effects of monetary policy I

• Monetary policy primarily influences the economy through changes in the interest rate

• Changes in the interest rate, in turn, affect the appeal of borrowing and lending, which can have significant impacts on the economy

The economic effects of monetary policy II

• The liquidity preference model explains how the Feds actions can change interest rates

  • Expansionary monetary policy results in higher quantity of money and lower interest rates

  • Contractionary monetary policy results in lower quantity of money and higher interest rates

Expansionary monetray policy

• During recessions, expansionary monetary policy decreases the interest rate

• Cheaper to borrow and less rewarding to save money

• Aggregate demand curve shifts out

• Price and output increase

Contractionary monetary policy

• During overheating, contractionary monetary policy increases the interest rate

• More expensive to borrow and encourages saving

• Aggregate demand curve shifts in

• Prices and output decrease

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