Frank & Bernanke
Ch. 14: Stabilizing Aggregate
Demand: The Role of the Fed
http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040316/default.htm
FOMC Decision
On March16, 2004 the FOMC declared that
it will keep the federal funds rate at 1.00%.
On March 22, 2005, the FOMC raised the
federal funds rate to 2.75%.
How does the Fed keep the federal funds
rate constant or lower or higher? What is
the connection of this interest rate to the
money supply?
Money Supply
By engaging in open market operations, the
Fed increases (buy bonds) or decreases (sell
bonds) the amount of money in the system.
If the demand for money remains the same,
the action of the Fed affects the federal
funds rate.
The Demand for Money
Money (currency + checking deposits) is
one of the assets a person, a household, a
business holds.
The benefit of money is its acceptability in
paying debts (liquidity).
The cost of money is the opportunity cost of
losing a return on other assets one could
hold.
The Demand for Money
If the opportunity cost of holding money
increases, less money will be held in portfolio.
– The higher the nominal interest rate, the lower is
the demand for money.
The more the income, the more will be the
amount kept in money form: the higher will be
the demand for money.
The higher the price level, the higher will be
the demand for money.
The Demand for Money
Nominal interest
rate
Quantity of Money
Shifts in Money Demand
Changes in real income (real GDP).
Changes in price level.
Technological/institutional changes.
Changes in foreign holdings of USD.
Psychological changes.
Seasonal changes.
Equilibrium in the Market for
Money
Explain how and why the market reaches equilibrium.
Equilibrium in the Market for
Money
If at the existing interest rate, supply exceeds
demand, that means people would like to hold
less money than there is.
How do people adjust their portfolios?
They buy “bonds” with the excess money in
their checking accounts.
The price of bonds goes up: interest rate goes
down.
Fed’s Control of Nominal
Interest Rate
By buying or selling bonds, the Fed
increases or decreases the supply of money
in the system.
Shifting the supply curve to the right or to
the left, lowers or raises the nominal interest
rate.
The Fed directly affects the federal funds
rate.
Fed Shifts the Money Supply
Fed Funds Rate vs. Prime
If Fed can affect the federal funds rate, why
should we care because we might be
interested in the interest rates on CDs,
mortgage rates, credit card interest rates?
Usually, interest rates all go hand in hand.
When the Fed increases the federal funds
rate, banks increase their prime rates, too.
Real and Nominal Interest
Rates
If the amount of savings and investments in
an economy determine the real interest rate,
and real interest rate is more important for
the decisions that will affect the wealth of
the society, why should we care what the
Fed does?
Because in the short run, prices are constant,
so inflation does not increase: any change in
nominal interest rates is reflected in the real
interest rate.
Real and Nominal Interest
Rates
Remember the Fisher Effect:
i=r+p
If the expected inflation hasn’t changed but the
Fed has increased i, then r is also increased.
In the long run p adjusts and it is the savings and
investments that determine the real rate of
interest.
Real Interest Rates and
Aggregate Demand
Y = C + I + G + NX
C = 400 + 0.8(Y-T) - 200r
I = 300 - 600r
G = 250; T = 200; NX = 10
Explain in words how this economy
operates.
Solving for the Unknowns
If the real interest rate is 3%, find the values
of C, I, and Y for the previous economy and
draw the Keynesian cross to show the Y.
If the Fed has increased the real interest rate
to 5%, find the values of C, I, and Y and
show the new AD curve on your graph.
Fighting Recession
The Fed reduced the fed funds rate 11 times
in 2001-2002.
In the second half of 2000, the rate stayed at
6.5%.
In 2002, it has been 1.75% until Nov. 6 and
the Fed decided to lower it further.
What was the effect of Fed’s lowering of
interest rates on AD?
Fighting Inflation
From the middle of 1999 to the middle of
2000, the Fed raised the fed funds rate from
4.75% to 6.50%.
At the beginning of 1977 the fed funds rate
was 4.5%. By the end of 1978 it was 10%.
A year later it was 13.75%. By April 1980,
it reached 17.6%.
What happens to AD?
Inflation and the Stock Market
Inflation is watched very closely by the Fed.
Any sign of inflation makes Fed increase
interest rates.
Higher real interest rates slow down the
economy and lower future profits.
Higher real interest rates lower the price of
bonds and shift the demand away from
stocks to bonds, lowering stock prices.
Policy Reaction Function
If there is a pattern of policies adopted
under the same economic circumstances,
then we have a policy reaction function.
For example, if there is a correlation
between low unemployment rates and lax
immigration policies and high
unemployment rates and strict immigration
policies, this can be shown with an
equation.
Taylor Rule
Taylor explained the behavior of the Fed as a
reaction to output gap and inflation.
If there is a positive, recessionary output gap, the
Fed wants to stimulate the economy.
If there is a negative, expansionary gap, the Fed
wants to slow down the economy.
The Fed also reacts to higher inflation by raising
the real interest rate and slowing down the
economy.
Taylor Rule
r = 0.01 –0.5 [(Y* - Y)/Y*] + 0.5 π
How does the Fed react when inflation rises?
How does the Fed react when output gaps appear?
What will the real and nominal interest rates be given
different values?