Fed and Monetary Policy

• Stabilization policies are govt policies affecting Planned Aggregate Expenditures
• Conducting monetary policy is Fed’s primary task
• Monetary policy is quick and responsive tool as it can be changed by FOMC, while fiscal policy can only be changed by legislative action
• FOMC changes money supply through monetary policy changes by modifying short-term nominal interest rates, or the Federal Funds Rate
• This is equivalent to setting the money supply since
  • Value of money supply implies given nominal interest rate
  • Vale of nominal interest rate implies given money supply
  • Nominal interest rate is opportunity cost of holding money

Fed and Interest Rates: Basic Model

• Demand for money is amount of wealth a nation’s people wish to hold in form of money
• Equilibrium in money market (i.e money supply = money demand) determines equilibrium nominal interest rate, equilibrium money supply/demand

National Demand for Money

• Nominal interest rate (i) - negative relationship
  • Higher interest rate, higher opp. cost of holding money, so lower demand for money
• Real income or output (Y) - positive relationship
  • Higher income, greater quantity of money demanded
• Price level (P) - positive relationship
  • Higher price level, greater quantity of money demanded
• Rightward shift in demand curve for money can be caused by
  • Increase in real GDP
  • Increase in price level
  • Tech. changes/improvements
  • Increase in foreign demand for dollars

Supply of Money

• Fed primarily controls money supply with open market operations
  • Seen in Short run spending and output, make open market purchase of bonds to increase money supply
  • Sell bonds (by Fed) to decease money supply
• Supply of money is vertical line in figure below
• Fed wants to increase money supply to new $M^\prime$
• This establishes a new equilibrium with lower interests, convincing market to hold the new larger amount of money

Fed Targets Interest Rate

• Sets interest rate because closely tied to bank reserve levels
• Policy also announced in interest rate because
  • Public not familiar with “money supply”
  • Interest rate affects planned spending and level of economic activity
  • Interests rates easier to monitor than money supply itself
• The Fed can control real interest rates in the short run
  • Inflation does not adjust very quickly, and real interest rate $r = i - \pi$, where $\pi$ is inflation rate, so $i$ has heavy impact on $r$
• But over long run inflation rate will change

Excess Reserves

• Banks could hold excess reserves (reserve amounts above legal minimum), reducing Fed’s ability to control money supply through open market operations
• Banks might hold these reserves in times of uncertainty

Quantitative Easing

• Quantitative easing is expansionary monetary policy where Fed buys long-term financial assets (like mortgage back securities, long term treasuries)
• Goal is to increase long-term interest rates, as they don’t always move with the Federal Funds Rate

The Fed and the Economy

Monetary Policy

Fed Fights Inflation

• Expansionary gaps can lead to inflation
• Fed tries to close these gaps by raising interest rates, causing a decrease in consumption, PAE, and equilibrium output’

Inflation and the Stock Market

• Bad news about inflation generally causes stock prices to fall
• Investors anticipate Fed will increase interest rates, meaning
  • Economic activity slows, lowering firm’s sales and potentially profits
  • Higher interest rates makes non-stock financial instruments more attractive
  • Reduces demand for stocks and thus their price drops

Fed and Stock Market

• Has limited ability to manage stock market
• Monetary policy not well suited to addressing asset bubble (increase in asset price over their market values)
• Fed could slow economy and raise interest rates, but might result in recession

Taylor’s Rule

• Describes Fed’s behavior, so called policy reaction function
• Written as $$r = 0.01 + 0.5 \frac{Y-Y^*}{Y^*} + 0.5\pi$$ where $r$ is real interest rate and the fraction is output proportional to potential GDP
• Maps inflation rate $\pi$ and output gap to real interest rate that Fed should set
• Useful simplifying assumption is that Fed’s choice of real interest rate depends only on rate of inflation