lecture 11 federal reserve and the macroeconomy (chapter 14 and chapter 15) ch. 12 & 13 in 4 th...

Lecture 11

Federal Reserve and the Macroeconomy (Chapter 14

And Chapter 15) Ch. 12 & 13 in 4th Edition

Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

The Federal Reserveand Interest Rates

The supply of money determines the interest rate, given the demand for money.



The Demand for MoneyMoney is an asset, and is used for transactions.Money is a store of value, and is used for

holding wealth.People must decide how to hold their wealth, or

make portfolio allocation decisions.There are many ways to hold wealth:

Cash, Checking, Bonds, Stocks



The Demand for Money The portfolio allocation decision is made by

comparing return relative to risk.Risk can be reduced by diversifying the

portfolio.Most people choose to hold some wealth as

money.



Demand for Money (Liquidity Preference)The amount of wealth an individual chooses

to hold in the form of money.



ExampleLouis’ wealth = $10,000

Holds $10,000 in cash His demand for money = $10,000 If he allocates his wealth to:

$1,000 cash $2,000 checking account $2,000 government bonds $5,000 rare stamps

His demand for money = $3,000



The Demand for MoneyHow much money to hold (demand for

money) is determined by the cost-benefit principle.

Benefit of holding moneyused to make transactions

Cost of holding money; the opportunity cost of foregoneinterest

vs.



Macroeconomic Factors that Affect the Demand for MoneyCost of holding money

The nominal interest rate (i) The quantity of money demanded is inversely related to

the nominal interest rate



Macroeconomic Factors that Affect the Demand for MoneyBenefit of holding money

Real income or output (Y) An increase in real income will increase the demand for

money and vice versa

The price level (P) The higher the price level, the greater the demand for

money and vice versa


The Money Demand Curve

Money M

No

min

al in

tere

st r

ate

i

MD

Demand for money is inversely related to the nominal interest rate (i)


A Shift In The Money Demand Curve

Money M

No

min

al in

tere

st r

ate

i

MD

MD’

Shifts in MD• Changes in Y & P

• MD will increase if Y or P increase

• Technological changes• Foreign demand



The Supply of Money and Money Market EquilibriumThe Fed controls the supply of money with

open-market operations.An open-market purchase of bonds by the

Fed will increase the money supply.An open-market sale of bonds by the Fed will

decrease the money supply.


Equilibrium inthe Market for Money

Money

Money demand curve, MD

E

Money supply curve, MS

M

i

M1

i1

If interest = i1

• Qmd > Qms

• People sell interest bearing assets to hold more money

• Price of financial assets falls and interest rates rise

No

min

al in

tere

st r

ate


The Fed Lowers the Nominal Interest Rate

No

min

al in

tere

st r

ate

MD

E

MS

MMoney

i

M’

I’ F

MS’The Fed wants to lower i• Fed buys bonds• The money supply increases• Creates a surplus of money• People buy interest bearing

assets• Non-money asset prices rise and

interest rates fall



The Supply of Money and Money Market EquilibriumThe Fed wants to raise i

Fed sells bonds The money supply falls Creates a shortage of money People sell non-money assets Non-money asset prices fall and the interest rate

increases



How the Fed Controls the Nominal Interest RateThe Fed cannot set the interest rate and the

money supply independently.



The Advantages of Targeting the Interest RateThe effects of monetary policy are exerted

through interest ratesPublic familiarity with interest rates Interest rates can be monitored easily



Federal Funds RateThe interest rate that commercial banks

charge each other for very short-term (usually overnight) loans

Because the Fed frequently sets its policy in the form of a target for the federal funds rate, this rate is closely watched in financial markets



Can the Fed Control the Real Interest Rate?The real interest rate = nominal interest -

inflation

- i r



Can the Fed Control the Real Interest Rate?The Fed controls the nominal interest rate. Inflation adjusts slowly to changing economic

conditions.Therefore, if the Fed changes the nominal

interest rate, the real rate will generally change by the same amount in the short run.



Can the Fed Control the Real Interest Rate?Short-run impact of Fed policy

Prices do not vary greatly in the short run. Changes in the money supply can change nominal and

real interest. Real interest influences consumption and investment. Fed’s ability to influence spending is strongest in the

short run.



Can the Fed Control the Real Interest Rate?Long-run impact of Fed policy

Prices adjust to changing economic conditions. The real interest rate is determined by the balance

of savings and investment. The Fed has less effect on spending in the long

run.



How much control does the Fed have over spending?The Fed has direct control over the federal funds rate.The federal funds rate may influence, but does not

control other interest rates which influence spending.The inability of the Fed to precisely control other

interest rates complicates monetary policy. New efforts to change this.


The Effects of Federal Reserve Actions on the Economy

The Fed can control i and r in the short run.

PAE is influenced by r.Lower r increases PAEHigher r reduces PAE

The Fed can stabilize output and employment.



Planned Aggregate Expenditure and the Real Interest RateReal interest rates and consumption

High real interest rates increases the incentive to save.

If savings increase, consumption decreases. High real interest rates reduces consumption.



Planned Aggregate Expenditure and the Real Interest RateReal interest rates and investment spending

High real interest rates increases the cost of investment spending.

The increased cost reduces profitability of investment spending and investment falls.

High real interest rates reduces investment spending.



ExampleAssume:

C = 1000+ .9(Y – T) – 500r -500r – a 1% increase in r reduces C by 5 units

IP = 800 – 400r -400r – a 1% increase in r reduces I by 4 units

G = 800 NX = 85 T = 650



ExamplePAE = C + IP + G + NX

85800400800500)650(9.1000 r - rYPAE

Autonomous spending depends on r Induced spendingdepends on Y

YrPAE 9.0 85800)400800(0.9 (1000 r) 500 - 650

YrPAE 9.0900100,2


ExampleThe real interest rate and short-run

equilibrium output Assume the Fed sets the r at 0.05 (5 percent)

YPAE 9.0)05.0(9002100

YPAE 9.0452100 YPAE 9.02055



ExampleEquilibrium occurs when Y = PAE

Y = 20,550

20550)20550(9.02055 PAE




ExampleThe Fed fights a recession

Assume

20550)20550(9.02055 PAE


The Fed Fights A Recession

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

Y = PAE

20,820

Recessionary gap

E

Expenditure line (r = 5%)

20,550Y*


F

A reduction in r shifts the expenditure line upward

• Multiplier = 10• Output gap = 270• Fed wants to increase

PAE by 270/10 =27 • C = 1,000 +.9(Y-T) – 500r• I = 800 – 400r• 1% change in r will

change C by 5 and I by 4• Reduce r to 0.02 to

increase C and I by 27 total


The Fed Fights Inflation

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE


Y = PAE

20,550

Expansionary gap

E

20,280Y*

G


An increase in r shifts the expenditure line downward



An example of a monetary policy reaction function:

)πg(π rr **


A Monetary Policy ReactionFunction for the Fed

0.00 (= 0%) 0.02 (= 2%)

0.01 0.03

0.02 0.04

0.03 0.05

0.04 0.06

Rate of inflation, Real interest rate set by Fed, r

)02.0(0.104.0 :Assume r


An Example of a Fed Policy Reaction Function

Rea

l in

tere

st r

ate

set

by

Fed

, r

0.01

0.02

0.03

0.04

0.05

0.06

0.02 0.03 0.04

Fed’s monetary policy reaction function

Inflation


A General MonetaryPolicy Reaction Function

Rea

l in

tere

st r

ate

set

by

Fed

, r MPRF

Inflation

r*

Slope = g

*

A



The FedA determinant of the Fed’s policy reaction

function is its objective for inflation.The slope of the reaction function indicates

how aggressive the Fed will pursue its target.

Inflation, Aggregate Supply, and Aggregate Demand (Chapter 15)


Introduction

The Keynesian model assumes that producers meet demand at preset prices.

The shortcoming of their assumption is that it does not explain the behavior of inflation.


Introduction

The aggregate demand/aggregate supply model will allow us to see how macroeconomic policy affects inflation and output.


Inflation, Spending, and Output: The Aggregate Demand Curve

Aggregate Demand (AD) CurveShows the relationship between short-run

equilibrium output Y and the rate of inflation, The name of the curve reflects the fact that

short-run equilibrium output is determined by, and equals, total planned spending in the economy



Aggregate Demand (AD) Curve Increases in inflation reduce planned

spending and short-run equilibrium output, so the aggregate demand curve is downward-sloping


The Aggregate Demand Curve

Output Y

AD

Aggregate Demand Curve

An increase in reduces Y(all other factors held constant)

Infl

atio

n



Inflation, the Fed, and the AD CurveA primary objective of the Fed is to maintain a

low and stable inflation rate. Inflation is likely to occur when Y > Y*.To control inflation, the Fed must keep Y from

exceeding Y*.



Inflation, the Fed, and the AD CurveThe Fed can reduce autonomous expenditure

by raising the interest rate. increases r increases autonomous spending

decreases Y decreases (AD curve)


The Aggregate Demand Curve and the Monetary Policy Reaction Function

Output Y

Infl

atio

n

Inflation

Rea

l in

tere

st r

ate

set

by

the

Fed

, r

A

A

1

r1

1

B

B

2

r2

2



Other Reasons for the Downward Slope of the AD CurveReal value of moneyDistributional effectsUncertaintyPrices of domestic goods and services sold

abroad


Effect of An Increase In Exogenous Spending

Output Y

ADExogenous Spending: spending unrelated to Y or r•Fiscal policy•Technology•Foreign demand

AD’

An increase in exogenous spending shifts AD to AD’ and vice versaIn

flat

ion


A Shift in the Fed’s Monetary Policy Reaction Function

Rea

l in

tere

st r

ate

set

by

Fed

, r

Output YInflation

Infl

atio

n

Fed “tightens” monetary policy – shifting reaction curve

The new Fed policy increases r and AD shifts to AD’

Old monetary policy reaction function

AD

A

Ar*

1*

New monetary policy reaction function AD’

B

B

2*



Movements Along the AD Curve and Y are inversely relatedChanges in cause a change in Y or a

movement along the AD curve increases r increases planned spending

decreases Y decreases (stationary monetary policy reaction function)



Shifts of the AD CurveAny factor that changes Y at a given shifts

the AD curve.Shifts of the AD curve can be caused by:

Changes in exogenous spending. Changes in the Fed’s policy reaction function.


Inflation andAggregate Supply

Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level.



Three factors that can increase the inflation rateOutput gap Inflation shockShock to potential output



Long-term Wage and Price ContractsUnion wage contracts set wages for several

years.Contracts setting the price of raw materials

and parts for manufacturing firms also cover several years.

These long-term contracts reflect the inflation expectations at the time they are signed.


The Output Gap and InflationRelationship of output

to potential output Behavior of inflation

1. No output gap Inflation remains unchangedY = Y*

2. Expansionary gap Inflation rises

Y > Y*

3. Recessionary gap Inflation falls

Y < Y*



The Output Gap and Inflation If Y* = Y

An increase in exogenous spending creates and expansionary gap (Y > Y*) -- inflation increases

A decrease in exogenous spending creates a recessionary gap (Y < Y*) -- inflation decreases



The Aggregate Demand—Aggregate Supply DiagramLong-run aggregate supply (LRAS)

A vertical line showing the economy’s potential output Y*



The Aggregate Demand—Aggregate Supply DiagramShort-run Aggregate Supply (SRAS)

A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions



The Aggregate Demand—Aggregate Supply DiagramShort-run Equilibrium

A situation in which inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate

Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line


The Aggregate Demand-Aggregate Supply (AD-AS) Diagram

Output

No

min

al in

tere

st r

ate

i

Aggregate demand, AD

Long-run aggregate

supply, LRAS

A

Y*Y

Short-run aggregate supply, SRAS

Short-run equilibrium•Y: SRAS() = AD•Y < Y* -- recessionary gap and Y adjust to the gap

decreases & Y increases

Long-run equilibrium• AD, SRAS (*), LRAS (Y*)

will intersect at the same point



The Aggregate Demand—Aggregate Supply DiagramLong-run Equilibrium

A situation in which actual output equals potential output and the inflation rate is stable

Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point



A Review of the Adjustment Process to a Recessionary GapFirms that are selling less than they want to

will start to lower prices.As falls the Fed lowers r and AD increases.Falling reduces uncertainty which also

increases AD


AD

LRAS

A

Y

SRAS1SRAS2SRAS3

The Adjustment of Inflation When a Recessionary Gap Exists

Output

Infl

atio

n

Y*

SRASFinal

B’


The Adjustment of Inflation When A Expansionary Gap Exists

Output

Infl

atio

n

LRAS

A

AD

Y* Y

SRAS

B

Short-run Eq. Y•Expansionary gap Y > Y* rises, AD falls – Y falls•Long-run equilibrium at Y*, *

’ SRASFinal

SRAS3SRAS2


Sources of Inflation Excessive Aggregate Spending Inflation Shocks Shocks to Potential Output


War and Military Buildup As A Source of Inflation

Output

Infl

atio

n

Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS

LRAS

A

Y*

SRAS

’ SRASFinal

C

increases shifting SRAS to SRASFinal

•Long-run equilibrium back to Y* with *

SRAS3

SRAS2

Y

B

AD’

Y

B

AD’

•Increase in military spending causes AD to increase•Creates an expansionary gap -- Y > Y*


Sources of Inflation

Inflation ShockA sudden change in the normal behavior of

inflation, unrelated to the nation’s output gap


Sources of Inflation

Inflation Shock -- ExamplesOPEC embargo of 1973Drop in oil prices in 1986


The Effects of an Adverse Inflation Shock

Output

Infl

atio

n

AD’

C

• No policy -- falls; long-run eq. at A• With policy--AD shifts to AD’; Y = Y*; rises

to *

AD

LRAS

A

Y*

SRAS

• Equilibrium @ A--Y* = Y

Y’

BSRAS’

• Inflation shock, increases to ‘ (SRAS’)• Short-run eq. At B, Y < Y*; recessionary gap

and higher inflation (stagflation)

’


The Effects of a Shock To Potential Output

Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS

•Equilibrium at A -- Y* = Y

Y*’

BSRAS’

LRAS’ •Y* falls to Y*’•Y > Y* -- expansionary gap increases--SRAS rises to SRAS’•Equilibrium at B

•Y = Y*’ increased to ‘ •Decline in output is permanent

’

lecture 11 federal reserve and the macroeconomy (chapter 14 and chapter 15) ch. 12 & 13 in 4 th...

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