Pump Primer:
• Define monetary policy.
31
Module 31
Monetary
Policy and
the Interest Rate
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration:
• Stabilization is a crafty word. It is defined
by Webster as: "to become stable, firm,
or steadfast." In 1 Cor. 15:58 God talks
about our labor not being in vain.
However, we need to be steadfast and
immoveable in our work for the Lord.
How is your stability?
What you will learn
in this Module:
• How the Federal Reserve implements
monetary policy, moving the interest rate
to affect aggregate output
• Why monetary policy is the main tool for
stabilizing the economy
Monetary Policy and the Interest
Rate:
We are ready to use the model of the
money market to explain how the Federal
Reserve can use monetary policy to
stabilize the economy in the short run.
Suppose the Fed took steps to increase
the money supply. This will usually be the
result of an open market operation to
buy Treasury bills from large commercial
banks.
The increase in the money supply causes
short-term interest rates to fall in the
money market.
Monetary Policy and the Interest
Rate:
Now suppose the Fed took steps to
decrease the money supply. This will
usually be the result of an open
market operation to sell Treasury bills
to large commercial banks.
The decrease in the money supply
causes short-term interest rates to rise
in the money market.
Usually, the Fed adjusts the money
supply to target a specific federal funds
rate.
Monetary Policy and the Interest
Rate:
If the current federal funds rate is
higher than the target, the Fed will
increase the money supply, so that the
rate falls to the target.
If the current federal funds rate is lower
than the target, the Fed will decrease
the money supply, so that the rate rises
to the target.
Monetary Policy and the Interest
Rate: Targeting the Fed Funds Rate
Expansionary and Contractionary
Monetary Policy
We have seen how fiscal policy can be
used to stabilize the economy. Now we will
see how monetary policy can play the
same role.
Expansionary and Contractionary
Monetary Policy
Investment spending is usually quite sensitive
to changes in the interest rate.
When interest rates fall, we see an increase
in investment spending. Some types of
consumption spending also increase when
the interest rate falls.
Examples: car/truck buying, college
educations, real estate.
Expansionary and Contractionary
Monetary Policy
Since both investment spending and
consumption spending are important
components of aggregate demand, it would
therefore make sense that when the interest
rate falls, AD should rise.
Note: the instructor can draw the AD/AS graph
with AD to the left of potential output. Ask the
students,
“What could the Fed do about this recession”?
Expansionary Monetary Policy
Expansionary Monetary Policy chain of
events
• The Fed observes that the economy is in a
recessionary gap.
• The Fed increases the money supply.
• The interest rate falls.
• Investment and consumption increase.
• AD shifts to the right.
• Real GDP increases, unemployment rate
decreases, the aggregate price level rises.
Expansionary Monetary Policy
The Economy
The
Money
Market
Contractionary Monetary Policy
“What could the Fed do about this inflation”?
Contractionary Monetary Policy chain of events
• The Fed observes that the economy is in an
inflationary gap.
• The Fed decreases the money supply.
• The interest rate rises.
• Investment and consumption decrease.
• AD shifts to the left.
• Real GDP decreases, unemployment rate
increases, the aggregate price level falls.
Contractionary Monetary Policy
The
Money
Market
The Economy
Monetary Policy in Practice
• The Fed is not only concerned with
the level of real GDP and whether
the economy is producing a full
employment, but also with price
stability. The Fed also monitors
inflation, so that the economy
doesn’t suffer unexpected spikes in
the inflation rate.
• In practice, this simply means that
the Fed’s goals and policies are
multifaceted. Some economists have
suggested that the Fed (and other
central banks) operates with a
monetary “rule” that dictates
monetary policy.
Stanford Economist, John Taylor
Monetary Policy in Practice
The Taylor rule for monetary policy is a rule for setting the
federal funds rate that takes into account both the inflation
rate and the output gap.
• The rule Taylor originally suggested was as follows:
• Federal funds rate = 1 + (1.5 × inflation rate) + (0.5 ×output
gap)
1+(1.5 X π%)+(0.5 X Output Gap)
• Example Inflation is 3% and real GDP is 4% below potential
GDP
• FFR = 1 + (1.5*3) - (.5*4) = 1 + 4.5 – 2 = 3.5 %
Inflation Targeting
Other nations have adopted a policy of
keeping interest rates at a level that creates
a specific level of price inflation, or at least
attempts to keep inflation rates within an
acceptable range.
One major difference between inflation
targeting and the Taylor rule is that inflation
targeting is forward looking rather than
backward-looking. That is, the Taylor rule
adjusts monetary policy in response to past
inflation, but inflation targeting is based on a
forecast of future inflation.
Inflation Targeting
Advocates of inflation targeting argue that it
has two key advantages, transparency and
accountability.
Transparency: Economic uncertainty is
reduced because the public knows the
objective of an inflation-targeting central
bank.
Accountability: The central bank’s success
can be judged by seeing how closely actual
inflation rates have matched the inflation
target, making central bankers