Chapter 14: Monetary Policy
After this chapter you should be able to do
the following.
 Define monetary policy and describe the
Federal Reserve’s monetary policy goals.
 Describe the Federal Reserve’s monetary
policy targets, and explain how
expansionary and contractionary monetary
policies affect the interest rate.
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 Use aggregate demand and aggregate
supply graphs to show the effects of
monetary policy on real GDP and the price
level.
 Discuss the Fed’s setting of monetary
policy targets and assess the arguments for
and against the independence of the Federal
Reserve.
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Monetary policy is the actions the Federal
Reserve takes to manage the money supply
and interest rates to pursue its economic
objectives.
The Fed’s objectives have changed over the
years. The Federal Reserve System’s chief
objective when it was first established was to
ensure the stability of the banking system by
acting as a lender of last resort.
By the 1950s its goal was to keep interest
rates low and stable.
The Federal Reserve Act of 1978 charged the
Fed with achieving both a low, stable
inflation rate and full employment.
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The Objectives of Monetary Policy
 Low, stable inflation (this is what they
concentrate on)
 Full employment implying no cyclical
unemployment
Natural rate of unemployment is the
rate where there is no cyclical
unemployment.
Other objectives
 Economic Growth
 Stability of Financial markets and
institutions
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Let’s look at price stability
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The Inflation Rate, 1952-2004
We will need to develop an aggregate money
market to show how the Fed can effect price
stability.
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The Aggregate Money Market
A person’s wealth can be held as stocks,
bonds which earn a return, or as money
(currency or checking account), which earns
no return (or very little in the case of interest
paying checking accounts). For simplicity
we will assume a person holds either money
or bonds.
The opportunity cost of holding money is
the forgone return measured by the interest
rate you could have received is you held
bonds.
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Determines of how much cash an
individual will decide to hold
Interest rates: Rising interest rates lead the
public to decrease its quantity of money
demanded.
 Changes results in movements on the
Money demand curve.
Real income: Rising real income will lead to
a desire to hold more money.
 Changes results in shifts of the Money
demand curve.
The price level: Rising price level will lead
to a desire to hold more money.
 Changes results in shifts of the Money
demand curve.
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Why hold money?
 To perform transactions quickly and easily
 Liquidity demand for money is the demand
for money that represents the needs or
desires off individuals or firms to make
purchases on short notice without incurring
excessive costs.
 Speculation demand for money is the
demand for money that reflects holding
money over short periods is less risky than
holding stocks or bonds.
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Money Market
Money Demand curve indicates how much
money will be willingly held at each interest
rate.
 A change in interest is a movement on the
money demand curve.
 A change in real income, price level, or
some other variable other than interest rates
that change money demand will shift the
money demand curve.
Money supply curve is a line showing the
total quantity of money in the economy at
each interest rate.
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Equilibrium in the money market occurs
when the quantity of money people are
actually holding (quantity supplied) is equal
to the quantity of money they want to hold
(quantity demanded).
Let’s look at the relationship between a
Treasury bill’s price or any bill, bond, or
note’s price and their interest rates. We will
look at bond prices but the same relation
exists for all 3 types of securities.
Bond prices and interest rates
The price of the bond depends on the bond’s
payment and the interest rate. Since the
payment equals the price plus the earned
interest. We can write the price as,
 Price = Payment/(1 + interest rate)
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If you had $100 today and invested it at 10%,
it would be worth $110 next year.
$100 today = $110/(1+.01)
If interest rates rise, the price of the bond
falls.
 To end up with $110 next year, you
don’t need to invest as much. Say interest
rates rise to 20% then a bond price =
$110/(1.2)=$91.67
If interest rates fall, the price of the bond
rises.
 Say interest rates decrease to 5% then
a bond
Price = $110/1.05=$104.76
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Why is good news for the economy bad for
the bond market?
How the money market reaches
equilibrium
Excess supply of money refers to the
situation when the amount of money
supplied exceeds the amount demanded at a
particular interest rate.
Excess demand for bonds refers to the
situation when the amount of bonds
demanded exceeds the amount supplied at a
particular interest rate.
When there is an excess supply of money
in the economy, there is also an excess
demand for bonds.
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What Happens When Things Change
Theories of where “the Interest rate”
is determined
 Short-run—money market
 Long-run—loanable funds market
Expectation and the interest rate
A general expectation that interest rates will
rise (bond prices will fall) in the future will
cause the money demand curve to shift
rightward in the present.
 When the public as a whole expects that the
interest rate will rise in the future, they will
drive up the interest rate in the present.
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 When the public as a whole expects that the
interest rate will fall in the future, they will
drive down the interest rate in the present.
The FED attempts to manage expectations on
interest rates.
Fed and Short Run Monetary Policy
Monetary Policy is the range of actions taken
by the Federal Reserve to influence the level
of GDP or the rate of inflation. All
accomplished through controlling the money
supply
 Discount rate
 Required reserve requirements
 Open market operations (buying and selling
of U.S. Securities which I will refer to as
“bonds”)
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 Purchases of lead to an increase in the
money supply
 Sale of bonds leads to decrease money
supply
How monetary policy affects
The economy
FED action to stimulate the economy
1. The FED purchases bonds
2. Increase in money supply → Excess
supply of money and excess demand of
bonds
3. Price of bonds increase → Interest rate
decreases
4. Spending increase
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5. Real GDP increase (through multiplier)
How Interest Rates Affect Aggregate
Demand
Changes in interest rates will not affect
government purchases, but they will affect
the other three components of aggregate
demand in the following ways:

Consumption

Investment

Net exports
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The Effects of Monetary Policy on Real
GDP and the Price Level
The Effects of Monetary Policy on Real
GDP and the Price Level
Expansionary monetary policy: The Federal
Reserve’s increasing the money supply and
decreasing interest rates in order to increase
real GDP.
Can the Fed Eliminate Recessions?
Federal Reserve Monetary Policy:
Theory and Practice
Passive monetary policy is when the FED
keeps the money supply growth rate constant
regardless of shocks to the economy.
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Active monetary policy is when the FED
changes the money supply in response to
economic shocks such as spending shocks,
aggregate supply shocks, and money demand
shocks.
 For example, if the Fed changes the money
supply in response to shifts in the money
demand curve or to spending shocks, it is
practicing active monetary policy.
Let’s see how the Fed could respond to
these shocks.
Responding to a Shock
in money demand
To deal with shifts in the money demand
curve, the Fed sets an interest rate target, and
changes the money supply as needed to
maintain the target.
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This policy enables the Fed to achieve its
twin goals of a stable price level and full
employment simultaneously.
Interest rate target is the interest rate the FED
aims to achieve by adjusting the money
supply.
 There are many interest rates in the
economy but for purposes of monetary
policy, the Fed has targeted the interest
rate known as the federal funds rate.
 When banks need additional reserves,
they borrow in the federal funds market
from banks that have reserves available.
The federal funds rate is the interest rate
banks charge on loans in the federal funds
market.
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Assume the economy is at its potential
output level and there is a positive money
demand shock.
What would the Fed need to do to
maintain a stable inflation rate and full
employment? Illustrate this graphically.
Responding to a change
in money demand
Responding to a spending shock
To achieve the twin goals after a spending
shock, the Fed must change its interest rate
target.
A positive spending shock requires an
increase in the target; a negative spending
shock requires a decrease in the target.
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Assume the economy is at its potential
output level and there is a positive
spending shock.
What would the Fed need to do to
maintain a stable inflation rate and full
employment? Illustrate this graphically.
Responding to a spending shock
The members of the Open Market
Committee must think hard before they vote
to change the interest rate target, because
when the Fed raises its target, stock and bond
prices fall.
 Recall that asset prices are inversely
related to interest rates.
Frequent changes in the target would make
financial markets less stable.
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Changes in expectations about the Fed’s
future actions can be as destabilizing as the
actions themselves since market agents will
act in response to their expectations about the
direction the Fed will move on interest rates.
The stock and bond markets move in the
opposite direction to the FEDS interest rate
target: When the FED raises it target, stock
and pond prices fall; when it lowers its
target, stock and bond prices rise.
What happens to expectations about the
Feds actions when there is prolong good
news about the economy?
Responding to Aggregate Supply Shocks
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Assume the economy is at its potential
output level and there is a negative supply
shock (say oil prices increase).
What can the Fed do to maintain a stable
inflation rate and full employment or can
it do both?
In responding to negative supply shocks, the
Fed faces a policy dilemma:
 decreasing the money supply will prevent
inflation but deepen a recession while
 increasing the money supply will limit the
recession but cause more inflation.
Inflation hawks lean more toward controlling
inflation, while inflation doves lean more
toward limiting unemployment.
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Expectations and Ongoing Inflation
The U.S. economy can be characterized as
having ongoing inflation. Looking at the
economy we see it has experienced ongoing
inflation, since at least the beginning in the
1960s. This has led the public to develop
expectations that the inflation rate in the
future will be similar to the inflation rates of
the recent past.
These expectations can be represented by
yearly upward shifts in the AS curve equal to
the built-in rate of inflation.
In the short run, the Fed can bring down the
rate of inflation by reducing the rightward
shifts of the AD curve, but only at the cost of
creating a recession.
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Let’s see what happens when there is a
series of large increases in oil prices and
the Fed response as it did in the 1970’s
A Closer Look at the Fed’s Setting of
Monetary Policy Targets
Some economists argued that rather than
using an interest rate as its monetary policy
target, the Fed should use the money supply
(monetarism thought).
A monetary growth rule, in contrast, is a plan
for increasing the money supply at a constant
rate that does not change in response to
economic conditions, which has been
proposed by Friedman and his followers.
By keeping the money supply growing at a
constant rate, Friedman argues, the Fed
would greatly increase economic stability.
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For active policy that we have been
discussing the Fed would reduce interest
rates when the economy is in recession and
when inflation is increasing, the Fed raises
interest rates.
The Fed cannot target both the money supply
and the interest rate because only
combinations of the interest rate and money
supply that represent equilibrium in the
money market are possible.
The Taylor rule is a rule developed by John
Taylor that links the Fed’s target for the
federal funds rate to economic variables.
Let π = current inflation rate
Federal funds target rate = π + Real
Equilibrium federal funds rate
+ (1/2) (π – target inflation)
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+ (1/2) (Output gap)
The Taylor rule has accurately predicted
changes in the federal funds target during the
period of Alan Greenspan’s leadership of the
Federal Reserve.
The central bank commits to conducting
policy to achieve a publicly announced
inflation target of, for example, 2 percent
using inflation targeting.
Arguments in favor of inflation targeting
 In the long run real GDP returns to its
potential level and potential real GDP is not
affected by monetary policy.
 By announcing an inflation target, the Fed
would make it easier for households and
firms to form accurate expectations of
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future inflation, improving their planning
and the efficiency of the economy.
 An announced inflation target would help
institutionalize good U.S. monetary policy.
 An inflation target would promote
accountability for the Fed by providing a
yardstick against which its performance
could be measured.
Arguments against inflation targeting
 A numerical target for inflation reduces the
flexibility of monetary policy to address
other policy goals.
 Inflation targeting assumes the Fed can
accurately forecast future inflation rates.
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 Holding the Fed accountable only for an
inflation goal may make it less likely that
the Fed will achieve other important policy
goals.
Is the Independence of the Federal
Reserve a Good Idea?
The main reason to keep the Fed independent
of the rest of the government is to avoid
inflation.
 The more bonds the central bank buys, the
faster the money supply grows and the
higher the inflation rate will be.
 The Fed’s independence from the rest of
the government, coupled with the Fed’s
decision-making process, has concentrated
power in the hands of the chairman.
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The More Independent the Central
Bank, the Lower the Inflation Rate
Some economists and politicians argue that
the Fed should operate like other parts of the
executive branch of government and not be
independent. Members of the Board of
Governors would serve only as long as the
president wanted them.
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