The Federal Reserve and Monetary Policy

1
The Federal Reserve and Monetary Policy

• The Demand for Money and the Quantity Equation
• The quantity of money and the rate of interest
• Reducing the interest rate increases investment,
  and therefore (with a multiplier effect) GDP.
• The connections dont always work perfectly in
  practice
• real/nominal rates and the Fisher effect
• short term (Federal Funds) and long term (AAA
  and BAA bonds)
• importance of expectations for investment
  decisions
• Potential conflicting goals GDP gap and
  inflation
• The Taylor Rule and the Feds policy reaction
  function.

2

• The Quantity Equation and the Demand for Money
• MV PY (money velocity GDPDEF GDP)
• Interest rates are the opportunity cost of
  holding money so people will hold LESS money at
  HIGHER interest rates.
• This means that velocity will INCREASE at higher
  interest rates -- money will change hands more
  rapidly.
• Let V 0.5 R for a numeric example the
  result is
• Md 2 PY / R, and since M.demand
  M.supply,
• Fed can change the money supply to set a target
  interest rate R 2 PY / Ms

3

• Fed control of interest rates
• The Federal Reserve
• TARGETS the Federal Funds rate (overnight bank
  loans)
• OPERATES in the Treasury Bill market
• Controls both those rates CLOSELY.
• However, those rates are SHORT TERM, SAFE,
  NOMINAL interest rates, and more important for
  the level of investment are
• LONG TERM, RISKY, REAL rates --
• the rates on corporate bonds such as Moodys AAA
  or BAA bonds adjusted for inflation

4
Fed Funds Rate and Treasury Bill (6 month) rate
5
Scatterplot of T-Bill and Federal Funds rates
6
The Federal Reserve influences, but does not
control, real long term interest rates (example
BAA bonds) The time series graph shows several
cases in which the Fed cut short-run rates
without much immediate response by long-run
interest rates. Note 1972.1 and 1977.1 and
1993.4 and 2001.3 -- the Fed cut rates to fight
recessions, and real BAA rates did NOT
follow. The scatterplot shows low real rates in
the 1970s despite high Federal Funds rates and
high real rates in the 1980s despite cuts in the
Federal Funds rates.
7
Federal Funds nominal rates and Moodys BAA real
rates
8
Scatterplot of Fed Funds and real BAA rates
9

• Investment is influenced by, but NOT determined
  by, real long term interest rate.
• The next scatterplot shows investment as a
  percentage of GDP against real, long term
  interest rates.
• Note especially
• In normal times, the interest rate does
  influence investment see the late 70s and early
  80s data points, during reasonably stable
  economic times.
• When expectations of future profit turn down,
  the investment relation shifts back note the
  data points for 1982 and 1983, when despite
  lower interest rates, investment fell sharply --
  as the economy moved into a recession, businesses
  refused to invest whatever the interest rate.

10
Investment as a share of GDP and interest
rates not an unchanging relationship.
11
The Fisher Effect the Dilemma of Monetary Policy

• Real rates nominal rates - inflation
• To preserve the value of interest payments,
  lenders will tend to set nominal rates real
  rate inflation
• The Fed lowers interest rates by expanding the
  money supply.
• But the long run effect of continuing to expand
  the money supply will be inflation.
• And inflation leads to higher interest rates
• The Fisher relation is loose enough to permit
  temporary impact of monetary policy, but it is
  there in the long run.

12
Inflation and BAA nominal rates the Fisher Effect
13

• Two policy targets, one policy instrument
• Target 1 GDP gap -- output below potential
  leads to unemployment which Fed would like to
  counter
• Target 2 inflation -- reduction of
  inflation is also a desirable policy goal.
• Policy instrument -- change in the Federal Funds
  rate. Cutting the Fed Funds rate might stimulate
  investment, but it might also increase inflation
• Taylor Rule (John B. Taylor) describes the
  Feds reaction function R 1.0 - 0.5
  YGAP 0.5 INFL
• R Real rate of interest
• YGAP (Potential GDP - Actual GDP) /
  Potential GDP given a positive (recessionary)
  YGAP, cut interest rates.
• INFL Inflation rate. As inflation
  increases, increase real rate of interest.