The Inflation Process and Monetary Policy

1
The Inflation Process and Monetary Policy
ECO 105 Lecture 4.6 21 November 2008
2
How the Fed Influences the Economy

• The Fed cannot
• The Fed has no direct control over
• The Fed can influence aggregate demand by altering

3
Loanable Funds Model (II)

• We used the LF model to determine the real
• Augmented for changes in bank lending, it can be
  used to determine
• DLF is still determined by
• SLF depends on saving and

4
How the Fed Affects Interest Rates

• The Fed works through the federal funds market
  the
• When the Fed buys bonds on the open market, it
  increases the
• The federal funds rate - the rate charged on

5
Federal Funds Market
iff
SR
SR1
iff0
iff1
DR
Reserves
6
From the Funds Rate to the Market Rate

• A lower federal funds rate reduces banks
  marginal
• Banks reduce their
• The interest rate on loans declines as banks

7
Determining the Interest Rate
SLF S
Interest
SLF1 S DMS1
Rate
i0
i1
DLF
Loanable Funds
8
Nominal and Real Interest Rates

• The reduction in i reduces the expected real
  interest rate if
• So long as market participants dont believe the
  lower interest rate will generate

9
Monetary Policy and Shifts in the AD Curve

• The Fed affects AD primarily through
• OM purchase injects reserves into the banking
  system,

10
Federal funds market
iff
SR
SR1
iff0
iff1
DR
Reserves
11
...

• Banks increase
• If expected inflation remains constant,

12
Loanable funds market
SLF S
Interest
SLF1 S DMS1
Rate
i0
i1
DLF
Loanable Funds
13
...

• Lower r e encourages more
• AD increases, and in the short run

14
Aggregate output market
Price Level
PI0
SRAS
ADo
AD1
Y
Y0
Y1