Pump%20Primer:

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Pump Primer
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• Define monetary policy.

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ModuleMonetaryPolicy and the Interest Rate
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• KRUGMAN'S
• MACROECONOMICS for AP

Margaret Ray and David Anderson
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Biblical Integration

• Stabilization is a crafty word. It is defined by
  Webster as "to become stable, firm, or
  steadfast." In 1 Cor. 1558 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?

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What you will learnin 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

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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.
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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.
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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.
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Monetary Policy and the Interest Rate Targeting
the Fed Funds Rate
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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.
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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.
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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?
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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.

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Expansionary Monetary Policy
The Economy
The Money Market
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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.

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Contractionary Monetary Policy
The Money Market
The Economy
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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 doesnt suffer unexpected spikes in the
  inflation rate.
• In practice, this simply means that the Feds
  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
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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 p)(0.5 X Output Gap)
• Example Inflation is 3 and real GDP is 4 below
  potential GDP
• FFR

1 (1.53) - (.54) 1 4.5 2 3.5
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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.
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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 banks success
can be judged by seeing how closely actual
inflation rates have matched the inflation
target, making central bankers accountable.