Macroeconomics- Chapter 8
Macroeconomics- Chapter 8 ECON 200
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Date Created: 03/12/16
Monetary policy refers to the actions the Fed takes to manage the money supply and interest rates to achieve its macroeconomic policy goals. 4 main goals: price stability, high employment, stability of financial markets and institutions, economic growth price stability- inflation leads to recession high employment- unemployed workers and underused factories and office buildings reduce gdp below its potential level. The fed uses variables, called monetary policy targets. The two main monetary policy targets are the money supply and interest rate. Why the demand curve for money slopes downward- when interest rates on treasury bills and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high; when interest rates are high, the opportunity cost of holding money will be high, so the quantity of money demanded will be low. The two most important variables that cause the money demand curve to shift- real GDP and price level. An increase in the price level increases the quantity of money demanded at each interest rate, shifting the money demand curve to the right. Assuming that the Fed has control of the money supply (demand and supply), the money supply line is vertical. When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money. Loanable funds model is concerned with the long term real rate of interest, and the money market model is concerned with the short term nominal rate of interest. The long term real rate of interest is the interest rate that is most relevant when savers consider purchasing a long-term financial investment, such as a corporate bond. Relevant to firms that are borrowing to finance long-term investment projects. Short-term nominal interest rate because it is the interest rate most affected by increases and decreases in the money supply. Federal funds rate is the interest rate banks charge each other on loans in the federal funds market. Aggregate demand is the total level of spending in the economy-four components- consumption, investment, government purchases, and net exports. Changes in interest rates will not affect government purchases. Consumption- lower interest rates on loans increase household spending on consumer durables, and keep people from putting the money into saving. Investment- lower interest rates make it less expensive for firms to borrow, therefore they’re spending more. Can also increase investment through their effect on stock prices. Net exports-if the value of the US dollar rises, less exports, more imports, net exports fall. To reach goal of high employment- expansionary monetary policy- increases the money supply and decreases the interest rates- causes things to move right, increase in production, rises employment. Price stability- contractionary monetary policy- decreases the money supply and increases interest rates. – decreases things, they need gdp to decline, because if it stays above potential, it will cause inflation. As it returns to potential, upward pressure on wages and prices will be reduced, allowing the fed to achieve its goal of price stability. Procyclical policy-increases the severity of the business cycle Countercyclical policy- meant to reduce the severity of the business cycle. Aggregate expenditures usually increase: as population grows and incomes rise, consumption will increase over time; as the economy grows, firms expand capacity, and new firms are established, increasing investment spending; an expanding population and an expanding economy require increased government services, so government purchases expand. Friedman and his followers favored replacing monetary policy with monetary growth rule. It is a plan for increasing the money supply at a constant rate that does not change in response to economic conditions. Taylor rule- begins with an estimate of the value of the equilibrium real federal funds rate, which is the federal funds rate-adjusted for inflation-that would be consistent with real gdp being equal to potential gdp in the long run. The fed should set the target for the federal funds rate so that it is equal to the sum of the inflation rate, the equilibrium real federal funds rate, and two additional terms (inflation gap- the difference between current inflation and a target rate, and output gap- the percentage difference between real gdp and potential gdp. Federal funds target rate= current inflation rate+ equilibrium real federal funds rate + [(1/2) x inflation gap)] + [(1/2) x output gap]. Inflation targeting- a framework for conducting monetary policy that involves the central bank announcing its target level of inflation. It allows monetary policy to focus on inflation and inflation forecasts, except during times of severe recession. Announcing explicit targets for inflation draws the public’s attention to what the Fed can actually achieve in practice. Announcing an inflation target provides an anchor for inflationary expectations. Inflation targets promote accountability for the fed by providing a yardstick against which its performance can be measured.
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