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Economics: Theory Through Applications

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Chapter 25Understanding the Fed

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Learning Objectives

• When and why was the Federal Reserve System created in the U. S.?

• Is the Federal Reserve System independent of the Executive and Legislative Branches of the U.S. government?

• How does our study of monetary policy apply to other Central Banks around the world?

• What is the link between the actions of the Fed and the state of the economy?

• What interest rate does the Fed target?

• What components of aggregate spending depend upon the interest rate?

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Learning Objectives

• How do prices adjustment in the economy?

• What are the effects of monetary policy on prices and inflation?

• What is the Taylor Rule?

• How does monetary policy operate in an open economy?

• How does monetary policy in other countries influence the U.S. economy?

• What do banks do?

• What are the tools of the Fed?

Learning Objectives

• What monetary policy did the Fed pursue during the Great Depression?

• Why is stabilization of the economy through monetary policy so difficult?

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Figure 25.1- The Links between Monetary Policy and the State of the Economy

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Figure 25.2 - The Monetary Transmission Mechanism

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Figure 25.3 - Target and Actual Federal Funds Rate, 1971 - 2005

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Figure 25.4 - Short-Term and Long-Term Interest Rates

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From Nominal Interest Rates to Real Interest Rates

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real interest rate nominal interest rate inflation rate

Figure 25.5 - Real and Nominal Interest Rates

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Figure 25.6 - Real Interest Rates and Spending on Durable Goods

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Table 25.1 - Return on Investment

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Discounted Present Value and Spending on Durable Goods

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year 2 profitsdiscounted present value year 1 profits

nominal interest factor500

5001.05

500 476

976.

Figure 25.7 - The Relationship between the Real Interest Rate and Spending on Durable Goods

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Figure 25.8 - Aggregate Spending Depends Positively on Income

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Figure 25.9 - An Increase in Real Interest Rates Reduce Real GDP

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Figure 25.10 - The Relationship between the Real Interest Rate and Real GDP

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Figure 25.11 - The Fed’s Influence on the Economy Depends on the Real Interest Rate–Real GDP Relationship

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Price Adjustment and Inflation

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inflation rate autonomous inflation inflation sensitivity output gap

output gap potential real GDP actual real GDP

Figure 25.12 - Price Adjustment

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Figure 25.13 - Interactions among Interest Rates, Output, and Inflation

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Figure 25.14 - Completing the Circle of Monetary Policy

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Figure 25.15 - The Taylor Rule

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Figure 25.16 - The Adjustment of Inflation over Time

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Figure 25.17

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Figure 25.18 - The Market for Government Bonds

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Figure 25.19 - Intervention by the Federal Reserve

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Figure 25.20 - Intervention by the Federal Reserve

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Figure 25.21- An Increase in the Discount Rate

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Figure 25.22- An Increase in Reserve Requirements

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Figure 25.23 - Controlling the Economy

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What Should the Fed Do When Its Goals Are in Conflict?

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1 1real interest rate output gap inflation rate 4 percent

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Key Terms

• Monetary transmission mechanism: The monetary transmission mechanism explains how the actions of the Federal Reserve Bank affect aggregate economic variables, and in particular real GDP

• Nominal interest rate: The nominal interest rate is the number of additional dollars that must be repaid for every dollar that is borrowed

• Real interest rate: The rate of return specified in terms of goods not money

• Investment: Investment is the purchase of new goods that increase the capital stock, allowing an economy to produce more output in the future

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Key Terms

• Durable goods: Durable goods are goods purchased by households which have long lifespan, such as cars and kitchen appliances

• Arbitrage: Arbitrage is the act of buying and then selling an asset to make a profit

– Arbitrage is usually carried out across two markets to profit from any difference in prices

– The strict definition of arbitrage refers to buying and selling where there is no risk

– A weaker meaning of arbitrage allows there to be risk associated with the process 25-36

Key Terms

• Maturity: The term in which an asset comes due

• Fisher equation: According to the Fisher equation, the real interest rate is approximately equal to the nominal interest rate minus the rate of inflation

• Discounted present value: Discounted present value is a device for measuring flows that occur over time

– It tells you the value of something you will receive in the future, discounted back to the present

• Aggregate expenditure model: The aggregate expenditure framework studies the relationship between planned spending and output 25-37

Key Terms

• Multiplier: The multiplier equals one divided by one minus the marginal propensity to spend and is key to understanding how a change in autonomous spending effects output in the aggregate expenditures model

• Inflation rate: The growth rate of the price index from one year to the next is a measure of the inflation rate

• Price level: The price level is a measure of average prices in the economy

• Price adjustment equation: The price-adjustment equation described how prices adjustment in response to the output gap, given autonomous inflation 25-38

Key Terms

• Output gap: The output gap is the difference between potential and actual output

• Deflation: A sustained decrease in the price level

• Taylor rule: A rule for monetary policy in which the target real interest rate increases when inflation is too high and decreases when output is too low

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Key Terms

• Foreign exchange market: A foreign exchange market is where one currency is traded for another

• Exchange rate: An exchange rate is the price of one currency in terms of another

• Net exports: Net exports equals exports minus imports

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Key Terms

• Reserves: Deposits received by a bank that it must set aside rather than loan to firms and households

• Reserve requirements: The reserve requirements are the deposits received by a bank that it must set aside rather than loan to firms and households

• Open market operations: Open market operations are purchases and sales of government debt by a central bank

• Discount rate: The discount rate is the interest rate paid by banks on loans from the Fed

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Key Takeaways

• The Federal Reserve System of the United States was created in 1913

– A key motivation for the creation of a Central Bank was to manage the stock of currency and thus influence the state of the aggregate economy, particularly output and prices

• In the United States, the Central Bank is independent: decisions about monetary policy are made within the Federal Reserve System

– Still members of the Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/aboutthefed/section%2010.htm) are nominated by the President and approved by the Senate

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Key Takeaways

• There are Central Banks around the world, conducting monetary policy with essentially the same tools with the same basic model of the aggregate economy in mind

• The monetary transmission mechanism describes the links between the actions of the Fed and the state of the aggregate economy

• The Fed targets a short-term nominal interest rate that called the federal funds rate

– The Fed does not set this rate directly but rather uses its tools to influence this interest rate

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Key Takeaways

• The main components of spending that depend on the real interest rate are spending by households on durable goods and investment

– When these components of spending are sensitive to the interest rate, then the Fed can influence the economy through small variations in its target federal funds rate

• The price adjustment equation describes the dependence of price changes (inflation) on the output gap, given the autonomous rate of inflation

• Given prices, monetary policy influences the output gap

– Over time, prices adjust in response to the effects of monetary policy on the output gap 25-44

Key Takeaways

• The Taylor rule describes the dependence of the interest rate targeted by the Fed on the rate of inflation and the output gap

• In an open economy, interest rate changes induced by monetary policy influence exchange rates and thus net exports

• Actions by monetary authorities in other countries influence the net exports of the U.S. through exchange rate changes and through the level of aggregate spending on the U.S. by households in other countries

• Banks act as intermediaries, taking the deposits of households and making loans to firms and households who wish to borrow

– Banks also borrow from other banks and from the Fed 25-45

Key Takeaways

• The main tools of the Fed are: (i) open market operations, (ii) lending at the discount rate to member banks and (iii) setting the reserve requirements on member banks

• Despite the large reduction in aggregate economy activity and the deflation during the Great Depression, the Fed did not pursue a very aggressive policy

– The effectiveness of the Fed was hampered by the unwillingness of households to deposit funds in banks and the unwillingness of banks to make loans

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Key Takeaways

• The conduct of monetary policy is made difficult by uncertainty over the current state of the economy and the inexact nature of the effects of interest rates on real GDP and prices

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