lecture 11
DESCRIPTION
Lecture 11. Federal Reserve and the Macroeconomy (Chapter 14 And Chapter 15) Ch. 12 & 13 in 4 th Edition. The Federal Reserve and Interest Rates. The supply of money determines the interest rate, given the demand for money. The Federal Reserve and Interest Rates. The Demand for Money - PowerPoint PPT PresentationTRANSCRIPT
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Lecture 11
Federal Reserve and the Macroeconomy (Chapter 14
And Chapter 15) Ch. 12 & 13 in 4th Edition
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The Federal Reserveand Interest Rates
The supply of money determines the interest rate, given the demand for money.
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The Federal Reserveand Interest Rates
The Demand for MoneyMoney is an asset, and is used for transactions.Money is a store of value, and is used for
holding wealth.People must decide how to hold their wealth, or
make portfolio allocation decisions.There are many ways to hold wealth:
Cash, Checking, Bonds, Stocks
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The Federal Reserveand Interest Rates
The Demand for Money The portfolio allocation decision is made by
comparing return relative to risk.Risk can be reduced by diversifying the
portfolio.Most people choose to hold some wealth as
money.
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The Federal Reserveand Interest Rates
Demand for Money (Liquidity Preference)The amount of wealth an individual chooses
to hold in the form of money.
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The Federal Reserveand Interest Rates
ExampleLouis’ wealth = $10,000
Holds $10,000 in cash His demand for money = $10,000 If he allocates his wealth to:
$1,000 cash $2,000 checking account $2,000 government bonds $5,000 rare stamps
His demand for money = $3,000
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The Federal Reserveand Interest Rates
The Demand for MoneyHow much money to hold (demand for
money) is determined by the cost-benefit principle.
Benefit of holding moneyused to make transactions
Cost of holding money; the opportunity cost of foregoneinterest
vs.
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The Federal Reserveand Interest Rates
Macroeconomic Factors that Affect the Demand for MoneyCost of holding money
The nominal interest rate (i) The quantity of money demanded is inversely related to
the nominal interest rate
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The Federal Reserveand Interest Rates
Macroeconomic Factors that Affect the Demand for MoneyBenefit of holding money
Real income or output (Y) An increase in real income will increase the demand for
money and vice versa
The price level (P) The higher the price level, the greater the demand for
money and vice versa
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The Money Demand Curve
Money M
No
min
al in
tere
st r
ate
i
MD
Demand for money is inversely related to the nominal interest rate (i)
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A Shift In The Money Demand Curve
Money M
No
min
al in
tere
st r
ate
i
MD
MD’
Shifts in MD• Changes in Y & P
• MD will increase if Y or P increase
• Technological changes• Foreign demand
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The Federal Reserveand Interest Rates
The Supply of Money and Money Market EquilibriumThe Fed controls the supply of money with
open-market operations.An open-market purchase of bonds by the
Fed will increase the money supply.An open-market sale of bonds by the Fed will
decrease the money supply.
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Equilibrium inthe Market for Money
Money
Money demand curve, MD
E
Money supply curve, MS
M
i
M1
i1
If interest = i1
• Qmd > Qms
• People sell interest bearing assets to hold more money
• Price of financial assets falls and interest rates rise
No
min
al in
tere
st r
ate
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The Fed Lowers the Nominal Interest Rate
No
min
al in
tere
st r
ate
MD
E
MS
MMoney
i
M’
I’ F
MS’The Fed wants to lower i• Fed buys bonds• The money supply increases• Creates a surplus of money• People buy interest bearing
assets• Non-money asset prices rise and
interest rates fall
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The Federal Reserveand Interest Rates
The Supply of Money and Money Market EquilibriumThe Fed wants to raise i
Fed sells bonds The money supply falls Creates a shortage of money People sell non-money assets Non-money asset prices fall and the interest rate
increases
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The Federal Reserveand Interest Rates
How the Fed Controls the Nominal Interest RateThe Fed cannot set the interest rate and the
money supply independently.
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The Federal Reserveand Interest Rates
The Advantages of Targeting the Interest RateThe effects of monetary policy are exerted
through interest ratesPublic familiarity with interest rates Interest rates can be monitored easily
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The Federal Reserveand Interest Rates
Federal Funds RateThe interest rate that commercial banks
charge each other for very short-term (usually overnight) loans
Because the Fed frequently sets its policy in the form of a target for the federal funds rate, this rate is closely watched in financial markets
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The Federal Reserveand Interest Rates
Can the Fed Control the Real Interest Rate?The real interest rate = nominal interest -
inflation
- i r
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The Federal Reserveand Interest Rates
Can the Fed Control the Real Interest Rate?The Fed controls the nominal interest rate. Inflation adjusts slowly to changing economic
conditions.Therefore, if the Fed changes the nominal
interest rate, the real rate will generally change by the same amount in the short run.
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The Federal Reserveand Interest Rates
Can the Fed Control the Real Interest Rate?Short-run impact of Fed policy
Prices do not vary greatly in the short run. Changes in the money supply can change nominal and
real interest. Real interest influences consumption and investment. Fed’s ability to influence spending is strongest in the
short run.
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The Federal Reserveand Interest Rates
Can the Fed Control the Real Interest Rate?Long-run impact of Fed policy
Prices adjust to changing economic conditions. The real interest rate is determined by the balance
of savings and investment. The Fed has less effect on spending in the long
run.
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The Federal Reserveand Interest Rates
How much control does the Fed have over spending?The Fed has direct control over the federal funds rate.The federal funds rate may influence, but does not
control other interest rates which influence spending.The inability of the Fed to precisely control other
interest rates complicates monetary policy. New efforts to change this.
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The Effects of Federal Reserve Actions on the Economy
The Fed can control i and r in the short run.
PAE is influenced by r.Lower r increases PAEHigher r reduces PAE
The Fed can stabilize output and employment.
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The Effects of Federal Reserve Actions on the Economy
Planned Aggregate Expenditure and the Real Interest RateReal interest rates and consumption
High real interest rates increases the incentive to save.
If savings increase, consumption decreases. High real interest rates reduces consumption.
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The Effects of Federal Reserve Actions on the Economy
Planned Aggregate Expenditure and the Real Interest RateReal interest rates and investment spending
High real interest rates increases the cost of investment spending.
The increased cost reduces profitability of investment spending and investment falls.
High real interest rates reduces investment spending.
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The Effects of Federal Reserve Actions on the Economy
ExampleAssume:
C = 1000+ .9(Y – T) – 500r -500r – a 1% increase in r reduces C by 5 units
IP = 800 – 400r -400r – a 1% increase in r reduces I by 4 units
G = 800 NX = 85 T = 650
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The Effects of Federal Reserve Actions on the Economy
ExamplePAE = C + IP + G + NX
85800400800500)650(9.1000 r - rYPAE
Autonomous spending depends on r Induced spendingdepends on Y
YrPAE 9.0 85800)400800(0.9 (1000 r) 500 - 650
YrPAE 9.0900100,2
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ExampleThe real interest rate and short-run
equilibrium output Assume the Fed sets the r at 0.05 (5 percent)
YPAE 9.0)05.0(9002100
YPAE 9.0452100 YPAE 9.02055
The Effects of Federal Reserve Actions on the Economy
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ExampleEquilibrium occurs when Y = PAE
Y = 20,550
20550)20550(9.02055 PAE
The Effects of Federal Reserve Actions on the Economy
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The Effects of Federal Reserve Actions on the Economy
ExampleThe Fed fights a recession
Assume
20550)20550(9.02055 PAE
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The Fed Fights A Recession
Output Y
Pla
nn
ed a
gg
reg
ate
exp
end
itu
re P
AE
Y = PAE
20,820
Recessionary gap
E
Expenditure line (r = 5%)
20,550Y*
Expenditure line (r = 2%)
F
A reduction in r shifts the expenditure line upward
• Multiplier = 10• Output gap = 270• Fed wants to increase
PAE by 270/10 =27 • C = 1,000 +.9(Y-T) – 500r• I = 800 – 400r• 1% change in r will
change C by 5 and I by 4• Reduce r to 0.02 to
increase C and I by 27 total
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The Fed Fights Inflation
Output Y
Pla
nn
ed a
gg
reg
ate
exp
end
itu
re P
AE
Expenditure line (r = 5%)
Y = PAE
20,550
Expansionary gap
E
20,280Y*
G
Expenditure line (r = 8%)
An increase in r shifts the expenditure line downward
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The Effects of Federal Reserve Actions on the Economy
An example of a monetary policy reaction function:
)πg(π rr **
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A Monetary Policy ReactionFunction for the Fed
0.00 (= 0%) 0.02 (= 2%)
0.01 0.03
0.02 0.04
0.03 0.05
0.04 0.06
Rate of inflation, Real interest rate set by Fed, r
)02.0(0.104.0 :Assume r
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An Example of a Fed Policy Reaction Function
Rea
l in
tere
st r
ate
set
by
Fed
, r
0.01
0.02
0.03
0.04
0.05
0.06
0.02 0.03 0.04
Fed’s monetary policy reaction function
Inflation
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A General MonetaryPolicy Reaction Function
Rea
l in
tere
st r
ate
set
by
Fed
, r MPRF
Inflation
r*
Slope = g
*
A
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The Effects of Federal Reserve Actions on the Economy
The FedA determinant of the Fed’s policy reaction
function is its objective for inflation.The slope of the reaction function indicates
how aggressive the Fed will pursue its target.
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Inflation, Aggregate Supply, and Aggregate Demand (Chapter 15)
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Introduction
The Keynesian model assumes that producers meet demand at preset prices.
The shortcoming of their assumption is that it does not explain the behavior of inflation.
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Introduction
The aggregate demand/aggregate supply model will allow us to see how macroeconomic policy affects inflation and output.
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Inflation, Spending, and Output: The Aggregate Demand Curve
Aggregate Demand (AD) CurveShows the relationship between short-run
equilibrium output Y and the rate of inflation, The name of the curve reflects the fact that
short-run equilibrium output is determined by, and equals, total planned spending in the economy
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Inflation, Spending, and Output: The Aggregate Demand Curve
Aggregate Demand (AD) Curve Increases in inflation reduce planned
spending and short-run equilibrium output, so the aggregate demand curve is downward-sloping
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The Aggregate Demand Curve
Output Y
AD
Aggregate Demand Curve
An increase in reduces Y(all other factors held constant)
Infl
atio
n
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Inflation, Spending, and Output: The Aggregate Demand Curve
Inflation, the Fed, and the AD CurveA primary objective of the Fed is to maintain a
low and stable inflation rate. Inflation is likely to occur when Y > Y*.To control inflation, the Fed must keep Y from
exceeding Y*.
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Inflation, Spending, and Output: The Aggregate Demand Curve
Inflation, the Fed, and the AD CurveThe Fed can reduce autonomous expenditure
by raising the interest rate. increases r increases autonomous spending
decreases Y decreases (AD curve)
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The Aggregate Demand Curve and the Monetary Policy Reaction Function
Output Y
Infl
atio
n
Inflation
Rea
l in
tere
st r
ate
set
by
the
Fed
, r
A
A
1
r1
1
B
B
2
r2
2
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Inflation, Spending, and Output: The Aggregate Demand Curve
Other Reasons for the Downward Slope of the AD CurveReal value of moneyDistributional effectsUncertaintyPrices of domestic goods and services sold
abroad
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Effect of An Increase In Exogenous Spending
Output Y
ADExogenous Spending: spending unrelated to Y or r•Fiscal policy•Technology•Foreign demand
AD’
An increase in exogenous spending shifts AD to AD’ and vice versaIn
flat
ion
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A Shift in the Fed’s Monetary Policy Reaction Function
Rea
l in
tere
st r
ate
set
by
Fed
, r
Output YInflation
Infl
atio
n
Fed “tightens” monetary policy – shifting reaction curve
The new Fed policy increases r and AD shifts to AD’
Old monetary policy reaction function
AD
A
Ar*
1*
New monetary policy reaction function AD’
B
B
2*
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Inflation, Spending, and Output: The Aggregate Demand Curve
Movements Along the AD Curve and Y are inversely relatedChanges in cause a change in Y or a
movement along the AD curve increases r increases planned spending
decreases Y decreases (stationary monetary policy reaction function)
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Inflation, Spending, and Output: The Aggregate Demand Curve
Shifts of the AD CurveAny factor that changes Y at a given shifts
the AD curve.Shifts of the AD curve can be caused by:
Changes in exogenous spending. Changes in the Fed’s policy reaction function.
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Inflation andAggregate Supply
Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level.
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Inflation andAggregate Supply
Three factors that can increase the inflation rateOutput gap Inflation shockShock to potential output
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Inflation andAggregate Supply
Long-term Wage and Price ContractsUnion wage contracts set wages for several
years.Contracts setting the price of raw materials
and parts for manufacturing firms also cover several years.
These long-term contracts reflect the inflation expectations at the time they are signed.
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The Output Gap and InflationRelationship of output
to potential output Behavior of inflation
1. No output gap Inflation remains unchangedY = Y*
2. Expansionary gap Inflation rises
Y > Y*
3. Recessionary gap Inflation falls
Y < Y*
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Inflation andAggregate Supply
The Output Gap and Inflation If Y* = Y
An increase in exogenous spending creates and expansionary gap (Y > Y*) -- inflation increases
A decrease in exogenous spending creates a recessionary gap (Y < Y*) -- inflation decreases
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Inflation andAggregate Supply
The Aggregate Demand—Aggregate Supply DiagramLong-run aggregate supply (LRAS)
A vertical line showing the economy’s potential output Y*
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Inflation andAggregate Supply
The Aggregate Demand—Aggregate Supply DiagramShort-run Aggregate Supply (SRAS)
A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions
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Inflation andAggregate Supply
The Aggregate Demand—Aggregate Supply DiagramShort-run Equilibrium
A situation in which inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate
Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line
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The Aggregate Demand-Aggregate Supply (AD-AS) Diagram
Output
No
min
al in
tere
st r
ate
i
Aggregate demand, AD
Long-run aggregate
supply, LRAS
A
Y*Y
Short-run aggregate supply, SRAS
Short-run equilibrium•Y: SRAS() = AD•Y < Y* -- recessionary gap and Y adjust to the gap
decreases & Y increases
Long-run equilibrium• AD, SRAS (*), LRAS (Y*)
will intersect at the same point
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Inflation andAggregate Supply
The Aggregate Demand—Aggregate Supply DiagramLong-run Equilibrium
A situation in which actual output equals potential output and the inflation rate is stable
Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point
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Inflation andAggregate Supply
A Review of the Adjustment Process to a Recessionary GapFirms that are selling less than they want to
will start to lower prices.As falls the Fed lowers r and AD increases.Falling reduces uncertainty which also
increases AD
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AD
LRAS
A
Y
SRAS1SRAS2SRAS3
The Adjustment of Inflation When a Recessionary Gap Exists
Output
Infl
atio
n
Y*
SRASFinal
B’
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The Adjustment of Inflation When A Expansionary Gap Exists
Output
Infl
atio
n
LRAS
A
AD
Y* Y
SRAS
B
Short-run Eq. Y•Expansionary gap Y > Y* rises, AD falls – Y falls•Long-run equilibrium at Y*, *
’ SRASFinal
SRAS3SRAS2
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Sources of Inflation Excessive Aggregate Spending Inflation Shocks Shocks to Potential Output
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War and Military Buildup As A Source of Inflation
Output
Infl
atio
n
Output
Infl
atio
n
AD
LRAS
A
Y*
SRAS
LRAS
A
Y*
SRAS
’ SRASFinal
C
increases shifting SRAS to SRASFinal
•Long-run equilibrium back to Y* with *
SRAS3
SRAS2
Y
B
AD’
Y
B
AD’
•Increase in military spending causes AD to increase•Creates an expansionary gap -- Y > Y*
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Sources of Inflation
Inflation ShockA sudden change in the normal behavior of
inflation, unrelated to the nation’s output gap
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Sources of Inflation
Inflation Shock -- ExamplesOPEC embargo of 1973Drop in oil prices in 1986
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The Effects of an Adverse Inflation Shock
Output
Infl
atio
n
AD’
C
• No policy -- falls; long-run eq. at A• With policy--AD shifts to AD’; Y = Y*; rises
to *
AD
LRAS
A
Y*
SRAS
• Equilibrium @ A--Y* = Y
Y’
BSRAS’
• Inflation shock, increases to ‘ (SRAS’)• Short-run eq. At B, Y < Y*; recessionary gap
and higher inflation (stagflation)
’
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The Effects of a Shock To Potential Output
Output
Infl
atio
n
AD
LRAS
A
Y*
SRAS
•Equilibrium at A -- Y* = Y
Y*’
BSRAS’
LRAS’ •Y* falls to Y*’•Y > Y* -- expansionary gap increases--SRAS rises to SRAS’•Equilibrium at B
•Y = Y*’ increased to ‘ •Decline in output is permanent
’