Chapter 16 Bb: Monetary Policy
What is Monetary Policy? Achange in the money supply changes the FFR which causes the
other interest rates to change, which causes changes in interest sensitive spending,AD, and
finally RGDP.
*The important thing to remember: Interest rates affect spending and therefore, RGDP!
How many interest rates are there in the country? Alot, but there are only a few that we
should know.
The most important for us is the Federal Funds Rate: the interbank, overnight lending rate of at
least 1 million dollars. This is the one that the FED watches the most closely.
The second is the discount rate: the rate at which the FED lends to banks when banks borrow
from the FED.
The third is the prime rate: the rate that banks charge their most preferred customers—like
NEU!
The fourth is the T-Bill rate: the rate that the treasury pays for lending to the treasury—our
national debt!
And fifth is the mortgage rate: this is the rate on houses.
Now, on to the FED and its tightrope walk of the money supply.
Remember that we talked about the tightrope that the FED walks: too much or too little money.
How does the FED know how much money to supply to the economy?
The Taylor Rule ties the MS to an important interest rate: the FFR. This is the interbank,
overnight lending rate of at least 1 million dollars. This interest rate is important…..
If the FED thinks that the economy is heading downward then it would want to lower the FFR.
If the FED thinks that the economy is heading upward then it would want to raise the FFR.
The Taylor Rule tells the FED what the optimal FFR should be given the current state of the
economy. Look at theAS/AD model below. YFE
P
AS
AD
RGDP
In this case, the economy is in a recession—what would the FED want the interest rate to do?
And what about this graph?
Y FE
P
AS
AD
RGDP
In this case, the economy is in inflation, what would the FED want the interest rate to do this
time?
So, the Taylor Rule uses the current state of the economy to determine what the optimal FFR
should be. The Taylor Rule:
FFR* = ΔP + FFR ave+ ½ (Inflation gap) + ½ ( RGDP gap)
FFR* = ΔP + FFR ave + ½ (ΔP – ΔP*) + ½ ( Y – Y ) t FE
This is a lot simpler than it might look: There are 4 terms that help the FED determine the
optimal FFR*:
c
the ΔP
the FFR ave
c
½ (ΔP – ΔP*) and
½ ( Y t Y )FE
Try it with numbers.
c
the ΔP = 1.5%
the FFR ave = 2.0%
c
½ (ΔP – ΔP*) = ½ (1.5 – 2.0) = - .25%
½ ( Y t Y )FE = ½ (16 – 17) = - .5%
When you plug in the numbers you get:
FFR* = ΔP + FFR ave + ½ (ΔP – ΔP*) + ½ ( Y – Y ) t FE
FFR* = 1.5% + 2% - .25% -.5 = 3.5 - .75 = 2.75%
So, according to the Taylor Rule the FFR SHOULD be 2.75%. What is it actually?
Generally, the FED follows the Taylor Rule pretty closely, but this is a bad recession and we’re
still not out of the woods, so the FED is keeping the FFR much lower than what the Taylor Rule
suggests.
So, now that we know the optimal FFR, how can the FED bring that about? For the answer to
that question we have to look at the money market. The money market is like any other market, there is a supply and demand for money and it
determines the equilibrium rate of interest.
The supply of money is M2: and we already know the reasons for using money in an economy.
It’s vertical to reflect the fact that the FED has control of the money supply—and we’ll talk
about how the FED controls the money supply shortly.
What about the demand? The demand for money is how much money we hold in our pockets—
not in a bond. The question is this: if we earn no interest by holding our money in our pocket,
and we could be earning interest if we used our money to buy a bond, why would we hold money
at all? There are 3 major reasons: transactions, speculation, and emergencies.
Each of these reasons to hold some of our money in our pocket should make sense to you and
how much we hold has a lot to do with our income: the higher our income, the more money we
hold in our pockets.
But how much money we hold also depends on the interest rate—in fact, that’s why the demand
for money is downward sloping: at higher interest rates we hold less money because the
opportunity cost of holding money is very high. What if the r were 100% per day?
So, the money market looks like this:
FFR MS 1
FFR 1
MD 1
MS 1 money
The MS is vertical meaning that the FED has control of the MS.
The MD is downward sloping to reflect the opportunity cost of holding money. If the money supply increases—shifts to the right—then the interest rate will fall: you all know
that the price of anything goes down when the supply increases.
But what exactly makes the interest rate fall when the MS goes up? Suppose that the MS were
at MS 1nd the FFR was FFR in1the graph above. What would happen if the MS were to
increase to MS2?
After the shift in the MS, at F1R ,………
MS 2
FFR
FFR
1
FFR2
MD
money
….after the increase in the MS, at FF1 the quantity supplied of money is much greater than the
quantity demanded. Banks are loaded with money but no one wants to borrow any. So, what do
banks do? How do they get people into the bank to borrow money? They lower t
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