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Chapter 12

ECON 2010 Chapter 12: Econ 2010 Chapter 12 Notes

Course Code
ECON 2010

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Econ 2010 Chapter 12 Notes
“Monetary Policy and Federal Reserve”
Fed Watch
- Analysts attempt to forecast Fed decisions about monetary policy
o Greenspan briefcase indicator
o Fed decisions have significant effects on financial markets and the macro
- Monetary policy is a major stabilization tool
o Quickly decided and implemented
o More flexible and responsive than fiscal policy
The Federal Reserve
- Responsibilities of the Federal Reserve:
o Conduct monetary policy
o Oversee and regulate financial markets
Central to solving financial crises
- The Federal Reserve System began operations in 1914
o Does not attempt to maximize profit
o Promotes public goals such as economic growth, low inflation, and smoothly
functioning financial markets
The Federal Reserve Organization
- 12 Federal Reserve Bank districts
o Assess economic conditions in their region
o Provide services to commercial banks in their region
- Leadership is provided by the Board of Governors
o Seven governors are appointed by the President to 14-year terms
o President selects one of the seven as chairman for a four-year term
- The Federal Open Market Committee (FOMC) reviews economic conditions and sets
monetary policy
o 12 members who meet eight times a year
Stabilizing Financial Markets
- Motivation for creating the Fed was to stabilize the financial markets and the economy
- Banking panics occurred when customers believe one or more banks might be bankrupt
o Depositors rush to withdraw funds
o Banks have inadequate reserves to meet demand
Banks close
- Fed prevents bank panics by
o Supervising and regulating banks
o Loaning banks funds if needed
- Fed did not prevent the bank panics of 1930 1933

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Banks Panic, 1930 1933
- One-third of the banks closed
o Increased the severity of the Great Depression
o Difficult for small businesses and consumers to get credit
o Money supply decreased
- With no federal deposit insurance, people held cash
o Feared banks would close and they would lose their deposits
o Holding cash reduced banks' reserves
Lower reserves decreased the money supply by a multiple of the change in
- Banks increased their reserve deposit ratio
o Further decreased the money supply
Deposit Insurance
- Congress created deposit insurance in 1934
o Deposits of less than $100,000 will be repaid even if the bank is bankrupt
Decreases incentive to withdraw funds on rumors
- No significant bank panics since 1934
- With less risk, depositors pay less attention to whether banks are making prudent
o In the 1980s, many savings and loan associations went bankrupt
Cost the taxpayers hundreds of billions of dollars
The Fed and the Economy
- Eliminate output gaps by changing the money supply
- Changes in money supply cause changes in nominal interest rate
- Interest rates affect planned aggregate expenditure, PAE
Can the Fed control the Real Interest Rate?
- Fed controls the money supply to control the nominal interest rate, i
o Investment and saving decisions are based on the real interest rate, r
Fed has some control over the real interest rate
r = i -
where is the rate of inflation
- The Fed has good control over i
- Inflation changes relatively slowly
o Changes in nominal rates become changes in real rates

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Role of the Federal Funds Rate
- The federal funds rate is the rate commercial banks charge each other on short-term
(usually overnight) loans
o Banks borrow from each other if they have insufficient funds
o Market determined rate
o Targeted by the Fed
- To decrease the federal funds rate, the Fed conducts open market purchases
o Reserves increase
- Interest rates tend to move together
Planned Spending and Real Interest Rate
- Planned aggregate expenditure has components that are affected by r
o Saving decisions of households
More saving at higher real interest rates
Higher saving means less consumption
o Investment by firms
Higher interest rates mean less investment
Investments are made if the cost of borrowing is less than the
return on the investment
- Both consumption and planned investment decrease when the interest rate increases
Interest in the Keynesian Model An Example
- Components of aggregate spending are
C = 640 + 0.8 (Y T) 400 r
IP = 250 600 r
G = 300
NX = 20
T = 250
- If r increases from 0.04 to 0.05 (that is, from 4% to 5%)
o Consumption decreases by 400 (0.01) = 4
o Planned investment decreases by 600 (0.01) = 6
- A one percentage point increase in r reduces planned spending by 10 before the
multiplier is considered
Planned Aggregate Expenditure
PAE = C + IP + G + NX
PAE = 640 + 0.8 (Y 250) 400 r + 250 600 r + 300 + 20
PAE = 1,010 1,000 r + 0.8 Y
- In this example, planned aggregate expenditure depends on both the real interest rate and
the level of output
- Equilibrium output can only be found once we know the value of r
PAE = 1,010 1,000 r + 0.8 Y
- Suppose the real interest rate is 5%, or 0.05
- Planned aggregate expenditure becomes
PAE = 1,010 1,000 (0.05) + 0.8 Y
PAE = 960 + 0.8 Y
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