Econ 1021 Chapter 12: Chapter 12

7 Pages
Unlock Document

Washington University in St. Louis
University College - Economics
University College - Economics Econ 1021
Bandyopadhay Sudeshna

Chapter 12: Monetary Policy and The Federal Reserve I. The Federal Reserve A. The Fed 1. Basics a. Responsibilities of the Fed, like other central banks are • Conduct monetary policy • Oversight and regulation of financial markets • Central to solving financial crises b. The Federal Reserve System began operations in 1914 • Does not attempt to maximize profit • Promotes public goals such as economic growth, low inflation, and smooth functioning of financial markets 2. Structure a. 12 Federal Reserve Bank districts • Conduct research and forecasts relevant to their region • Provide services to commercial banks in their region b. Board of Governors is the leadership of the Fed • Seven Governors are appointed by the President to 14 year terms • President selects one of the seven as Chairman for a four year term c. Federal Open Market Committee (FOMC) reviews economic conditions and sets monetary policy • 12 members who meet eight times a year 3. Role in Financial Markets a. Motivation for creating the Fed was to stabilize the financial markets and the economy b. Banking panics can occur when customers believe one or more banks might be bankrupt • Depositors rush to withdraw funds • Banks have inadequate reserves to meet demand  banks close c. Fed prevents bank panics by supervising and regulating banks, loaning funds to banks if needed d. Fed did not prevent the bank panics of 1930 – 1933 4. Bank Panics 1930-33 a. One-third of the banks closed • Increased the severity of the Great Depression • Difficult for small businesses and consumers to get credit • Money supply decreased b. With no federal deposit insurance, people held cash • Feared banks would close and they would lose their deposits • Holding cash reduced banks' reserves • Lower reserves decreased money supply by a multiple of the change in reserves c. Banks increased their actual reserve – deposit ratio, which further decreased the money supply 5. Deposit Insurance a. Congress created deposit insurance in 1934 • Deposits of less than $250,000 (used to be $100,000) will be repaid even if the bank is bankrupt • Decreases incentive to withdraw funds on rumors b. THE GOOD: No significant bank panics since 1934 c. THE BAD: With less risk, depositors pay less attention to whether banks are making prudent investments • In the 1980s, many savings and loan associations went bankrupt • The banking crisis of 2008-09 also saw banks taking unreasonable risks – a moral hazard problem • Cost the taxpayers hundreds of billions of dollars B. Economic Control 1. Fed and the Economy a. Eliminate output gaps by changing the money supply b. Changes in money supply cause changes in nominal interest rate c. Interest rates affect planned aggregate expenditures, PAE 2. Targeting Interest Rates a. Fed controls the money supply to control nominal interest rates, i b. Investment and saving decisions are based on the real interest rate, r c. Fed has some control over the real interest rate • r = i -  • where  is the rate of inflation • The Fed has good control over r IF inflation is constant or changes relatively slowly and changes in nominal rates become changes in real rates 3. Planned Aggregate Expenditure (PAE) and Interest Rates a. Planned Aggregate Expenditures have components that are affected by r (real rate of interest) • Savings decisions of households: more saving at higher real interest rates, higher saving means less consumption • 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 p b. Components of PAE = C + I + G + NX + T • If r increases, both C and planned investment decrease c. Equilibrium output can only be found once we know the value of r • Short run eq’b output is found where Y = PAE 4. Fed and Interest Rates a. Controlling the money supply is the primary task of the FOMC • Money supply and demand determine the interest rate • Fed manipulates supply to achieve its desired interest rate b. Portfolio allocation decisions allocate a person's wealth among alternative forms • Diversification is owning a variety of different assets with unrelated risks so as to temper the overall degree of risk C. Monetary Policy Basics 1. Close a Recessionary Gap a. Decrease interest rates b. Increase C and I P c. Increase PAE d. Increase short run output (Y) via the multiplier 2. Close an Expansionary Gap a. Increase interest rates b. Decrease C and I p c. Decrease PAE d. Decrease Y via the multiplier 3. The Federal Funds Rate a. The federal funds rate is the interest rate that banks charge each other for very short-term loans • Closely watched in financial markets b. The Fed targets this interest rate because it is closely tied to the level of bank reserves • Changes in the federal funds rate indicate the Fed's plans for monetary policy • Other interest rates could be used to indicate the Fed's intentions c. Fed Response to 9/11 • Economy began slowing in late 2000 • Terrorist attack led to contraction in travel, financial, and other industries • The federal funds rate is the interest rate banks charge each other for overnight loans i. This interest rate is the one the Fed targets when changing the money supply • In late 2000, the fed funds rate was 6.5% • January, 2001, the Fed cut the rate to 6.0% i. More rate cuts followed • July, 2001, the rate was less than 4% • After the 9/11 (Sept 2001) attacks, the Fed immediately worked to restore normal operation of the financial markets and institutions • The Fed temporarily lowered the rate to 1.25% in the week following the attack • In the aftermath, the Fed grew concerned that consumers would decrease spending • Interest rate was 2.0% in November, 2001, 4.5 percentage points lower than a year before • Combination of tax cuts and aggressive monetary policy helped keep the 2001 recession shallow and short 4. Fed Fights Inflation a. Expansionary gap can lead to inflation • Planned spending is greater than normal output levels at the established prices • Short-run unplanned decreases in inventories • If gap persists, prices will increase b. The Fed attempts to close expansionary gaps • Raise interest rates • Decrease consumption and planned investment • Decrease planned aggregate expenditures • Decrease equilibrium output c. With slow recovery beginning in November, 2001, the Fed continued to decrease interest rates until it reached 1.0% in June 2003 • Real GDP growth was nearly 6% in the 2 half, 2003 • Growth was 4.4% in 2004 • Unemployment was 5.6% in June 2004
More Less

Related notes for University College - Economics Econ 1021

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.