the federal reserveand monetary policy f ernando q uijano, y vonn q uijano, k yle t hiel & a...

The Federal Reserve and Monetary Policy

FERNANDO QUIJANO, YVONN QUIJANO,

KYLE THIEL & APARNA SUBRAMANIAN

PREPARED BY:

© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

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2 of 25© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

1 What happens to interest rates when the economy recovers from a recession?

Rising Interest Rates During an Economic Recovery

2 Is it better for decisions about monetary policy to be made by a single

individual or by a committee?

The Effectiveness of Committees

3 What are the advantages and disadvantages of the Federal Reserve becoming

more transparent about its actions and decisions and disclosing more

information to the public?

Making the Federal Reserve More Transparent

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• money marketThe market for money in which theamount supplied and the amountdemanded meet to determine thenominal interest rate.

• transaction demand for moneyThe demand for money based on the desire to facilitate transactions.

THE MONEY MARKET14.1

The Demand for Money

INTEREST RATES AFFECT MONEY DEMAND

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INTEREST RATES AFFECT MONEY DEMAND


FIGURE 14.1Demand for Money

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THE PRICE LEVEL AND GDP AFFECT MONEY DEMAND

FIGURE 14.2Shifting the Demand for Money

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OTHER COMPONENTS OF MONEY DEMAND

• illiquidNot easily transferable to money.

• liquidity demand for moneyThe demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs.

• speculative demand for moneyThe demand for money that arises because holding money over short periods is less risky than holdingstocks or bonds.

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• open market operationsThe purchase or sale of U.S.government securities by the Fed.

HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY14.2

Open Market Operations

• open market purchasesThe Fed’s purchase of governmentbonds from the private sector.

• open market salesThe Fed’s sale of government bonds to the private sector.

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• discount rateThe interest rate at which banks can borrow from the Fed.

HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY14.2

Other Tools of the Fed

• federal funds marketThe market in which banks borrow and lend reserves to and from one another.

• federal funds rateThe interest rate on reserves that banks lend each other.

CHANGING RESERVE REQUIREMENTS

CHANGING THE DISCOUNT RATE

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HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY14.3

FIGURE 14.3Equilibrium in the Money Market

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FIGURE 14.4Federal Reserve and Interest Rates

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RISING INTEREST RATES DURING AN ECONOMIC RECOVERY

APPLYING THE CONCEPTS #1: What happens to interest rates when the economy recovers from a recession?

Economists have often noticed that interest rates start to rise:

•As an economy recovers from a recession.

•As the economy grows quickly.

Why should a recovery be associated with higher interest rates?

•The extra income being generated by firms and individuals during the recovery will increase the demand for money.

•Because the demand for money increases while the supply of money remains fixed, interest rates rise.

•The Federal Reserve itself may want to raise interest rates as the economy grows rapidly to avoid overheating the economy.

•The Fed cuts back on the supply of money to raise interest rates.

The public should expect rising interest rates during a period of economic recovery and rapid GDP growth.

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BERNANKE’S STEADY COURSE

• There are still fears among some economists that the Fed may not react fast enough to a slowing economy.

• The general consensus is the cuts will begin to come late next year if the economy continues to show signs of weakness.

Fed chief Ben Bernanke appears to be filling Greenspan’s shoes well. He generated positive buzz for the recent decision to leave rates unchanged for the second time at the Fed’s September 20 meeting. Many analysts feared the Fed might react to inflation pressures by increasing rates again. However, it appears Bernanke may favor a softer approach. The financial markets responded positively with the Dow Jones Industrial Average moving up 72 points for the day.

Extra Application 4

The expectation that interest rates will soon fall usually pushes stock prices higher. Lower interest rates decrease the cost of doing business for firms and also push the intrinsic value of stocks higher due to discounting expected cash flows at a lower rate. Both of these factors cause investors to reassess stock values and increase demand for stocks resulting in pushing prices higher.

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GETTING THE PRICE RIGHT

• The Fed receives economic data ahead of the general public and many Fed watchers believe that core personal consumption expenditure (PCE) data play a bigger role in the Fed’s decision-making than the CPI or PPI.

• The PCE data is considered to be more responsive to economic changes and thus a better measure of inflation.

It is difficult to separate the different inflation measures. The PCE is compiled by the Commerce Department and uses both CPI and PPI data (compiled by the Labor Department) to adjust for inflation. The government also monitors import prices and compiles an Import Price Index that indicated import prices increased by 1.6% in May. So, what does the Fed look at?

The Fed probably considers all of this information when making interest rate determinations. However, how much weight each factor carries is indeterminate since we are on the outside looking in.

All the markets have the inflation jitters largely due to Ben Bernanke’s control of the Fed. Investors have yet to determine Bernanke’s likely reaction to economic news and are concerned over how the Fed might react to personal income and spending data soon to be released. If inflation appears imminent, the Fed will likely raise rates.

Extra Application 5

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Interest Rates and Bond Prices

HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES

GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES

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INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP)14.4

FIGURE 14.5The Money Market and Investment Spending

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FIGURE 14.6Monetary Policy and Interest Rates

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FIGURE 14.7Money Supply and Aggregate Demand

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Monetary Policy and International Trade

• exchange rateThe rate at which currencies trade for one another in the market.

• depreciation of a currencyA decrease in the value of a currency.

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Monetary Policy and International Trade

• appreciation of a currencyAn increase in the value of a currency.

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THE EFFECTIVENESS OF COMMITTEES

APPLYING THE CONCEPTS #2: Is it better for decisions about monetary policy to be made by a single individual or by a committee?

Professor Alan Blinder was convinced that committees were not effective for making decisions about monetary policy.

Blinder developed an experiment to see whether individuals or groups make better decisions and who makes them more rapidly. The experiment was designed to explore how quickly individuals and groups could distinguish changes in underlying trends from random events.

Example:

• If unemployment were to rise in one month, such a rise could be-

•a temporary aberration.

•the beginning of a recession.

Problems:

• Changing monetary policy would be a mistake if the rise were temporary.

• Waiting too long to change policy would be costly if the change were permanent.

Who is better at making these sorts of determinations?

• Committees make decisions as quickly and are more accurate than individuals making decisions by themselves.

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MAKING THE FEDERAL RESERVE MORE TRANSPARENT

APPLYING THE CONCEPTS #3: What are the advantages and disadvantages of the Federal Reserve becoming more transparent about

its actions and decisions and disclosing more information to the public?

In recent years, the Fed has gradually become more open in its deliberations.

But should the Fed go further in describing its intended future policies?

• Some members of the FOMC believe that the financial markets need more information so that they have a clearer idea of what future Fed policy and short-term interest rates are likely to be.

• Other members feel that the financial markets understand the implicit rules that the Fed follows and that issuing a more complex public statement will just confuse matters.

Now the members of the FOMC participate in drafting statements. The Fed clearly recognizes that its statements may be just as important as its actions.

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FED SUCCEEDS BY DOING NOTHING

• The fear is that stagflation, slow growth and high inflation, similar to the late 1970s may return.

• If the current growth and inflation trends continue, many believe the Fed will increase rates at the next meeting to curb inflation.

• Others believe that even slower growth will force the Fed to lower interest rates to stimulate the economy.

To date the Fed seems content to leave rates unchanged and attempt to influence the markets through commentary, or “jawboning.” Look for the Fed to threaten raising rates to curb inflation with the hopes that talking tough will keep the economy growing and prices in check. Changing interest rates is likely a last resort in the current environment.

Fed watchers believe the nation’s central bank will leave interest rates unchanged for now but agree on very little else after that. Some believe the next move will be down, others believe the next interest rate move will be up. The point of contention lies with the economy. While the economy has slowed considerably, inflation is still higher than central bank targets.

Extra Application 6

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MONETARY POLICY CHALLENGES FOR THE FED14.5

Lags in Monetary Policy

Influencing Market Expectations: From the Federal Funds Rate to Interest Rates on Long-Term Bonds

Looking Ahead: From the Short Run to The Long Run

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appreciation of a currency

depreciation of a currency

discount rate

exchange rate

federal funds market

federal funds rate

illiquid

liquidity demand for money

money market

open market operations

open market purchases

open market sales

speculative demand for money

transaction demand for money

the federal reserveand monetary policy f ernando q uijano, y vonn q uijano, k yle t hiel & a...

Documents

money market

money slide

money demand slide

money figure

money supply

gdp affect money demand

transaction demand

liquidity demand