Frank Bernanke 3 rd edition 2007 Ch

Frank & Bernanke 3 rd edition, 2007 Ch. 14: Stabilizing the Economy: The Fed 1

What is Demand for Money? l Demand for Money (Liquidity Preference) l The amount of wealth an individual chooses to hold in the form of money. l The portfolio allocation decision is made by comparing return relative to risk. l Risk can be reduced by diversifying the portfolio. l Most people choose to hold some wealth as money. 2

The Demand for Money (currency + checking deposits) is one of the assets a person, a household, a business holds. l The benefit of money is its acceptability in paying debts (liquidity). l The cost of money is the opportunity cost of losing a return on other assets one could hold. l 3

Demand for Money by K’s Restaurant l Currently holding $50, 000/day; Interest rate = 6% l Two ways to reduce cash holdings: Increase cash pickups costing $500/yr; reduce cash holdings by $10, 000. l Use a computerized cash management service costing $800/yr plus more cash pickups of $500/yr; reduce cash holdings by $20, 000 l l Benefit: . 06(10, 000) or. 06(20, 000) Cost: $500 or $1, 300. What is the cash holdings? How do they change when i = 8%? 4

Consuelo’s Balance Sheet Assets Cash Liabilities $80 Checking account 1, 200 Shares of stock 3, 500 Furniture Total Credit card balance $3, 000 1, 000 Car (market value) Student loan 250 500 $6, 280 $3, 250 Net Worth • Demand for money = $1, 280 • To hold more money • Sell stocks • Credit card cash advance $3, 030 • To hold less money • Buy stocks • Reduce her credit card balance 5

The Demand for Money l If the opportunity cost of holding money increases, less money will be held in portfolio. l The higher the nominal interest rate, the lower is the demand for money. The more the income, the more will be the amount kept in money form: the higher will be the demand for money. l The higher the price level, the higher will be the demand for money. l 6

Nominal interest rate i A Shift In The Money Demand Curve Shifts in MD • Changes in Y & P • MD will increase if Y or P increase • Technological changes • Foreign demand MD’ MD Money M 7

Shifts in Money Demand l l l l Businesses hold more than half of the total money stock. Changes in real income (real GDP). Changes in price level. Technological change and sophisticated financial markets have reduced the demand for money in the U. S. Changes in foreign holdings of USD. Between 1960 and 2004 M 1 as a percent of GDP fell from 28% to 12%. Psychological changes. Seasonal changes. 8

Foreign Holdings of USD l More than $300 billion in currency circulating outside the U. S. l Foreign citizens will hold dollars to avoid the impact of high inflation. l Foreign citizens will hold dollars to protect against political instability. 9

FOMC Decision On March 16, 2004 the FOMC declared that it will keep the federal funds rate at 1. 00%. l On March 22, 2005, the FOMC raised the federal funds rate to 2. 75%. l On March 21, 2007 the FOMC announced l How does the Fed keep the federal funds rate constant or lower or higher? What is the connection of this interest rate to the money supply? l 10

Money Supply By engaging in open market operations, the Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system. l If the demand for money remains the same, the action of the Fed affects the federal funds rate. l l. S up; D same => P down 11

Equilibrium in the Market for Money Explain how and why the market reaches equilibrium. 12

Equilibrium in the Market for Money If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is. l How do people adjust their portfolios? l They buy other assets with the excess money in their checking accounts. l The price of bonds (non-money assets) goes up: interest rate goes down. l 13

Fed’s Control of Nominal Interest Rate By buying or selling bonds, the Fed increases or decreases the supply of money in the system. l Shifting the supply curve to the right or to the left, lowers or raises the nominal interest rate. l The Fed directly affects the federal funds rate. l 14

15 http: //www. federalreserve. gov/newsevents/press/monetary/20090203 a. htm

The Federal Funds Rate, 1970 -2004 http: //research. stlouisfed. org/publications/mt/page 9. pdf 16

The Fed Wants to Raise i Fed sells bonds l The money supply falls l Creates a shortage of money l People sell non-money assets l Non-money asset prices fall and the interest rate increases l 17

Interest Rates and Money Supply The Fed cannot set the interest rate and the money supply independently. l The Fed controls the money supply by controlling bank reserves. l Bank reserves influence the federal funds rate. l Therefore, the federal funds rate reflects the impact of open market operations. l 18

The Fed and Money Supply l Second Way : Discount Window Lending l The lending of reserves by the Federal Reserve to commercial banks l Discount Rate (primary credit rate): The interest rate that the Fed charges commercial banks to borrow reserves. 19

The Fed and Money Supply l Third Way: Changing Reserve Requirements l l Set by the Fed The minimum values of the ratio of bank deposits that commercial banks are allowed to maintain Lowering the reserve ratio increases the ability of banks to make loans and therefore expand the money supply. Increasing the reserve ratio reduces the ability of banks to make loans and create money. 20

The New Tools http: //www. federalreserve. gov/monetarypolicy/default. htm 21

Fed Funds Rate vs. Prime l If Fed can affect the federal funds rate, why should we care? l We might be interested in the interest rates on CDs, mortgage rates, credit card interest rates? l Usually, interest rates all go hand in hand. l When the Fed increases the federal funds rate, banks increase their prime rates, too. 22

Real and Nominal Interest Rates If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does? l Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate. l 23

Real and Nominal Interest Rates Remember the Fisher Effect: li=r+p l If the expected inflation hasn’t changed but the Fed has increased i, then r is also increased. l In the long run p adjusts and it is the savings and investments that determine the real rate of interest. l 24

The Federal Reserve and Interest Rates l Can the Fed Control the Real Interest Rate? l Long-run impact of Fed policy l Prices adjust to changing economic conditions. l The real interest rate is determined by the balance of savings and investment. l The Fed has less effect on spending in the long run. 25

How much control does the Fed have over spending? The Fed has direct control over the federal funds rate. l The federal funds rate may influence, but does not control other interest rates which influence spending. l The inability of the Fed to precisely control other interest rates complicates monetary policy. l 26

Aggregate Expenditures and the Real Interest Rate l Real interest rates and consumption High real interest rates increases the incentive to save. l If savings increase, consumption decreases. l High real interest rates reduces consumption. l l Real interest rates and investment spending High real interest rates increases the cost of investment spending. l The increased cost reduces profitability of investment spending and investment falls. l High real interest rates reduces investment spending. l l Real interest rates and NX l R up => $ up => NX down 27

Real Interest Rates and Aggregate Demand Y = C + I + G + NX l C = 400 + 0. 8(Y-T) - 200 r l I = 300 - 600 r l G = 250; T = 200; NX = 10 l Explain in words how this economy operates. l 28

Solving for the Unknowns If the real interest rate is 3%, find the values of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y. l If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph. l 29

Fighting Recession The Fed reduced the fed funds rate 11 times in 2001 -2002. l In the second half of 2000, the rate stayed at 6. 5%. l In 2002, it had been 1. 75% until Nov. 6 and the Fed decided to lower it further. l What was the effect of Fed’s lowering of interest rates on AD? l 30

The Fed Fights A Recession Expenditure line (r = 1%) Planned aggregate expenditure PAE • Multiplier = 5 • Output gap = 200 • Fed wants to increase PAE by 200/5 = 40 • C = 1, 010 – 1, 000 r • 1% change in r will change C by 10 • Reduce r to 0. 01 Y = PAE Expenditure line (r = 5%) F A reduction in r shifts the expenditure line upward E Recessionary gap 4, 800 5, 000 Y* Output Y 31

Fighting Inflation From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4. 75% to 6. 50%. l At the beginning of 1977 the fed funds rate was 4. 5%. By the end of 1978 it was 10%. A year later it was 13. 75%. By April 1980, it reached 17. 6%. l What happens to AD? l 32

Raising Interest Rates From June 2004 to June 2005 the Fed Funds Rate rose from 1. 0% to 3. 25%. l Real GDP growth of nearly 6% in late 2003 and 4. 4% in 2004 and a falling unemployment rate to 5. 6% in June 2004 indicated the possible emergence of an expansionary gap. l 33

The Fed Fights Inflation Planned aggregate expenditure PAE Y = PAE Expenditure line (r = 5%) E G Expenditure line (r = 9%) An increase in r shifts the expenditure line downward Expansionary gap 4, 600 4, 800 Y* Output Y 34

Inflation and the Stock Market Inflation is watched very closely by the Fed. l Any sign of inflation makes Fed increase interest rates. l Higher real interest rates slow down the economy and lower future profits. l Higher real interest rates lower the price of bonds and shift the demand away from stocks to bonds, lowering stock prices. l 35

Policy Reaction Function If there is a pattern of policies adopted under the same economic circumstances, then we have a policy reaction function. l For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation. l 36

Taylor Rule l l Taylor explained the behavior of the Fed as a reaction to output gap and inflation. If there is a positive, recessionary output gap, the Fed wants to stimulate the economy. If there is a negative, expansionary gap, the Fed wants to slow down the economy. The Fed also reacts to higher inflation by raising the real interest rate and slowing down the economy. 37

Taylor Rule r = 0. 01 – 0. 5 [(Y* - Y)/Y*] + 0. 5 π How does the Fed react when inflation rises? How does the Fed react when output gaps appear? What will the real and nominal interest rates be given different values? 38

A Monetary Policy Reaction Function for the Fed Rate of inflation, Real interest rate set by Fed, r 0. 00 (= 0%) 0. 02 (= 2%) 0. 01 0. 03 0. 02 0. 04 0. 03 0. 05 0. 04 0. 06 39

An Example of a Fed Policy Reaction Function Real interest rate set by Fed, r 0. 06 Fed’s monetary policy reaction function 0. 05 0. 04 0. 03 0. 02 0. 01 0. 02 0. 03 Inflation 0. 04 40