Monetary Policy, Toll Brothers, and the Housing Market The Sequel: Housing Bubble Sub-prime mortgage crisis Recession of 2008 - 09 By driving down interest rates, the Fed succeeded in heading off what some economists had predicted would be a prolonged and severe recession. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 1 of 39
What Is Monetary Policy? Monetary policy How the Federal Reserve manages the money supply and interest rates to pursue its economic goals. The Goals of Monetary Policy Chapter 14: Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy: 1 Price stability 2 High employment 3 Economic growth 4 Stability of financial markets and institutions © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 2 of 38
The Money Market and the Fed’s Choice of Monetary Policy Targets Chapter 14: Monetary Policy The Fed tries to keep both the unemployment and inflation rates low, but it can’t affect either of these economic variables directly. The Fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level. The federal funds rate is the Fed’s most important direct target variable The federal funds rate affects the money supply. Money supply growth affects inflation, unemployment, and growth. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 3 of 38
The Money Market and the Fed’s Choice of Monetary Policy Targets Chapter 14: Monetary Policy The Demand for Money (An increase in the price of bonds) Substitute away from bonds toward money. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 4 of 38
Chapter 14: Monetary Policy Shifts in the Money Demand Curve © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 5 of 38
Equilibrium in the Money Market The Impact on the Interest Rate When the Fed Increases the Money Supply Chapter 14: Monetary Policy People try to buy bonds. Bond prices fall. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 6 of 38
Federal funds rate The interest rate banks charge each other for overnight loans of reserves (deposits held at the Fed). Chapter 14: Monetary Policy Federal Funds Rate Targeting, January 1997–May 2007 When Fed increases supply of reserves by buying something, fed funds rate falls. When Fed decreases supply of reserves by selling something, fed funds rate rises. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 7 of 38
Monetary Policy and Economic Activity Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: • Consumption • Investment Chapter 14: Monetary Policy • Net exports Expansionary monetary policy The Federal Reserve increasing the money supply and decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserve adjusting the money supply to increase interest rates to reduce inflation. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 8 of 38
Making the Chapter 14: Monetary Policy Connection The Inflation and Deflation of the Housing Market “Bubble” © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 9 of 38
Monetary Policy and Economic Activity Chapter 14: Monetary Policy The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 10 of 38
Making the Chapter 14: Monetary Policy Connection The Fed Responds to the Terrorist Attacks of September 11, 2001 The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 11 of 38
Learning Objective 14. 3 Monetary Policy and Economic Activity Using Monetary Policy to Fight Inflation FIGURE 14. 9 Chapter 14: Monetary Policy A Contractionary Monetary Policy in 2000 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 12 of 38
Learning Objective 14. 3 Solved Problem 14 -3 The Effects of Monetary Policy Chapter 14: Monetary Policy The hypothetical information in the table shows what the values for real GDP and the price level will be in 2011 if the Fed does not use monetary policy. YEAR POTENTIAL REAL GDP PRICE LEVEL 2010 $13. 3 trillion 140 2011 $13. 7 trillion $13. 6 trillion 142 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 13 of 38
Monetary Policy and Economic Activity Chapter 14: Monetary Policy A Summary of How Monetary Policy Works BEST: Buy Ease Sell Tighten © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 14 of 38
Some Issues Regarding the Conduct of Monetary Policy 1. Should the Fed Target the Money Supply? Rather than use an interest rate as its monetary policy target, the Fed should target the money supply. Economists who make this argument belong to the Monetarist School. Chapter 14: Monetary Policy The leader of the monetarist school was Nobel laureate Milton Friedman and his followers favored replacing monetary policy with a monetary growth rule. Steady money growth steady, predictable inflation Steady money growth automatic stabilizer. Problem is, it’s hard to get the money supply where you want it. The public’s changing split of its money holdings between currency and demand deposits changes the money multiplier. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 15 of 38
2. Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? Chapter 14: Monetary Policy The Fed Can’t Target Both the Money Supply and the Interest Rate © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 16 of 38
Monetary Policy and Economic Activity 3. Can the Fed Get Timing Right? Chapter 14: Monetary Policy The Effect of a Poorly Timed Monetary Policy on the Economy Friedman’s complaint about discretionary monetary policy: “Too much too late” © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 17 of 38
4. Should the Fed adhere to a simple rule … or exercise discretion? Taylor rule A rule developed by John Taylor -- a Stanford professor and advisor to Presidents Bush -- that links the Fed’s target for the federal funds rate to economic variables. Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap Chapter 14: Monetary Policy + (1/2) x Output gap According to Taylor rule, if inflation rises by one percentage point, the Federal Funds rate should rise by 1 ½ percentage points. The real federal funds rate then rises by ½ %, slowing inflation. 5. Should the Fed Target Inflation? Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 18 of 38
6. Is the Independence of the Federal Reserve a Good Idea? The Case for Fed Independence Chapter 14: Monetary Policy The More Independent the Central Bank, the Lower the Inflation Rate © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 19 of 38
How Does the Fed Measure Inflation? Chapter 14: Monetary Policy Personal Consumption Expenditure Price Index: A Chained Index © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 20 of 38
Key Terms Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Chapter 14: Monetary Policy Taylor rule © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2 e. 21 of 38
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