Lecture 7

Monetary Policy
 Lecture Outline

1 What Is Monetary Policy?

2 The Money Market and the Fed’s Choice of Monetary

Policy Targets
3 Monetary Policy and Economic Activity

4. Monetary Policy in the Dynamic Aggregate Demand and

Aggregate Supply Model

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 What Is Monetary Policy?

1 LEARNING OBJECTIVE

Define monetary policy and describe the Federal Reserve’s monetary policy
goals.

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 Monetary policy The actions the Federal Reserve takes to manage the money
supply and interest rates to pursue macroeconomic policy goals.

The Goals of Monetary Policy

The Fed has four main monetary policy goals that are intended to promote a
well-functioning economy:

1. Price stability

2. High employment

3. Stability of financial markets and institutions

4. Economic growth

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 Price Stability
Figure 26.1
The Inflation Rate,
January 1952–
August 2011
For most of the
1950s and 1960s,
the inflation rate in
the United States
was 4 percent or
less.
During the 1970s,
the inflation rate
increased,
peaking during
1979–1981, when
it averaged more
than 10 percent.
After 1992, the inflation rate was usually less than 4 percent, until increases in oil prices
pushed it above 5 percent during the summer of 2008.
The effects of the recession caused several months of deflation—a falling price level—
early in 2009.
Note: The inflation rate is measured as the percentage change in the consumer price index (CPI) from
the same month in the previous year.

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 High Employment The goal of high employment extends beyond the Fed to
other branches of the federal government.

Price stability and high employment are both sometimes said to be goals that
the Fed has a dual mandate to attain and are explicitly mentioned in the
Employment Act of 1946 that Congress passed at the end of World War II.

Stability of Financial Markets and Institutions The Fed promotes the

stability of financial markets and institutions so that an efficient flow of funds from
savers to borrowers will occur.

To ease liquidity problems facing investment banks unable to obtain short-term

loans in 2008, the Fed temporarily allowed them to receive discount loans.

Economic Growth Policymakers aim to encourage stable economic growth

because it allows households and firms to plan accurately and encourages the
long-run investment that is needed to sustain growth.

Congress and the president may be better able to promote economic growth in
particular than is the Fed, such as through changes in tax laws that increase
the return to saving and investing.
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 The Money Market and the Fed’s Choice of Monetary Policy
Targets

2 LEARNING OBJECTIVE

Describe the Federal Reserve’s monetary policy targets and explain how
expansionary and contractionary monetary policies affect the interest rate.

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 Monetary Policy Targets

The Fed tries to keep both the unemployment and inflation rates low, but it can’t
affect either of these economic variables directly.

Instead, it uses monetary policy targets, which are variables that it can affect
directly and that, in turn, affect variables, such as real GDP, employment, and the
price level, that are closely related to its policy goals.

The two main monetary policy targets are the money supply and the interest rate,
although the Fed was forced to develop new policy tools during the recession of
2007–2009.

During normal times, the Fed typically uses the interest rate as its policy target.

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Figure 26.2 The Demand for Money

The money demand curve slopes downward because lower interest rates cause households
and firms to switch from financial assets, such as U.S. Treasury bills, to money.
All other things being equal, a fall in the interest rate from 4 percent to 3 percent will increase
the quantity of money demanded from $900 billion to $950 billion.
An increase in the interest rate will decrease the quantity of money demanded.

The interest rate is the opportunity cost, or what you forgo, to hold money.
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Figure 26.3 Shifts in the Money Demand Curve

Changes in real GDP or the price level cause the money demand curve to shift.
An increase in real GDP or an increase in the price level will cause the money demand
curve to shift from MD1 to MD2.
A decrease in real GDP or a decrease in the price level will cause the money demand
curve to shift from MD1 to MD3.

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 How the Fed Manages the Money Supply: A Quick Review
If the Federal Open Market Committee (FOMC) decides to increase the money
supply, it orders the trading desk at the Federal Reserve Bank of New York to
purchase U.S. Treasury securities.

The sellers of these Treasury securities deposit the funds they receive from the
Fed in banks, which increases the banks’ reserves.

Typically, the banks loan out most of these reserves, which creates new
checking account deposits and expands the money supply.

If the FOMC decides to decrease the money supply, it orders the trading desk
to sell Treasury securities, which decreases banks’ reserves and contracts the
money supply.

Equilibrium in the Money Market

Just as with other markets, equilibrium in the money market occurs where the
money demand curve crosses the money supply curve.

When the Fed increases the money supply, the short-term interest rate must fall
until it reaches a level at which households and firms are willing to hold the
additional money.
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 Figure 26.4

The Effect on the Interest Rate

When the Fed Increases the
Money Supply
When the Fed increases the
money supply, households and
firms will initially hold more
money than they want, relative
to other financial assets.
Households and firms use the
money they don’t want to hold
to buy Treasury bills and make
deposits in interest-paying
bank accounts.
This increase in demand allows
banks and sellers of Treasury
bills and similar securities to
offer lower interest rates.
Eventually, interest rates will fall enough that households and firms will be willing to hold the
additional money the Fed has created.
In the figure, an increase in the money supply from $900 billion to $950 billion causes the
money supply curve to shift to the right, from MS1 to MS2,
and causes the equilibrium interest rate to fall from 4 percent to 3 percent.

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 Figure 26.5

The Effect on Interest Rates When the

Fed Decreases the Money Supply
When the Fed decreases the
money supply, households and
firms will initially hold less
money than they want, relative
to other financial assets.
Households and firms will sell
Treasury bills and other
financial assets and withdraw
money from interest-paying
bank accounts.
These actions will increase
interest rates.
Eventually, interest rates will
rise to the point at which
households and firms will be
willing to hold the smaller
amount of money that results
from the Fed’s actions.
In the figure, a reduction in the money supply from $900 billion to $850 billion causes the
money supply curve to shift to the left, from MS1 to MS2,
and causes the equilibrium interest rate to rise from 4 percent to 5 percent.
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 A Tale of Two Interest Rates

The loanable funds model is concerned with the long-term real rate of interest,
and the money market model is concerned with the short-term nominal rate of
interest, but there is often a close connection between their movements.

The long-term real rate of interest is the interest rate that is most relevant when:

• Savers consider purchasing a long-term financial investment

• Firms borrow to finance long-term investment projects

• Households take out mortgage loans

When conducting monetary policy, however, the short-term nominal interest rate
is most relevant because it is the interest rate most affected by increases and
decreases in the money supply.

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 Choosing a Monetary Policy Target

There are many different interest rates in the economy, but for purposes of
monetary policy, the Fed has targeted the interest rate known as the federal
funds rate.

The Importance of the Federal Funds Rate

In normal times, banks keep few excess reserves, and when they need
additional reserves, they borrow in the federal funds market from banks that
have reserves available.

Federal funds rate The interest rate banks charge each other for overnight
loans.

The Fed can set a target for the federal funds rate, which is determined by the
supply of reserves relative to the demand for them.

Changes in the federal funds rate have greater and quicker effects on short-
term interest rates than they do on long-term interest rates.
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Figure 26.6 Federal Funds Rate Targeting, January 1998–September 2011

The Fed does not set the federal funds rate, but its ability to increase or decrease bank
reserves quickly through open market operations keeps the actual federal funds rate close
to the Fed’s target rate.
The orange line is the Fed’s target for the federal funds rate, and the jagged green line
represents the actual value for the federal funds rate on a weekly basis.
Note: The federal funds target for the period after December 2008 was 0 to 0.25 percent.

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 Monetary Policy and Economic Activity

3 LEARNING OBJECTIVE

Use aggregate demand and aggregate supply graphs to show the effects of
monetary policy on real GDP and the price level.

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 How Interest Rates Affect Aggregate Demand

With the exception of government purchases, changes in interest rates will affect
the components of aggregate demand in the following ways:

• Consumption. Lower interest rates lower the cost of durable goods and
reduce the return to saving, leading households to save less and spend more.

Higher interest rates raise the cost of consumer durables and increase the return
to saving, leading households to save more and spend less.

• Investment. Higher interest rates make it more expensive for firms and
households to borrow, thereby decreasing investment.

Lower interest rates increase the demand for stocks and make it less expensive
for firms and households to borrow, thereby increasing investment.

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 • Net exports. If interest rates in the United States rise relative to interest
rates in other countries, the value of the dollar will rise and net exports will fall.

If interest rates in the United States decline relative to interest rates in other
countries, the value of the dollar will fall and net exports will rise.

The Effects of Monetary Policy on Real GDP and the Price Level

The Fed can use monetary policy to affect the price level and, in the short run,
the level of real GDP, allowing it to attain its policy goals of high employment
and price stability.

In the basic version of the aggregate demand and aggregate supply model,
we assume that there is no economic growth, so the long-run aggregate supply
curve doesn’t shift.

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 Figure 26.7a
Monetary Policy
The economy begins in a recession
at point A, with real GDP of $13.8
trillion and a price level of 98.
An expansionary monetary policy
causes aggregate demand to shift
to the right, from AD1 to AD2,
increasing real GDP from $13.8
trillion to $14.0 trillion and the price
level from 98 to 100 (point B).
With real GDP back at its potential
level, the Fed can meet its goal of
high employment.

Expansionary monetary policy The Federal Reserve’s decreasing interest

rates to increase real GDP.

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 Figure 26.7b
Monetary Policy
The economy begins at point A,
with real GDP at $14.2 trillion and
the price level at 102.
Because real GDP is greater than
potential GDP, the economy
experiences rising wages and
prices.
A contractionary monetary policy
causes aggregate demand to shift
to the left, from AD1 to AD2,
decreasing real GDP from $14.2
trillion to $14.0 trillion and the price
level from 102 to 100 (point B).
With real GDP back at its potential
level, the Fed can meet its goal of
price stability.

Contractionary monetary policy The Federal Reserve’s increasing interest

rates to reduce inflation.

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 Making Too Low for Zero: The Fed Tries “Quantitative
the Easing” and “Operation Twist”
Connection

To stimulate the economy in late 2008, the Fed pushed the target for the federal funds rate to
nearly zero and kept it there through 2011, but faced a liquidity trap when many banks began
piling up excess reserves rather than lending the funds out to those whose financial positions
had been damaged by the recession.
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 Making Too Low for Zero: The Fed Tries “Quantitative
the Easing” and “Operation Twist”
Connection
Because the federal funds rate
cannot be negative, the Fed embarked on a
policy of quantitative easing by purchasing
securities—including certain mortgage-backed
securities—beyond the short-term Treasury
securities that are usually involved in open
market operations.

The economic recovery remained weak

following two rounds of quantitative easing between November 2008 and June 2011.

So in September 2011, the Fed announced a new program, which some people in
financial markets called “Operation Twist,” under which it would purchase $400 billion
in long-term Treasury securities while it would sell an equal amount of shorter-term
Treasury securities.

Both quantitative easing and Operation Twist had the same objective: to reduce
interest rates on long-term Treasury securities, which typically move closely with
those on home mortgage loans, in order to increase aggregate demand.

MyEconLab Your Turn: Test your understanding by doing related problems 3.11 and 3.12 at the end of this chapter.

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 Can the Fed Eliminate Recessions?

A lag, or delay, can occur before the Fed recognizes that a recession has begun
because it takes months for economic statistics to be gathered by the Commerce
Department, the Census Bureau, the Bureau of Labor Statistics, and the Fed
itself.

By the time the FOMC analyzes the data and concludes that the economy is in
recession, it may begin an expansionary monetary policy when it is not needed if
the recession has already ended and an expansion has begun.

In that case, the increase in aggregate demand caused by the Fed’s lowering
interest rates is likely to push the economy beyond potential real GDP and cause
a significant acceleration in inflation.

In sum, the Fed has inadvertently engaged in a procyclical policy, which increases
the severity of the business cycle, as opposed to a countercyclical policy, which is
meant to reduce its severity and is what the Fed intended to use.

Making this mistake is less likely in a long and severe recession such as that of
2007–2009.
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Figure 26.8 The Effect of a Poorly Timed Monetary Policy on the Economy

The upward-sloping straight line represents the long-run growth trend in real GDP.
The curved red line represents the path real GDP takes because of the business cycle.
If the Fed is too late in implementing a change in monetary policy,
real GDP will follow the curved blue line.
The Fed’s expansionary monetary policy results in too great an increase in aggregate
demand during the next expansion, which causes an increase in the inflation rate.

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 Making Trying to Hit a Moving Target: Making Policy with
the “Real-Time Data”
Connection

In addition to the other problems the Federal Reserve encounters in successfully conducting
monetary policy, it must make decisions using data that may be subject to substantial
revisions.
MyEconLab Your Turn: Test your understanding by doing related problems 3.13 and 3.14 at the end of this chapter.

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 A Summary of How Monetary Policy Works

Table 26.1 Expansionary and Contractionary Monetary Policies

The arrows point to the steps involved in the policy that occur relative to what
would have happened without the policy.

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 By isolating the impact of monetary policy, holding constant all other factors
affecting the variables involved, we are invoking the ceteris paribus condition.

This point is important because a contractionary monetary policy does not cause
the price level to fall; rather, it causes the price level to rise by less than it would
have risen without the policy.

An expansionary monetary policy is sometimes referred to as a loose policy, or

an easy policy.

A contractionary monetary policy is sometimes referred to as a tight policy.

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 Monetary Policy in the Dynamic Aggregate Demand and
Aggregate Supply Model*

4 LEARNING OBJECTIVE

Use the dynamic aggregate demand and aggregate supply model to analyze
monetary policy.

*This section may be omitted without loss of continuity.

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 The Fed can use monetary policy to affect aggregate demand, thereby
changing the price level and the level of real GDP.

The dynamic aggregate demand and aggregate supply model can provide us
with a more complete understanding of monetary policy.

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 The Effects of Monetary Policy on Real GDP and the Price Level:
A More Complete Account
Figure 26.9
An Expansionary Monetary
Policy
The economy begins in
equilibrium at point A,
with real GDP of $14.0 trillion
and a price level of 100.
Without monetary policy,
aggregate demand will shift
from AD1 to AD2(without policy),
which is not enough to keep
the economy at full
employment because long-
run aggregate supply has
shifted from LRAS1 to LRAS2.
The economy will be in short-run
equilibrium at point B, with real GDP of $14.3 trillion and a price level of 102.
By lowering interest rates, the Fed increases investment, consumption, and net exports
sufficiently to shift aggregate demand to AD2(with policy).
The economy will be in equilibrium at point C, with real GDP of $14.4 trillion, which is its
full employment level, and a price level of 103. The price level is higher than it would have
been if the Fed had not acted to increase spending in the economy.
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 Using Monetary Policy to Fight Inflation
Figure 26.10
A Contractionary Monetary Policy
in 2006
The economy began 2005 in
equilibrium at point A, with real GDP
equal to potential GDP of $12.6
trillion and a price level of 100.0.
From 2005 to 2006, potential GDP
increased from $12.6 trillion to $12.9
trillion, as long-run aggregate supply
increased from LRAS2005 to LRAS2006.
The Fed raised interest rates
because it believed the housing boom
was causing aggregate demand to
increase too rapidly.
Without the increase in interest rates,
aggregate demand would have shifted from AD2005 to AD2006(without policy),
and the new short-run equilibrium would have occurred at point B.
Real GDP would have been $13.2 trillion—$300 billion greater than potential GDP—
and the price level would have been 104.5.
The increase in interest rates resulted in aggregate demand increasing only to AD2006(with policy).
Equilibrium occurred at point C, with real GDP of $13.0 trillion being only $100 billion greater
than potential GDP, and the price level rising only to 103.2.
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 Solved Problem 26.4
The Effects of Monetary Policy
Year Potential GDP Real GDP Price Level
2014 $15.2 trillion $15.2 trillion 114
2015 15.6 trillion 15.4 trillion 116

The hypothetical information in the table above shows what the values for real GDP and the
price level will be in 2015 if the Fed does not use monetary policy.
a. If the Fed wants to keep real GDP at its potential level in 2015, should it use an
expansionary policy or a contractionary policy?
Should the trading desk buy Treasury bills or sell them?
Solving the Problem
Step 1: Review the chapter material.
Step 2: Answer the questions in part a. by explaining how the Fed can keep real
GDP at its potential level.
Because the economy will be below potential real GDP in 2015 without monetary policy,
the Fed must undertake an expansionary policy to keep real GDP at its potential level
by buying Treasury bills, which will increase reserves in the banking system.
Banks will increase their loans, which will increase the money supply and lower the
interest rate.

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 Solved Problem 26.4
The Effects of Monetary Policy
Year Potential GDP Real GDP Price Level
2014 $15.2 trillion $15.2 trillion 114
2015 15.6 trillion 15.4 trillion 116

The hypothetical information in the table above shows what the values for real GDP and the
price level will be in 2015 if the Fed does not use monetary policy.
b. Suppose the Fed’s policy is successful in keeping real GDP at its potential level in 2015.
State whether each of the following will be higher or lower than if the Fed had taken
no action:
i Real GDP
ii Potential real GDP
iii The inflation rate
iv The unemployment rate
Step 3: Answer part b. by explaining the effect of the Fed’s policy.
If the Fed’s policy is successful, real GDP in 2015 will increase from $15.4 trillion to its
potential level of $15.6 trillion.
Potential real GDP is not affected by monetary policy, so its value will not change.
The expansionary monetary policy shifts the AD curve to the right, so short-run equilibrium
will move up the short-run aggregate supply (SRAS) curve, and the price level will be higher.
Because the level of real GDP will be higher, the unemployment rate will be lower than it
would have been without policy.
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 Solved Problem 26.4
The Effects of Monetary Policy
Year Potential GDP Real GDP Price Level
2014 $15.2 trillion $15.2 trillion 114
2015 15.6 trillion 15.4 trillion 116

The hypothetical information in the table above shows what the values for real GDP and the
price level will be in 2015 if the Fed does not use monetary policy.
c. Draw an aggregate demand and aggregate supply graph to illustrate your answer.
Be sure that your graph contains LRAS and SRAS curves for 2014 and 2015; AD curves
for both years, with and without monetary policy action; and equilibrium real GDP and the
price level in 2015, with and without policy.
Step 4: Answer part c. by drawing the graph.
Your graph should look similar to Figure 26.9.

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 Solved Problem 26.4
The Effects of Monetary Policy
Year Potential GDP Real GDP Price Level
2014 $15.2 trillion $15.2 trillion 114
2015 15.6 trillion 15.4 trillion 116

The economy starts in equilibrium

in 2014 at point A, with the AD and
SRAS curves intersecting along the
LRAS curve.
Real GDP is at its potential level of
$15.2 trillion, and the price level is 114.
Without monetary policy, the AD curve
shifts to AD2015(without policy),
and the economy is in short-run
equilibrium at point B.
Because potential real GDP has increased
from $15.2 trillion to $15.6 trillion,
short-run equilibrium real GDP of
$15.4 trillion is below the potential level.
The price level has increased from 114
to 116.
With policy, the AD curve shifts to AD2015(with policy),
and the economy is in equilibrium at point C.
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 Solved Problem 26.4
The Effects of Monetary Policy
Year Potential GDP Real GDP Price Level
2014 $15.2 trillion $15.2 trillion 114
2015 15.6 trillion 15.4 trillion 116

Real GDP is at its potential level

of $15.6 trillion.
Because we only know that the
new equilibrium price level will be
higher than 116, the graph shows
it rising to 118.
Without the Fed’s expansionary policy,
the inflation rate in 2015 would have
been about 1.8 percent.
With policy, it will be about 3.5 percent.
Bear in mind that in reality, the Fed is
unable to use monetary policy to keep
real GDP exactly at its potential level,
as this problem suggests.

MyEconLab Your Turn: For more practice, do related problems 4.4 and 4.5 at the end of this chapter.

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