How Monetary Policy Works. Aggregate Demand and Potential Output. Inflation and Unemployment Zones

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1 How Monetay Policy Woks Final xam Facts How is the Fedeal Reseve Stuctued? What ae the goals of U.S. monetay policy? What ae the tools of U.S. monetay policy? Why does changing the Fed Funds ate affect the economy? What Have We Leaned? Final xam Facts Final xam is Decembe 18, noon-3:00 PM Only the college can excuse an absence fom the final exam. Those with excuses must pesent them to me by the end of the semeste. The only makeup exam is Decembe 19, 9:00 AM. Pactice Questions fo the Final will be posted on o befoe Decembe 9. Aggegate Demand and Potential Output Inflation and Unemployment Zones pefect Y = C+I+G+NX Y Low Inflation Risk High Inflation Risk High Unemployment Low Unemployment 1

2 If a ecession takes the economy to and thee is not anothe shift in AD, the Fed can etun the economy to full employment without inflation by loweing the eal ate to AD expansion AD ecession Use You Clickes to Answe the Following Gaded Question. Y 0 Which of the following best explains why loweing the inteest ate will aise the equilibium level of output? A lowe inteest ate will A. Raise the level of potential output. B. Cause consumes to incease household saving. C. Cause fims to incease capital building. D. Raise the level of impots. D. If the Fed lowes the inteest ate to 1 and thee is a positive demand shock, the economy will end up in the inflation zone. 0 1 Y 0 AD actual AD expected 2

3 If the Fed lowes the inteest ate to 1 and thee is a positive demand shock, the economy will end up in the inflation zone. 0 1 Y 0 AD actual AD expected How is the Fedeal Reseve Stuctued? The Fedeal Reseve is the U.S. Cental Bank. The Fed was established in The Fed consists of the Boad of Govenos in Washington and twelve Fedeal Reseve Distict Banks. Chapel Hill is seved by the Richmond Regional Fed and its banch in Chalotte. The Fed is Lagely Independent of Political Contol The Seven Fed Govenos ae appointed by the Pesident and confimed by the Senate. Appointments ae fo 14 yeas. Appointments ae staggeed. The Fed is financially self-sufficient. sufficient. Why is it impotant that the Fed be independent of political contol? 3

4 The Politics of Cental Banking The Politics of Cental Banking The Politics of Cental Banking Independence Allows the Fed To Pusue Its Inflation Objectives ven When Doing So Is Politically Unpopula The Fed may believe that it must aise inteest ates to assue that the inflation ate does not begin to incease. Highe inteest ates will cause an economic slowdown. Politicians may fea that the electoate will blame them fo loss in jobs and pofits. 4

5 Cental Bank Independence and Inflation Use You Clickes to Answe the Following Gaded Question. The data on cental bank independence show a coelation between cental bank independence and. A. Positive, the ate of inflation. B. Negative, the ate of inflation. C. Positive, unemployment. D. Negative, unemployment Fedeal Open Maket Committee Monetay policy is conducted by the Fedeal Open Maket Committee. FOMC has twelve membes: Seven Govenos Pesident of the New Yok Regional Bank Fou of Twelve Othe Regional Pesidents Congess does mandate egula epots by the Fed. 5

6 The goals of US monetay policy To pomote maximum sustainable output means keeping eal GDP on its long un gowth path. Two Pat Mandate: Pomote maximum sustainable output and employment. Pomote stable pices. The goals ae pescibed in a 1977 amendment to the Fedeal Reseve Act US Gows xponentially Tend Jan-47 Jan-50 Jan-53 Jan-56 Jan-59 Jan-62 Jan-65 Jan-68 Jan-71 Jan-74 Jan-77 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 To pomote stable pices means keeping the inflation ate low and steady. CPI Inflation Jan-60 Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 The Two Goals Ae in Conflict Cuently, the Fedeal Reseve esolves the conflict by teating stable pices as he pimay goal of monetay policy and maximum sustainable output as a seconday goal to be pusued only when the pimay goal is vey likely to be met

7 If the Fed keep inteest ates low to make sue output gowth is as high as possible, the economy can end up in the inflation zone. If the Fed keep inteest ates high to make sue inflation does not occu, the economy can end up with ising unemployment. AD actual AD expected 0 1 AD expected AD actual Y 0 Y 0 The Tools of Monetay Policy Banks ae equied to keep a cetain amount of funds in eseve to meet unexpected outflows. Banks may hold eseves eithe as cash in thei vaults o as deposits at the Fed. Commecial Bank Balance Sheet Commecial Bank Balance Sheet (August, 2006) Billions of Dollas Bank Cedit Cash Othe Total Assets $8,034 $299 $1,012 $9,345 Deposits Boowings Othe Total Capital Liabilities 6,038 1, ,

8 The Fedeal Funds Maket Banks that have less eseves than equied can boow them fom banks that have moe than equied. Banks boow and lend eseves in the Fedeal Funds maket. The inteest ate chaged by a lending bank fo a loan of eseves is called the Fedeal Funds ate. Fedeal Funds Rate Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 The Fed Contols the Supply of Fedeal Funds Raising the Fedeal Funds Rate When the Fed wants to lowe the fedeal funds ate it buys govenment bonds and inceases the supply of fedeal funds. When the Fed wants to aise the fedeal funds ate it sells govenment bonds and deceases the supply of fedeal funds. To Raise the Fedeal Funds Rate The Fed Sells Govenment Bonds and lowes the Supply of Reseves Fed Funds Rate S S D Fed Funds 8

9 Loweing the Fedeal Funds Rate To Lowe the Fedeal Funds Rate The Fed Buys Govenment Bonds and aises the Supply of Reseves Fed Funds Rate S S Fed Funds D How does the Fed Incease The Supply of Bank Reseves? The Fed Buys Govenment Bonds. It pays fo the bonds with a check dawn on itself. The selle of the bond deposits the check in a bank. The bank pesents the check to the Fed fo payment. The Fed honos the check by inceasing the banks eseve balance. Use You Clickes to Answe the Following Gaded Question. Between July, 2004 and June, 2006, the Fed decided to act in a way that would educe the isk of inflation. What did it do duing this peiod? The Fed govenment bonds and the Fedeal Funds Rate. A. Bought, Inceased B. Sold, Inceased C. Bought, Deceased D. Sold, Deceased A. B. C. D. 9

10 Why does changing the Fedeal Funds ate change the desied level of spending in the economy? When the Fed lowes the fedeal funds ate, othe inteest ates tend to fall as well. When the Fed aises the fedeal funds ate, othe inteest ates tend to ise as well. But the coelation between the Fed funds ate and some ates is less than pefect Inteest Rates Fed Funds Rate Pime Copoate AAA Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 How Monetay Policy Woks What Have We Leaned? The Fed is made up of a Boad of Govenos, Regional Banks, and a Fedeal Open Maket Committee. The goals of monetay policy ae low and stable inflation and full employment. Nomally, monetay policy amounts to changes in the Fedeal Funds ate. Nomally, othe inteest ates move togethe with the Fedeal Funds ate. 10