Chapter 14

Stabilizing the Economy:

The Role of the Fed

Learning Objectives

1. How the demand for money and the supply of money interact to determine the equilibrium nominal interest rate.
2. How the Fed uses its ability to affect the money supply to influence nominal and real interest rates.
3. How the Fed uses its ability to affect bank reserves and the reserve-deposit ratio to affect the money supply.
4. Unconventional monetary policy methods that the Fed can use when interest rates hit the zero lower bound.
5. How changes in real interest rates affect aggregate expenditure and how the Fed uses changes in the real interest rate to fight a recession or inflation.
6. Discuss the extent to which monetary policymaking is an art or science.

12-2

Fed Watch

Analysts attempt to forecast Fed decisions about monetary policy

• Greenspan briefcase indicator
• Fed decisions have significant effects on financial markets and the macro economy

​

Monetary policy is a major stabilization tool

• Quickly decided and implemented
• More flexible and responsive than fiscal policy

3

FED & PRINTING MONEY

The Fed and Interest Rates

Controlling the money supply is the primary task of the FOMC

• Money supply and demand determine the interest rate
• Fed manipulates supply to achieve its desired interest rate

Portfolio allocation decisions allocate a person's wealth among alternative forms

• Diversification is owning a variety of different assets to manage risk

The demand for money is the amount of wealth held in the form of money

6

Leading Indicators

• Job Quits
• Job Openings
• Producers Price Index
• Manufacturing
• Wholesale prices
• Bond Prices
• Equity Prices

Demand for Money

Demand for money is sometimes called an individual's liquidity preference

• The Cost – Benefit Principle indicates people will balance the marginal cost of holding money versus the marginal benefit
• Money's benefit is the ability to make transactions
• Quantity of money demanded increases with income
• Technologies such as online banking and ATMs have reduced the demand for money
• M1 has decreased from 26% of GDP in 1960 to 17% in 2016

8

Demand for Money

Marginal cost of holding money is the interest foregone

• Most forms of money pay little or no interest
• Assume the nominal interest rate on money is 0
• Alternative assets such as stocks or bonds have a positive nominal interest rate

​

Higher the nominal interest rate, the smaller the quantity of money demanded

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Business demand for money is similar to individuals'

• Businesses hold more than half of the money stock

9

Nominal interest rate (i)

​

The higher the interest rate, the lower the quantity of money demanded by increase the cost of holding money

10

Demand for Money

Demand for money depends on:

​

1) Real income or output (Y)

• The higher the level of income, the greater the quantity of money demanded

2) The price level (P)

• The higher the price level, the greater the quantity of money demanded

3) Technology

4) Institutions

11

The Money Demand Curve

Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate

​

The money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal �interest rate

• An increase in the �nominal interest rate �increases the �opportunity cost of �holding money
• Negative slope

12

Changes to Price levels

↑ Price Levels = ↑ Money Demand

↓ Price Levels = ↓ Money Demand

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• Changes in price levels proportional to money demand
• (if things get more expensive relatively, we need more money to buy things)

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Changes to REAL GDP

↑ Real GDP = ↑ Money Demand

↓ Real GDP = ↓ Money

​

The more output there is, generally the more money we can hold

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Changes credit markets and technology

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↑ Credit Markets/Technology = ↓ Money Demand

↓ Credit Markets/Technology = ↑ Money Demand

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Upcoming Changes: Google Wallet, Square, Paypal, Bitcoin, etc

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Sweden says no to cash

16

Changes in institutions

Direction may vary based on type of banking regulation changes.

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Changes in interests rates will change demand for money.

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(example: when banks were allowed to pay interest on savings in 1980s)

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The Money Demand Curve

Changes in factors other than the nominal interest rate cause a shift in the money demand curve

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An increase in demand for money can result from

• An increase in output
• Higher price levels
• Technological advances
• Financial advances
• Foreign demand for �dollars

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18

Money (M)

Nominal interest rate (i)

MD

The Demand for Money

Interest Rates and the Opportunity Cost of Holding Money

Long term interest rates

• Long-term interest rates don’t necessarily move with short-term interest rates. �
• If investors expect short-term interest rates to rise, investors may buy short-term bonds.�
• If investors expect short-term interest rates to fall, investors may buy long term bonds.�
• In practice, long-term interest rates reflect the average expectation in the market about what’s going to happen to short-term rates in the future.

​

• Long term rates also reflect the risk associated with higher risk.

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Fear and interest rates

• Treasury bills generally pay a slightly lower interest rate than other short-term assets in normal times.

​

• In the third week of October 2008, one-month CDs were paying 4.04% interest, but one-month Treasury bills were paying only 0.26%.
• The reason: fear. A sharp plunge in housing prices had led to big losses at a number of financial institutions, leaving investors nervous about the safety of many nongovernment assets.
• On December 10, 2008, in fact, three-month Treasury bills paid 0% interest for a brief period.

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23

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Flight to Quality

Demand for Dollars in Argentina

The average Argentine holds more dollars than the average US citizen

​

In the 1970s and 1980s, Argentina had high rates of inflation

• Real returns on assets in pesos declined
• Argentines switched to dollars as a store of value

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In 1990, the US dollar and Argentine peso traded 1:1

• Both were accepted for transaction

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By 2001, inflation in Argentina caused the system to break down

• Peso was worth less than the dollar

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International Demand for Dollars

Political instability in some countries also increases the demand for dollars

• Avoids confiscation and taxes

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Largest U.S. bill is $100, popular with drug dealers

• The Euro is available in €500 bills, worth more than $500
• More compact way of storing a given amount of wealth
• If drug dealers switch to holding their cash in Euros, the demand for the U.S. dollar will decrease

28

​

Cryptocurrency���

Supply of Money

• The Fed primarily controls the supply of money with open-market operations
• An open-market purchase of bonds by the Fed increases the money supply
• An open-market sale of �bonds by the Fed �decreases the money �supply
• Supply of money is vertical
• Equilibrium is at E

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Equilibrium in the Money Market

• Bond prices are inversely related to the interest rate
• Suppose the interest rate is at i₁, below equilibrium
• Quantity of money demanded is M_1, more than the money available
• To get more money, people�sell bonds
• Bond prices go down,�interest rates rise
• Quantity of money �demanded decreases �from M₁ to M

​

31

Money (M)

MD

E

MS

M

Nominal interest rate (i)

Role of the Federal Funds Rate

• The federal funds rate is the rate commercial banks charge each other on short-term (usually overnight) loans
• Banks borrow from each other if they have insufficient funds - closely tied with bank reserves
• Market determined rate
• Targeted by the Fed
• To decrease the federal funds rate the Fed conducts open market purchases
• Reserves increase
• Interest rates tend to move together

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33

The Fed Targets the Interest Rate

The Fed cannot set the interest rate and the money supply independently

​

Fed policy is announced in terms of interest rates because

• Public is not familiar with the size of the money supply
• Main effects of monetary policy on the economy work through interest rates
• Interest rates are easier to monitor than the money supply

The Federal Funds Rate, �1955-2020

34

The Fed Control The Real Interest Rate?

Fed controls the money supply to control the nominal interest rate, i

• Investment and saving decisions are based on the real interest rate, r
• Fed has some control over the real interest rate

r = i - π

where π is the rate of inflation

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The Fed has good control over i but not complete control

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Inflation changes relatively slowly

• Changes in nominal rates become changes in real rates

35

The target versus the market

A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works.

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The money market works the same way as always: the interest rate is determined by the supply and demand for money.

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The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate.

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It’s important not to confuse a change in the Fed’s operating procedure with a change in the way the economy works.

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The Fed Targets the Interest Rate

The Fed cannot set the interest rate and the money supply independently

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Fed policy is announced in terms of interest rates because

• Public is not familiar with the size of the money supply
• Interest rate changes affect planned spending and the level of economic activity
• Interest rates are easier to monitor than the money supply

12-37

Ample Versus Limited Reserves

https://www.federalreserve.gov/econres/notes/feds-notes/closing-the-monetary-policy-curriculum-gap-20201023.html

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IOR - Interest on Reserves

RRP - Reverse Repurchase Agreement (Repo)

Discount Vs Federal Funds

Discount Rate

- The interest rate the Federal Reserve charges banks that are having trouble meeting their reserve requirements.

- usually higher than the federal funds rate, often by 1%.

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FFR

- Interest rate banks charge each other for overnight loans.

- Federal Open Market Committee (FOMC) sets a target for the federal funds rate, which it pursues by buying and selling U.S. Treasuries.

IOR vs RRP

IOR (earn)

- Interest paid on reserves that banks hold in their accounts at a Federal Reserve Bank.

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RRP (borrow)

- An overnight transaction in which the Federal Reserve sells a security to an eligible counterparty and simultaneously agrees to buy the security back the next day.

Fed Controls Nominal Interest Rate

Fed policy is stated in terms of interest rates

• The tool they use is the supply of money

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• Initial equilibrium at E
• Fed increases the money �supply to MS'
• New equilibrium at F
• Interest rated decrease to i'�to convince the market�to hold the new, larger�amount of money

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Money (M)

MD

MS

M

Nominal interest rate (i)

F

The effect of an increase in the money supply on the interest rate

1

M

2

E

2

MS

2

An increase

in the money

supply . . .

r

1

E

MS

1

MD

M

1

Quantity of money

​

Interest

rate, r

Setting the Federal Funds Rate

Pushing the Interest Rate Down to the Target Rate

The target federal funds rate is the Federal Reserve’s desired federal funds rate.

M

r

1

r

E

1

MS

1

MD

M

1

Quantity of money

​

Interest

rate, r

E

2

T

Setting the Federal Funds Rate

Pushing the Interest Rate Up to the Target Rate

M

1

r

1

E

1

E

MD

MS

1

Quantity of money

Interest

rate, r

2

MS

2

M

2

An open-market

sale . . .

r

T

. . . drives the interest rate up.

Changing money supply is changing the nominal interest rates

Another way to look at it

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To Decrease the Money Supply

To Increase the Money Supply

The Fed and the Economy

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Additional Controls over the Money Supply

• Open market operations are the main tool of money supply
• Fed offers lending facility to banks, called discount window lending
• If a bank needs reserves, it can borrow from the Fed at the discount rate
• The discount rate is the rate the Fed charges banks to borrow reserves
• Lending increases reserves and ultimately increases the money supply
• Changes in the discount rate signal tightening or loosening of the money supply

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Additional Controls over the Money Supply

• Money supply is determined by three things:�

Money Supply = Public Currency +

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​

• The Fed can affect the money supply by affecting any of these three things:
• Currency held by the public
• Bank reserves
• The desired reserve-deposit ratio
• Open-market operations can affect banking reserves

Bank Reserves

Reserve-Deposit Ratio

Additional Controls over the Money Supply

• The Fed can also change the reserve requirement for banks
• The reserve requirement is the minimum percentage of bank deposits that must be held in reserves
• The reserve requirement is rarely changed
• The Fed could increase the money supply by decreasing the reserve requirement
• Banks would have excess reserves to loan
• The Fed could decrease the money supply by increasing the reserve requirement

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Do Interest Rate Always Move Together

• Zero lower bound: a level, close to zero, below which the Fed cannot further reduce short-term interest rates
• Can’t go far below zero – would you pay someone to lend them money?
• The fed has some tools it can use in this case

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What do you do when you cannot drop rates anymore?

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Additional Controls over the Money Supply

Quantitative Easing (QE): The Fed buys financial assets, lowering the yield or return of those assets while increasing the money supply.

• Used to stimulate the economy by purchasing assets of longer maturity thereby lowering longer-term interest rates.
• Fed has purchased trillions worth of assets since 2008

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Forward Guidance: The Fed gives indications of its future policies so that markets will react.

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Interest on Excess Reserves: Even at an interest rate of zero, the Fed can offer interest on its reserves to give banks a reason to keep money at the Fed

12-55

2007 QE

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$4T in Quantitative Easing (QE)

• 2009 - QE1 - 1.5T
• 2010 - QE2 - 600B
• 2012 - QE3 - 1.6T (end 2014)

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Excess Reserves: The Norm since 2008

• Reserve requirements do not prevent banks from maintaining reserve-deposit ratios that are well above that minimum level.

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• Excess reserves - Bank reserves in excess of the reserve requirements set by the central bank.
• As a result, the money supply may not change even if the fed changes the supply of reserves

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• Since the Fed’s quantitative easing in August 2008, banks have maintained historically unprecedented excess reserves.

Planned Spending & Real Interest Rate

Planned aggregate expenditure has components that are affected by r

• Saving decisions of households
• More saving at higher real interest rates
• Higher saving means less consumption
• Investment by firms
• Higher interest rates mean less investment
• Investments are made if the cost of borrowing is less than the return on the investment

Both consumption and planned investment decrease when the interest rate increases, vice versa.

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60

Interest in the Keynesian Model – An Example

• Components of aggregate spending are

C = 640 + 0.8 (Y – T) – 400r

I^P = 250 – 600 r

G = 300

NX = 20

T = 250

• If r increases from 0.04 to 0.05 (that is, from 4% to 5%)
• Consumption decreases by 400 (0.01) = 4
• Planned investment decreases by 600 (0.01) = 6
• A one percentage point increase in r reduces planned spending by 10 – before the multiplier is considered

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Planned Aggregate Expenditure

PAE = C + I^P + G + NX

PAE = 640 + 0.8 (Y – 250) – 400r + 250 – 600r + 300 + 20

PAE = 1,010 – 1,000r + 0.8Y

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• In this example, planned aggregate expenditure depends on both the real interest rate and the level of output
• Equilibrium output can only be found once we know the value of r

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Planned Aggregate Expenditure

PAE = 1,010 – 1,000r + 0.8Y

• Suppose the real interest rate is 5%, or 0.05
• Planned aggregate expenditure becomes

PAE = 1,010 – 1,000 (0.05) + 0.8Y

PAE = 960 + 0.8Y

• Short-run equilibrium output is PAE = Y

Y = 960 + 0.8Y

0.2Y = 960

Y = $4,800

• The graphical solution is the same as before

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63

Monetary Policy for a Recessionary Gap

PAE = 1,010 – 1,000 r + 0.8 Y

• The real interest rate, r, is 5%
• Short-run equilibrium output is $4,800
• Potential output is $5,000
• Recessionary gap is $200
• Multiplier is 5
• Monetary policy can be used to increase PAE
• The first change in spending required is 200 / 5 = 40

1,000 (change in r) = 40

Change in r = 40 / 1,000 = 0.04

• The Fed should decrease the real interest rate to 1%

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The Fed Fights a Recession

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Output (Y)

Planned aggregate expenditure (PAE)

Y = PAE

A reduction in r shifts the expenditure line upward and closes the recessionary gap

Monetary Policy for an Expansionary Gap

PAE = 1,010 – 1,000r + 0.8Y

• The real interest rate, r, is 5%
• Short-run equilibrium output is $4,800
• Potential output is $4,600
• Expansionary gap is $200
• Multiplier is 5
• Monetary policy can be used to decrease PAE
• The first change in spending required is 200 / 5 = 40

1,000 (change in r) = 40

Change in r = 40 / 1,000 = 0.04

• The Fed should decrease the real interest rate to 9%

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Monetary Policy

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Recessionary Gap

Expansionary Gap

Expansionary and Contractionary Monetary Policy in the Income-Expenditure Model

Y

1

AE

1

Y

1

AE

1

Real GDP

Planned

aggregate

spending

Real GDP

Planned

aggregate

spending

(a) Expansionary Monetary Policy

(b) Contractionary Monetary Policy

45-degree line

45-degree line

Expansionary and Contractionary Monetary Policy

Monetary Policy and Aggregate Demand

AD

1

AD

1

AD

2

AD

3

Real GDP

Real GDP

Aggregate price level

(a) Expansionary Monetary Policy

(b) Contractionary Monetary Policy

Aggregate price level

Expansionary Monetary Policy to Fight a Recessionary Gap

Response to 2001 Recession

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The Fed’s Response to 9/11

• Economy began slowing in late 2000
• Terrorist attack led to contraction in travel, financial, and other industries
• The federal funds rate is the interest rate banks charge each other for overnight loans
• This interest rate is the one the Fed targets when changing the money supply
• In late 2000, the fed funds rate was 6.5%
• January, 2001, the Fed cut the rate to 6.0%
• More rate cuts followed
• July, 2001, the rate was less than 4%

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The Fed Response to 9/11

• After the 9/11 attacks
• Fed immediately worked to restore normal operation of the financial markets and institutions
• The Fed temporarily lowered the rate to 1.25% in the week following the attack
• In the aftermath, the Fed grew concerned that consumers would decrease spending
• Interest rate was 2.0% in November, 2001
• 4.5 percentage points lower than a year before
• Combination of tax cuts and aggressive monetary policy helped keep the 2001 recession shallow and short

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Fed Fights Inflation

• Expansionary gap can lead to inflation
• Planned spending is greater than normal output levels at the established prices
• Short-run unplanned decreases in inventories
• If gap persists, prices will increase
• The Fed attempts to close expansionary gaps
• Raise interest rates
• Decrease consumption and planned investment
• Decrease planned aggregate expenditure
• Decrease equilibrium output

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As a result, stock market and real estate market exploded

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Was the 2008 Recession like 2001? Or More like 1987?

Response to 2006 Expansion

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Interest Rates Increased in 2004 and 2006

• With slow recovery beginning in November, 2001, the Fed continued to decrease interest rates until it reached 1.0% in June 2003
• Real GDP growth was nearly 6% in the 2^nd half, 2003
• Growth was 4.4% in 2004
• Unemployment was 5.6% in June 2004
• Inflation increased in 2004, mainly due to oil prices
• Fed began tightening in June, 2004
• Fed funds rate increased from 1.0% to 1.25%
• Continued gradually raising the fed funds rate
• August, 2006, the rate was 5.25%

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The Fed Fights Inflation

80

Output (Y)

Planned aggregate expenditure (PAE)

Y = PAE

An increase in r shifts the expenditure line down and closes the expansionary gap

Inflation and the Stock Market

• Bad news about inflation causes stock prices to decrease
• Investors anticipate the Fed will increase interest rates
• Slows down economic activity, lowering firms' sales and perhaps profits
• Lower profits mean lower dividends which mean lower stock prices
• Higher interest rates make non-stock financial instruments more attractive
• Reduces the demand for stocks and the stock prices

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Fed and the Stock Market

• Fed gets credit for sustained economic growth and rising asset prices in the 1990s
• S&P 500 increased 233% between January 1995, and March 2000
• Stocks buoyed consumption; supported growth
• Possible stock speculation led to sharp decreases
• If the Fed had acted sooner, the run-up would have been curtailed and the crash moderated
• Greenspan's response is
• Separating speculation from growth is difficult
• The Fed could not have timed the stock market

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Monetary Policy and the Stock Market

• The Fed has limited ability to manage the stock market
• Fed does not know the "right" prices
• Information available to the Fed is publicly available
• Monetary policy is not well suited to addressing an asset bubble (a speculative increase in asset prices over their underlying market value)
• Fed can raise interest rates and slow the economy
• Could result in a recession and rising unemployment
• The debate over the Fed's role in asset prices got new attention after the mortgage meltdown on 2007 - 2008

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Initial Response to 2007 Recession

84

Mad money cramer

86

The Fed’s Policy Reaction Function

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88

An Example of a Fed Policy Reaction Function

Real interest rate set by Fed, r

Inflation, π

0.06

​

0.05

​

0.04

​

0.03

​

0.02

0 0.01 0.02 0.03 0.04

Fed’s policy reaction function

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Policymaking: Art or Science?

• Macroeconomic policy works best with
• Accurate knowledge of current economic conditions
• Knowledge of the future path of the economy without policy
• Precise value of potential output
• Good control of fiscal and monetary policies
• Knowledge of how and when the economy will respond to policy changes

Fed reverses course

• On August 7, 2007, the Federal Open Market Committee decided to stand pat, making no change in its interest rate policy. �
• On September 18, the Fed cut the target federal funds rate “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.”
• Given the increases in interest rates prior to 2007, this was a reversal of previous policy: previously, the Fed had generally been raising rates, not reducing them, out of concern that inflation might become a problem (more on that later in this chapter). �
• Starting in September 2007, fighting the financial crisis took priority.

The Fed Reverses Course

After rates are at zero?

What else can you do after rates are at zero and you cannot lower anymore?

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Only choice left:

Long Term Rates & Quantitative Easing

93

• Oct 2019 - $60B/month in overnight lending
• Mar 15, 2020 - Fed cut rates to zero, reserve requirement to zero, lowered discount rate by 1.5 points
• March 17, 2020 - Fed buying commercial paper and short term unsecured debt
• March 20, 2020 - Fed buying municipal debt
• March 23, 2020 - Fed unveils another $700B in asset purchases, $300B credit program (total $4T)
• March 26, 2020 - CARES Act - $2.2T congressional bill
• April 9, 2020 - Fed adds $2.3T lending program and to buy corporate bonds including high yield.

US Financial Response 2020

94

Stabilizing the Economy: The Role of the Fed

Money Demand

Money Supply

Interest Rates

Open-Market Ops.

Discount Window

Reserve Req’s

The Fed

Zero-Lower-Bound Strategies

Inflation

PAE

Y

Appendix

Monetary Policy in the Basic Keynesian Model

The Algebra of Monetary Policy

• The real interest rate affects consumption and planned investment

C = C + c(Y – T) – ar

I^p = I - br

• Then, since PAE = C + I^p + G+ NX,

PAE = C + c(Y – T) – ar + I – br + G + NX

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96

The Algebra of Monetary Policy

• Combine with Y = PAE and then solve to get

Y = (C + cT + I + G + NX – (a+b)r)

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1

1 - c