Definitions and terminology

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1 I love the Case & Fai textbook but it is out of date with how monetay policy woks today. Please use this handout to supplement the chapte on monetay policy. The textbook assumes that the Fedeal Reseve (Fed) uses a money supply taget. A money supply taget model is appopiate in the 1960s though 1980s, but cuent monetay policy uses an inteest ate taget. The handout will compae and contast the diffeences and similaities between a money supply taget and inteest ate taget. Definitions and teminology What ae you talking about when you say money supply taget and inteest ate taget? I am efeing to the goals of the Fed s monetay policy tools. Recall that the Fed has thee tools to change its monetay policy: 1. Change the equied eseve equiement atio 2. Change the discount ate 3. Change the fedeal funds ate (though the buying and selling of bonds) A money supply taget means that the Fed uses its tools in ode to each a cetain money supply level in the economy. An inteest ate taget means that the Fed uses its tools in ode to each a cetain inteest ate in the economy. The Fed aely changes the eseve equiement atio and discount ate. Hence, fo the puposes of this handout, we ae only concened about the buying the selling of bonds (i.e. Fedeal Open aket Tansactions). Shift fom oney Supply Taget to Inteest Rate Taget Why did the Fed switch fom tageting the money supply to tageting the inteest ate? If we assume that the Fed has complete contol ove the money supply, then the equilibium inteest ate is detemined by the money maket (whee money demand = money supply). s Page 1 of 7

2 Lets petend that the Fed changes its money supply taget fom $9 tillion to $9.5 tillion. Hence the Fed will buy bonds and expand the money supply until the money supply eaches $9.5 tillion. This is a money supply taget: the Fed uses its tools to each a cetain level of money in the economy. s s2 2 The equilibium inteest ate falls when the Fed expands its money supply taget. An incease in the money supply aimed at inceasing aggegate output (Y) is called expansionay monetay policy. The Fedeal Open aket Committee (FOC) basically buys bonds which aises the pice of bonds and expands the money supply which esults in a lowe ate of etun on bonds and lowe inteest ates. But the Fed ealized that a money supply taget is difficult and costly to maintain in a wold with high financial integation. In othe wods, the Fed began to lose contol of the money supply as financial integation inceased. If the Fed wanted to maintain a money taget today, then it would have to pesistently monito and intevene in the bond makets to fix the money supply at the taget level. Hence the Fed switched to an inteest ate taget. Inteest Rate Taget and oney aket If the Fed s inteest ate taget is at, then the money maket would look like the following: Even though I did not daw in a vetical money supply cuve, it is still thee. But since the Fed is using an inteest ate taget, then we ae not concened about the position of s because the Fed will use its tools to maintain the inteest ate at the taget inteest ate (). Page 2 of 7

3 Lets assume that the Fed lowe its inteest ate taget fom to 1. The money maket gaph would show the hoizontal line shift down fom to 1. 1 FOC buys bonds which aises the pice of bonds which lowes the ate of etun of bonds which lowes the inteest ate. Remembe that the inteest ate effects of monetay policy do NOT change between a money supply taget and inteest ate taget. The FOC is still expanding s when it buys bonds. Gaphically speaking, the diffeence between a money supply taget and an inteest ate taget is the hoizontal lines (inteest ate taget) and the vetical lines (money supply taget). Conceptually speaking, thee is a BIG diffeence between a money supply taget and an inteest ate taget. Hee ae the two big diffeences: 1. The closed-economy govenment spending multiplie is smalle than (1/(1-mpc)) if the Fed maintains a money supply taget. Because when G goes up, PAE goes up, Y goes up due to the multiplie effect. But when Y goes up, goes up because the economy demands moe money to spend thei additional income, when goes up, then goes up. A highe inteest ate educes investment spending and educes PAE and educes Y. We call this the cowding-out effect. Hence Y inceases by LESS THAN the incease in G times the multiplie. 2. The Fed destoys the cowding-out effect (in the shot-un) by using an inteest ate taget. The closed-economy govenment spending multiplie is (1/(1-mpc)) if the Fed maintains an inteest ate taget. Because when G goes up, PAE goes up, Y goes up due to the multiplie effect. But when Y goes up, goes up because the economy demands moe money to spend thei additional income, LUCKILY the Fed expands s such that is UNCHANGED! Hence Y inceases by the incease in G times the multiplie. Bond akets The most-used tool to affect the inteest ate and/o change the money supply is open maket tansaction (i.e. the buying and selling of bonds). The buying and selling of bonds always have the same effects on money supply and inteest ates. Hence, you will almost always answe questions about the bond makets using the same logic and gaphs whethe o not the Fed uses a money supply taget o inteest ate taget. FOC Action Bond Pice Effects oney Supply Effects Inteest Rate Effects Y Effects Buy bonds Incease Incease Decease Incease Sell bonds Decease Decease Incease Decease Page 3 of 7

4 Thee is an invese elationship between the pice of bonds and the ate of etun on bonds. Rate of Retun on Bonds = (Face Value Pice) / Pice Hence, you can see the invese elationship between the ate of etun on bonds and the pice of bonds. Remembe that the elationship still holds if you sell the bond befoe matuity! Thee is a diect elationship between the ate of etun on bonds and the inteest ate. Lets look at why thee is a diect elationship between the ate of etun on bonds and the inteest ate. The inteest ate is the cost of boowing. A bond is an IOU. The bond issue is basically boowing money fom the bondholde. Hence the ate of etun on bonds is diectly coelated with the cost of boowing. Remembe that the inteest ate does NOT equal the ate of etun on bonds due to diffeent isks and matuities on diffeent bonds and debts (this is moe a finance concept). If the Fed buys bonds, then the bond maket looks like: Pb S P2 P1 D2 D Q If the Fed sells bonds, then the bond maket looks like: Pb S P1 S2 P2 D Q Page 4 of 7

5 Bonus Quiz 1. The economy is in die despai due to high unemployment. Congess aises govenment spending in ode to stimulate the economy. Assume the Fed maintains a money supply taget. Daw the Keynesian-coss model showing the effects of the initial suge in govenment spending with a subscipt 1. Show the cowding-out effects with a subscipt The economy is in die despai due to high unemployment. Congess aises govenment spending in ode to stimulate the economy. Assume the Fed maintains a money supply taget. Daw the money maket model showing the effects of expansionay fiscal policy on inteest ates. Label subscipt 0 fo befoe the fiscal policy, and subscipt 1 fo afte the fiscal policy. Explain the elationship between output and inteest ates. 3. The economy is in die despai due to high unemployment. Congess efuses to do anything. The Fed intevenes. Assume the Fed maintains a money supply taget. Daw the money maket model showing the effects of an expansionay monetay policy. Label subscipt 0 fo befoe the monetay policy, and subscipt 1 fo afte the monetay policy. Page 5 of 7

6 4. The economy is in die despai due to high unemployment. Congess aises govenment spending in ode to stimulate the economy. Assume the Fed maintains an inteest ate taget. Daw the Keynesian-coss model showing the effects of the initial suge in govenment spending with a subscipt 1. Show the cowding-out effects with a subscipt The economy is in die despai due to high unemployment. Congess aises govenment spending in ode to stimulate the economy. Assume the Fed maintains an inteest ate taget. Daw the money maket model showing the effects of expansionay fiscal policy on inteest ates. Label subscipt 0 fo befoe the fiscal policy, and subscipt 1 fo afte the fiscal policy. Explain the elationship between output and inteest ates. 6. The economy is in a die despai due to high unemployment. You ae hied as Alan Geenspan s chief adviso. Advise Alan on what he should do to educe unemployment. Explain you poposal with a bond maket gaph AND Keynesian-coss model. Page 6 of 7

7 7. Explain why the closed-economy govenment spending multiplie is SALLER with a money supply taget than inteest ate taget. 8. The economy is gowing out of contol, and the unemployment ate is TOO LOW. You ae hied as Alan Geenspan s chief adviso. Advise Alan on what he should do. Explain you poposal with a bond maket gaph AND Keynesian-coss model. Page 7 of 7

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