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## The Federal Reserve and Monetary Policy

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**The Federal Reserve and Monetary Policy**• The Demand for Money and the Quantity Equation • The quantity of money and the rate of interest • Reducing the interest rate increases investment, and therefore (with a multiplier effect) GDP. • The connections don’t always work perfectly in practice: • real/nominal rates and the Fisher effect • short term (Federal Funds) and long term (AAA and BAA bonds) • importance of expectations for investment decisions • Potential conflicting goals: GDP gap and inflation • The Taylor Rule and the Fed’s policy reaction function.**The Quantity Equation and the Demand for Money**• MV = PY(money * velocity = GDPDEF * GDP) • Interest rates are the opportunity cost of holding money; so people will hold LESS money at HIGHER interest rates. • This means that velocity will INCREASE at higher interest rates -- money will change hands more rapidly. • Let V = 0.5 R for a numeric example; the result is: • Md = 2 PY / R, and since M.demand = M.supply, • Fed can change the money supply to set a target interest rate: R = 2 PY / Ms**Fed control of interest rates**• The Federal Reserve: • TARGETS the Federal Funds rate (overnight bank loans) • OPERATES in the Treasury Bill market • Controls both those rates CLOSELY. • However, those rates are SHORT TERM, SAFE, NOMINAL interest rates, and more important for the level of investment are: • LONG TERM, RISKY, REAL rates -- • the rates on corporate bonds such as Moody’s AAA or BAA bonds adjusted for inflation**Fed Funds Rate and**Treasury Bill (6 month) rate**The Federal Reserve influences, but does not control, real**long term interest rates (example: BAA bonds) The time series graph shows several cases in which the Fed cut short-run rates without much immediate response by long-run interest rates. Note: 1972.1 and 1977.1 and 1993.4 and 2001.3 -- the Fed cut rates to fight recessions, and real BAA rates did NOT follow. The scatterplot shows low real rates in the 1970s despite high Federal Funds rates; and high real rates in the 1980s despite cuts in the Federal Funds rates.**Investment is influenced by, but NOT determined by, real**long term interest rate. • The next scatterplot shows investment as a percentage of GDP against real, long term interest rates. • Note especially: • In normal times, the interest rate does influence investment: see the late 70s and early 80s data points, during reasonably stable economic times. • When expectations of future profit turn down, the investment relation shifts back: note the data points for 1982 and 1983, when despite lower interest rates, investment fell sharply -- as the economy moved into a recession, businesses refused to invest whatever the interest rate.**Investment as a share of GDP and interest rates: not an**unchanging relationship.**The Fisher Effect: the Dilemma of Monetary Policy**• Real rates = nominal rates - inflation • To preserve the value of interest payments, lenders will tend to set nominal rates = real rate + inflation • The Fed lowers interest rates by expanding the money supply. • But the long run effect of continuing to expand the money supply will be inflation. • And inflation leads to higher interest rates • The Fisher relation is loose enough to permit temporary impact of monetary policy, but it is there in the long run.**Two policy targets, one policy instrument**• Target # 1 = GDP gap -- output below potential leads to unemployment; which Fed would like to counter • Target # 2 = inflation -- reduction of inflation is also a desirable policy goal. • Policy instrument -- change in the Federal Funds rate. Cutting the Fed Funds rate might stimulate investment, but it might also increase inflation • Taylor Rule (John B. Taylor) describes the Fed’s reaction function R = 1.0 - 0.5 YGAP + 0.5 INFL • R = Real rate of interest • YGAP = (Potential GDP - Actual GDP) / Potential GDP given a positive (recessionary) YGAP, cut interest rates. • INFL = Inflation rate. As inflation increases, increase real rate of interest.