Module 31 Monetary Policy & the Interest Rate

Module 31 Essential Questions

1. How does the Federal Reserve implement monetary policy, moving the interest rate to affect aggregate output? (GDP)

2. Why is monetary policy is the main tool for stabilizing the economy?

Monetary Policy and the Interest Rate: Targeting the Fed Funds Rate

How does the money market model explain how the Federal Reserve can use monetary policy to stabilize the economy in the short run? 1. Fed increases the money supplyWhen is this done: Most used Tool: Action: Result to Interest Rates:

2. Fed decreases the money supply:When is this done: Most used Tool: Action: Result to interest rates:

Usually the Fed adjusts the money supply to target a specific federal funds rate.

If the current federal funds rate is higher than the target, the Fed will i___________the money supply so that the rate falls to the target.

If the current federal funds rate is lower than the target, the Fed will d____________the money supply so that the rate rises to the target.

Monetary Policy & the Interest Rate: Targeting the Fed Funds Rate

How does the money market model explain how the Federal Reserve can use monetary policy to stabilize the economy in the short run? 1. Fed increases the money supplyWhen is this done: recessionMost used Tool: open market operation Action: buy Treasury bills from large commercial banksResult to Interest Rates: short-term interest rates will fall in the money market

2. Fed decreases the money supply:When is this done: recessionMost used Tool: open market operation Action: sell Treasury bills to large commercial banks.Result to interest rates: short-term interest rates to rise in the money market.

Usually the Fed adjusts the money supply to target a specific federal funds rate.

If the current federal funds rate is higher than the target, the Fed will increase the money supply so that the rate falls to the target.

If the current federal funds rate is lower than the target, the Fed will decrease the money supply so that the rate rises to the target.

Monetary Policy & the Interest Rate: Targeting the Fed Funds Rate

1. What happens to investment spending when interest rates fall? (draw a graph if you need to!)

2. What happens to consumption spending?

Since both investment spending and consumption spending are important components of aggregate demand, it would therefore make sense that when the interest rate f______, AD should r_____.

Expansionary Monetary Policy Review

1. What happens to investment spending when interest rates fall?Investment spending increases.

2. What happens to consumption spending?Some consumption spending increases when the interest rate falls. Examples: car/truck buying, college educations, real estate. Since both investment spending and consumption spending are important components of aggregate demand, it would therefore make sense that when the interest rate falls, AD should rise.

Expansionary Monetary Policy Review

The economy in a recessionary gap. What could the Fed do about this recession? Draw a graph to illustrate. Once the Fed has completed its monetary action, draw a graph to illustrate the effect on the economy & real GDP.  

Expansionary Monetary Policy chain of events1. The Fed observes that the economy is in a recessionary gap.2. The Fed increases the money supply.3. The interest rate falls.4. Investment and consumption increase.5. AD shifts to the right.6. Real GDP increases, unemployment rate decreases, the aggregate price level rises.

Graphing Expansionary Monetary Policy

Expansionary Monetary Policy

The EconomyThe Economy

The Money Market

The Money Market

The economy is in an inflationary gap. What could the Fed do about this inflation? Draw a graph to illustrate. Once the Fed has completed its monetary action, draw a graph to illustrate the effect on the economy & real GDP.

Contractionary Monetary Policy chain of events1. The Fed observes that the economy is in an inflationary gap.2. The Fed decreases the money supply.3. The interest rate rises.4. Investment and consumption decrease.5. AD shifts to the left.6. Real GDP decreases, unemployment rate increases, the aggregate price level falls.

Graphing Contractionary Monetary Policy

Contractionary Monetary Policy

The EconomyThe Economy

The Money Market

The Money Market

Module Review Questions p. 313

Read Module 32 p. 315 - 319