Nov. 13 th, 2002ECON 1 – Section 20 – Page 1GSI: R. Estopina ECON 1 – Section 20 Stabilizing...

Nov. 13th, 2002 ECON 1 – Section 20 – GSI: R. Estopina

ECON 1 – Section 20Stabilizing Aggregate

Demand:The Role of the Fed

ECON 1 – Section 20 – GSI: R. EstopinaNov. 13th, 2002

Contact Details GSI: Ramon Estopina Office Hours: Thursday 1:45-3:45 PM Office: Evans 508-7 Email: [email protected] Handouts (only sections 104 & 133) after

class in: http://www.ocf.berkeley.edu/~jaychen/econ1/

Please read: Read before downloading!.


Section 20 Agenda Administrative Stuff (10

min) Recap Quiz (10 min) Example 26.4 (10 min) Problem 26.8 (10 min) Problem 26.9 (10 min) Re-cap (2 min)


Administrative Stuff

PS #4 due today !!! Leave them on the table.

Remember, no class next Monday!! -Midterm.

Review session probably Friday, check Econ-1 website.


Review of Last Lecture - 11/6th

Chapter 23 & 26: Federal Reserve (Fed) Federal Funds Rate (Federal Open Market

Committee) Discount Rate Buying/Selling Bonds (Open Market

Operations) Relationship between Price of Bonds and Interest rate Money D& S (equilibrium, shifts, stabilization by FED)

Keynesian Model Keynesian cross, AD as function of r FED fights inflation, FED fights recession

Taylor Rule


Recap Quiz - 1 The interest rate that commercial

banks charge each other for very short-term loans is called:

1)discount rate.

2)reserve rate.

3)real interest rate.

4)federal funds rate.

5)prime rate.


Recap Quiz - 2 When the real interest rate rises, which

of the following is true?

1)C and Ip spending rise.

2)C and Ip spending fall.

3)C rises while Ip spending falls.

4)C falls while Ip spending rises.

5)C falls while Ip spending is unchanged.


Recap Quiz - 3 To fight a recession, the Fed should do

which of the following?

1)Raise the real interest rate.

2)Lower the real interest rate.

3)Keep the real interest rate constant.

4)Allow the real interest rate to

fluctuate with the market.

5)Raise the nominal interest rate.


Recap Quiz - 4 The Taylor rule is a(n)

1) rule the Fed is required to follow regarding

monetary policy.

2) example of a policy reaction function.

3) rule that helps Congress coordinate fiscal policy

with monetary policy.

4) guideline for individuals in making their portfolio

allocation decisions.

5) "rule of thumb" for solving the basic Keynesian

model.


Recap Quiz - 5

An increase in the interest rate by the Fed, made with the intention of reducing an expansionary gap, is called

1)expansionary monetary policy.

2)monetary loosening.

3)contractionary fiscal policy.

4)expansionary fiscal policy.

5)contractionary monetary policy.


Review Question

You hear a news report that employment growth is lower than expected.

How do you expect that report to affect market interest rates?


Review Answer Slow employment growth is indicative

of a possible recessionary output gap. Typically the Fed responds to a

slowing of the economy by lowering the nominal interest rate.

A weaker economy also reduces the demand for money, which reduces the nominal interest rate.


Another Review Question

The Fed faces a recessionary gap. How would you expect it to respond?

How its policy change is likely to affect the economy?


Another Review Answer The Fed is likely to respond to a recessionary

gap with an expansionary monetary policy intended to stimulate aggregate demand.

The first step is an open-market purchase of government bonds, which puts additional money into circulation and lowers the nominal interest rate.

The lower interest rate stimulates aggregate demand (consumption and investment spending).

An increase in aggregate demand in turn raises short-run equilibrium output, as firms produce enough to meet the extra demand.


Important to remember: Equations of the day: The real interest affects consumption

ad planned investment.

br

arc

II

)T(YCCp

-

Where a, b >0 and measure the strength of the interest rate effect.


Important to remember (2) Combined with the equations we

know:

Composed of: Autonomous AD, effect of r & Induced AD

Y)(-)XNGIT-C(AD crbac

TT

XNNX

GG

NXGICAD p


Important to remember (3) In equilibrium Y = AD, so:

]-XNGIT-C[1

1Y b)r(ac

c

Y)(-)XNGIT-C(Y crbac

Vary scary, isn’t it?


Example 26.4 (F&B page 707)

In a certain economy, we have:

250TT

20XNNX

300GG

600-250I

400-T)0.8(Y640Cp

r

r

Where r is set by the Fed = 5% Solve for the short-run equilibrium.


Example 26.4 (Conclusion) We know the definition of Aggregate Demand is:

AD = C + Ip + G + NX Substituting the components:

AD = [640 + 0.8(Y-250)-400(0.05)] + [250-600(0.05)] +300+20

And finally:AD = 960 + 0.8Y

In addition, from the short term equilibrium: Y=AD So the previous equation will be:

Y = 960 + 0.8Y Solving for Y:

Y = 960 / 0.2 = 4,800


Problem 26.8 (F&B page 719)

For the following economy, find at what rate should the Fed set the real interest rate to eliminate any output gap.

40,000 *Y

8,000TT

-1,800XNNX

7,000GG

20,000r-8,000I

40,000r-T)0.5(Y14,400Cp


Problem 26.8 (cont’d) A) The relationship between aggregate

demand and output is given by:

Autonomous aggregate demand equals 23,600 the part of aggregate demand that does not depend on output nor on r.

rYAD

r

rYAD

NXGICAD p

000,605.0600,23

18007000000,208000

000,40)8000(5.0400,14


Problem 26.8 (cont’d) To find short-run equilibrium output, use

the equation Y=AD and solve for Y:

Potential output Y*=40,000. To find the real interest rate consistent with no output gap, we set Y=40,000 in the equation for short-run equilibrium output and solve for r.

rY

rYY

000,60600,235.0

000,605.0600,23


Problem 26.8 (cont’d)

So the real interest rate that eliminates any output gap is 6%.

06.0

3600000,60

000,60600,23)000,40(5.0

r

r

r

So we have:



With Y*=Y as found before, now G increases to 7,600.

What happens to the SR equilibrium if the Fed leaves r unchanged?

What should the Fed do to keep the economy at full employment?


Problem 26.8 (cont’d) Let’s solve for the new value of

short-run equilibrium output. Recall for this economy:

rYAD 000,605.0600,23

Now there is an increase in government purchases from 7000 to 7600 so autonomous AD raises by 600, from 23,600 to 24,200.



And r = 6%, consequently:

YAD

YAD

5.0600,20

)06.0(000,605.0200,24

Solving for output:

200,41

600,205.0

5.0600,20

Y

Y

YY

ADY


Problem 26.8 (cont’d) So if the Fed keeps the interest rate

at 6%, the increase in government purchases raises output above potential (an expansionary gap, remember Y*=40,000).

To keep the economy at full employment (and reduce inflation), the Fed has to offset the increase in government purchases with a higher real interest rate.



Remember the process for contractionary monetary policy: Fed Increases interest rates by

reducing money supply (selling bonds)…

This will reduce C and I… Then AD Decreases… …and Decrease GDP and employment.


Problem 26.8 (cont’d) To see how much the real interest

rate must rise, note that after the increase in government purchases aggregate demand is given by:

rYAD 000,605.0200,24 Solving for output:

rY

rYY

ADY

000,60200,245.0

000,605.0200,24


Problem 26.8 (cont’d) We want to know the value of r that sets

Y at its full-employment level of 40,000. To find that rate, we set Y=40,000 in the previous equation and solve for r:

07.0

200,4000,60

000,60200,24)000,40(5.0

r

r

r



So to keep the economy at full employment when government purchases increase, the Fed should raise the real interest rate from 6% to 7%.

The increase in r is consistent with the effects of an increased government deficit in the market for saving and investment (Chapter 22).


Problem 26.8 (Conclusion) In other words,

40,000

Expenditure line(r=6%)

Expenditure line(r=7%)

41,200


Problem 26.9 (F&B page 720)

Supposing the Fed follows the Taylor rule, find the real int. rate (r) and the nominal int. rate (i) that the Fed will set in each of the following situations:

A) Inflation or 4% and a expansionary gap equal to 1% of potential output.


Problem 26.9 (cont’d) Remember Taylor rule:

Fed sets r, so it decreases as relative income gap grows, and increases as inflation increases.

Fed’s goals: Y = Y* Low (inflation rate)

5.0*

*5.001.0

Y

YYr



Taylor rule is an example of a Policy reaction function.

It describes how the action a policymaker takes depends on the state of the economy

Ideally policymakers should try to react in such a way as to optimize economic performance



A) Inflation of 4% and a expansionary gap equal to 1% of potential output.

r i=r+

0.04 -0.010.03

50.075

4% -1% 3.5% 7.5%

*

)*(

Y

YY



B) Inflation of 2% and a recessionary gap equal to 2% of potential output.

r i=r+

0.02 0.02 0.01 0.03

2% 2% 1% 3%

*

)*(

Y

YY



C) Inflation of 6% and no output gap.

r i=r+

0.06 0 0.04 0.10

6% 0% 4% 10%

*

)*(

Y

YY


Problem 26.9 (Conclusion) D) Inflation of 2% and a recessionary

gap equal to 5% of potential output.

r i=r+0.02 0.05 -0.05 0.015

2% 5%-

0.5%1.5%

*

)*(

Y

YY

Can the Fed set a negative real interest rate? It’s possible for the Fed to set a negative r, by

setting the nominal rate below .


Problems for next sections !!!

For next section: Chapter 27: Problems 2, 4, 6 &

8. Remember: This is not

mandatory. It won’t be graded. Only for

those of you that need improvement in Exam grades.


Next class Next Class:

Section 21 – Wednesday, Nov 20th

No class next Monday. Midterm Exam. Due PS#4 !!!! If you want more practice, work on Next Sections

Problems (although you probably have enough). Read ch. 27. You can download handouts this afternoon. Thank you for coming on time !!!

Enjoy the long weekend & C-U Wednesday !!.

Nov. 13 th, 2002ECON 1 – Section 20 – Page 1GSI: R. Estopina ECON 1 – Section 20 Stabilizing...

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