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Hubbard Macro Sg 14

Hubbard Macro Sg 14

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Chapter14 (26)
Monetary Policy
Chapter Summary
In Chapter 13, you learned that banks play an important role in creating the money supply and in how the
Fed manages the money supply. In Chapter 14, you will learn about monetary policy, the actions the Fed
takes to manage the money supply and interest rates to pursue its macroeconomic policy objectives. The
Fed has set four monetary policy goals that are intended to promote a well-functioning economy:
1. Price stability
2. High employment
3. Economic growth
4. Stability of financial markets and institutions
The Fed’s monetary policy targets are economic variables that it can affect directly and that in turn affect
variables such as real GDP and the price level that are closely related to the Fed’s policy goals. The
Federal Open Market Committee announces a target for the federal funds rate after each meeting. The
federal funds rate is the interest rate banks charge each other for overnight loans.
To fight a recession, the Fed conducts expansionary monetary policy, which lowers interest rates to
increase consumption, investment, and net exports. To reduce the inflation rate, the Fed conducts
contractionary monetary policy, which raises interest rates to decrease consumption, investment, and
net exports. Over the past decade, many economists and central bankers have expressed significant
interest in using inflation targeting, under which monetary policy is conducted to commit the central
bank to achieving a publicly announced inflation target. A number of foreign central banks have adopted
inflation targeting, but the Fed has not.
Learning Objectives
When you finish this chapter, you should be able to:
1.Define monetary policy and describe the Federal Reserve’s monetary policy goals. Monetary
policy is the Federal Reserve’s use of changes in the money supply and interest rates to pursue its
policy objectives. The Fed has set four monetary policy goals that are intended to promote a well-
functioning economy: price stability, high employment, economic growth, and stability of financial
markets and institutions. The Fed’s monetary policy targets are economic variables that it can affect
directly. In turn, the targets affect variables such as real GDP and the price level that are closely
related to the Fed’s policy goals. The two main monetary policy targets are the money supply and the
interest rate. The Fed has most often chosen to use the interest rate as its monetary policy target. The
Federal Open Market Committee announces a target for the federal funds rate after each meeting.
The federal funds rate is the interest rate banks charge each other for overnight loans.
CHAPTER 14 (26)|Monetary Policy
392
2.Describe the Federal Reserve’s monetary policy targets and explain how expansionary and
contractionary monetary policies affect the interest rate. A macroeconomic policy that
successfully reduces the severity of the business cycle is called a countercyclical policy. To fight a
recession, the Fed conducts an expansionary policy by increasing the money supply. The increase in
the money supply lowers the interest rate. To reduce the inflation rate, the Fed conducts a
contractionary policy by increasing the money supply. The decrease in the money supply raises the
interest rate. In a graphical analysis of the money market, an expansionary policy shifts the money
supply curve to the right, causing a movement down the money demand curve, and a new equilibrium
at a lower interest rate. A contractionary policy shifts the money supply curve to the left, causing a
movement up the money demand curve, and a new equilibrium at a higher interest rate.
3.Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on
real GDP and the price level.An expansionary monetary policy lowers interest rates to increase
consumption, investment, and net exports. This increased spending causes the aggregate demand
curve (AD) to shift to the right more than it otherwise would, raising the level of real GDP and the
price level. A contractionary monetary policy raises interest rates in order to decrease consumption,
investment, and net exports. This decreased spending causes the aggregate demand curve to shift to
the right less than it otherwise would, reducing the level of real GDP and the price level.
4.Discuss the Fed’s setting of monetary policy targets. Some economists have argued that the Fed
should use the money supply as its monetary target, rather than an interest rate. Milton Friedman and
other monetarists argue that the Fed should adopt a monetary growth rule of increasing the money
supply every year at a fixed rate. Support for this proposal declined after 1980 because the
relationship between movements in the money supply and movements in real GDP and the price level
has weakened. John Taylor has analyzed the factors involved in Fed decision making and developed
the Taylor rule for federal funds targeting. The Taylor rule links the Fed’s target for the federal funds
rate to economic variables. Over the past decade, many economists and central bankers have
expressed significant interest in using inflation targeting. Under inflation targeting, monetary policy
is conducted so as to commit the central bank to achieving a publicly announced inflation target. A
number of foreign central banks have adopted inflation targeting, but the Fed has not. The Fed’s
performance in the 1980s, 1990s, and early 2000s has generally received high marks from
economists, even without formal inflation targeting.
5.Assess the arguments for and against the independence of the Federal Reserve. The Fed
conducts monetary policy without input from the Congress or the president. The Fed’s entire
operating budget is the interest it earns from purchasing U.S. Treasury bills. That means the Fed does
not depend on Congress for its operating funds. But the Fed’s independence is not absolute, because
Congress and the president can pass legislation at any time to reorganize (or even abolish) the Fed.
Advocates of Fed independence argue that isolating it from political pressure allows it to choose
policies in the best interest of the economy. Internationally, countries with more independent central
banks tend to have lower inflation rates. Opponents of Fed independence argue that concentrating so
much power in the hands of unelected officials is inconsistent with democratic principles.
CHAPTER 14 (26)|Monetary Policy393
Chapter Review
Chapter Opener: Monetary Policy, Toll Brothers, and the Housing Market (pages
466-467)
Usually, recessions hit the homebuilding industry very hard as new home sales fall due to increases in
unemployment and falling income. The recession of 2001 was very different. Residential construction
increased by 5 percent during this recession. The profits of Toll Brothers, a residential construction
company, increased to record levels. This unusual behavior was a direct result of the Fed’s decision in
early 2001 to begin to implement an expansionary monetary policy to keep the recession as short and
mild as possible. By lowering interest rates sharply, the Fed was able to head off what was predicted to be
a prolonged and severe recession. By 2005, however, the housing market had turned into a housing
“bubble.” Prices rose to levels that are not sustainable and then began to fall. With lower levels of
construction, Toll Brothers’ profits fell. Initially, the Fed did not lower interest rates because it believed
that doing so might make inflation worse. By late 2007, Toll Brothers and most other home builders were
suffering significant losses, and the Fed had begun to cut interest rates.
Helpful Study Hint
Read An Inside Look at the end of the chapter to learn the
macroeconomic effects of housing market slowdowns in the United
States and Europe. Although the prices of houses are increasing more
slowly in both economies, only the U.S. economy has slowed as a result
of this weakness. While home-equity loans are readily available to U.S.
homeowners, they are not readily available to euro-zone homeowners.
This is important because a home-equity loan allows a homeowner to
borrow against—and, in effect, spend—the difference between the value
of a home and the amount of the mortgage loan on the home. Therefore,
in an economy in which home equity loans are prevalent, consumption
spending may rise and fall with house prices; however, in an economy
where home equity loans are not prevalent, consumption spending may
not be much affected by changes in house prices. According to the
article, the weak housing market slowed consumption spending in the
United States, but had relatively little effect on consumption spending in
the euro-zone economy.
Imagine that you have graduated and are working full time.
You’ve built up enough money for a down payment on a house. Now,
imagine that the economy dips into a recession. Would you buy a house
during a recession? The Economics in YOUR Life! at the start of this
chapter poses this question. Keep the question in mind as you read the
chapter. The authors will answer the question at the end of the chapter.

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