The Fed has four main monetary policy goals that
are intended to promote a well-functioning economy
1. Price stability
2. High employment
3. Stability of financial markets and institutions
4. Economic growth
Two Main Monetary Policy Targets
Money Supply and Interest Rate
Loanable Funds Model Measures
Long-term real interest Rate
Money Market
Short Term Nominal Interest Rate
Federal Funds Rate
Interest rate banks charge each other for
overnight loans
-determined by the supply of reserves relative to the demand for them
Changes in Interest Rates affect (3) components of AD
- consumption
- investment
- net exports
Expansionary Monetary Policy
The Fed increases the money supply and decreases
interest rates to increase real GDP.
Contractionary Monetary Policy
The Fed decreases the money supply to increase
interest rates to reduce inflation.
Monetarists
economists have argued that rather than use an
interest rate as its monetary policy target, the Fed should
use the money supply.
The Taylor Rule
A rule developed by John Taylor that links the Fed's target for the federal funds rate to economic variables
Inflation Targeting
Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation
PCE
Personal Consumption Expenditure Price Index
similar to GDP deflator except it includes only the prices of goods from the consumption category of GDP
The fed can increase or decrease supply of bank reserves through......
open market operations
**Changes in interest rates do not effect...... but will effect ...(3)
will not effect: (G) gov. purchases
will effect: Consumption, investment, net exports
Relationship b/t Treasury bill prices and Their Interest Rates formula
I/R (return on investment) = [(face value - price) / price]
Fiscal Policy
Changes in Federal TAXES and purchases that are intended to achieve macroeconomic policy objectives
Monetary Policy
The actions the Federal Reserve takes to mange INTEREST RATES to pursue its economic objectives
**When the economy is in recession (increases/decreases) in gov purchases or (increases/decreases) in taxes will increase aggregate demand
increases, decreases
Expansionary Fiscal Policy
increasing gov. purchases or decreasing taxes. Increase in gov. purchases will increase AD directly, cut in taxes will increase AD indirectly (b/c increases consumption spending)
Contractionary Fiscal Policy
decreasing gov. purchases or increasing taxes. Used to reduce increases in AD that seem likely to lead to inflation.
Multiplier Effect
Series of induced increases in consumption spending that result from an initial increase in autonomous expenditures (AE)
Federal gov. purchases
receives good in return
Fed gov. Expenditures
purchases + all other federal spending (interest on debt, grants to local govs, transfer payments)
Government purchases multiplier & formula
Ratio of change..
Gov. purchases multiplier = (change in equilibrium real GDP/ Change in gov. purchases)
Tax multiplier & formula
Cutting taxes increases the disposable income of households and consumption spending
- negative number b/c changes in taxes and changes in real GDP move in opp. directions
[tax multiplier = (change in equilibrium real GDP/ Change in taxes)]
**The actual change in real GDP resulting from increase in gov. purchases or cut in taxes will....
be LESS than indicated by the simple multiplier effect with a constant P level
Crowding out
A decline in private expenditures as a result of an increase in government purchases. The greater the sensitivity of consumption, investment and net exports to changes in IR, the more crowding out will occur.
Budget Deficit
government's expenditures are greater than its tax revenue
Budget Surplus
government's expenditures are less than its tax revenue
Deficits occur automatically during recessions because (2)
1. During recession, wages, profits and gov. tax revenues fall
2. The government automatically increases spending on transfer payments when the economy moves into recession
Tax Wedge
The difference between the pretax and post-tax return to an economic activity
applies to marginal tax rate (the fraction of each additional dollar of income that must be paid in taxes)
**Reducing the marginal tax rates on INDIVIDUAL INCOMES will...
Reduce the tax wedge faced by workers, thereby increasing the quantity of labor supplied
** Cutting MARGINAL CORPORATE INCOME TAX RATE would...
Encourage investment spending by increase in the return corp.s receive from new investments in equip., factories and office buildings
** lowering the tax rates on DIVIDENDS AND CAPITAL GAINS
Increase the supply of loanable funds from household to firms, increasing saving and investment and lowering equilibrium real IR
Automatic Stabilizers
Gov. spending and taxes that automatically increase or decrease along with the business cycle.
(ex. Tax revenue, unemployment benefits)
A cut in tax rates affects equilibrium real GDP through two channels:
(1) A cut in tax rates increases the disposable
income of households (consumption spending increases)
(2) A cut in tax rates increases the size of the
multiplier effect
Security
Fungible, negotiable instrument representing financial value. Broadly categorized into debt securities (banknotes, bonds), equity securities ( common stocks), and derivative contracts
Treasury Bills
Mature in 1 year or less, sold at discount of the par value to create positive yield to maturity. (least risky investment)
Treasury Notes
Mature 2-10 years, coupon payment every 6 months, issued with maturity dates
Treasury Bonds
longest maturity, 20-30 years. Coupon payment every 6 years, issued with maturity of 30 years.