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## Chapter 11 Monetary Policy and the Fed

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**1. MONETARY POLICY IN THE UNITED STATES**Learning Objectives • Discuss the Fed’s primary and secondary goals and relate these goals to the legislation that created the Fed as well as to subsequent legislation that affects the Fed. • State and show graphically how expansionary and contractionary monetary policy can be used to close gaps.**1.1 The Goals of Monetary Policy**• The federal reserve act • The employment act of 1946 • The full employment and balanced growth act of 1978 • Federal reserve policy and goals**1.2 Monetary Policy and Macroeconomic Variables**• Policy responses given a recessionary gap. • If the economy is below potential output, the Fed might pursue an expansionary monetary policy, shifting the AD curve to the right to close the gap. • Policy responses given a inflationary gap. • If the economy is above potential output, the Fed might pursue a contractionary monetary policy, shifting the AD curve to the left to close the gap.**2.4 Effects of Changes in the Money Market: Expansionary**Monetary Policy There is a recessionary gap (YP-Y1) The Fed buys bonds… LRAS SRAS S1 P2b The gap is closed. P1 P1b AD2 AD1 D2 D1 Y1 YP Thus increasing the money supply The exchange rate falls. S2 S1 S1 r1 S2 E1 r2 E2 D2 D1 D1 M’ M**2.4 Effects of Changes in the Money Market: Contractionary**Monetary Policy There is an inflationary gap (Y1-YP) The Fed sells bonds… LRAS S1 S2 SRAS P1b P1 The gap is closed. P2b AD1 AD2 D1 Y1 YP Thus decreasing the money supply The exchange rate rises. S1 S2 S2 r1 S1 E2 r1 E1 D2 D1 D1 M’ M**2. PROBLEMS AND CONTROVERSIES OF MONETARY POLICY**Learning Objectives • Explain the three kinds of lags that can influence the effectiveness of monetary policy. • Indentify the macroeconomic targets at which the Fed can aim in managing the economy, and discuss the difficulties inherent in using each of them as a target. • Discuss how each of the following influences a central bank’s ability to achieve its desired macroeconomic outcomes: political pressures, the degree of impact on the economy (including the situation of a liquidity trap), and the rational expectations hypothesis.**2.1 Lags**• Recognition lag is the delay between the time a macroeconomic problem arises and the time at which policy makers become aware of it. • Implementation lag is the delay between the time at which a problem is recognized and the time at which a policy to deal with it is enacted. • Impact lag is the delay between the time a policy is enacted and the time that policy has its impact on the impact.**2.2 Choosing Targets**• Interest rates • Money growth rates • Price level or expected changes in the price level**2.3 Political Pressures**• The Fed is insulated from the political process • The degree of independence that central banks have around the world varies • The Fed was created by Congress. Its charter could be altered or even revoked**2.4 The Degree of Impact on the Economy**• A liquidity trap is a situation that exists when a change in monetary policy has no effect on interest rates. • Quantitative easing is a policy in which a bank convinces the public that it will keep interest rates very low by providing substantial reserves for as long as is necessary to avoid deflation. • Credit easing is a strategy that involves the extension of central bank lending to influence more broadly the proper functioning of credit markets and to improve liquidity.**A Liquidity Trap**A liquidity trap exists when a change in the money supply has no effect on the interest rate.**2.5 Rational Expectations**• The rational expectations hypothesis states that individuals form expectations about the future based on the information available to them, and they act on those expectations. LRAS SRAS2 SRAS1 P2 B P1 A AD2 AD1 YP**3. MONETARY POLICY AND THE EQUATION OF EXCHANGE**Learning Objectives • Explain the meaning of the equation of exchange, MV=PY, and tell why it must hold true. • Discuss the usefulness of the quantity theory of money in explaining the behavior of nominal GDP and inflation in the long run. • Discuss why the quantity theory of money is less useful in analyzing the short run.**3.1 The Equation of Exchange**• EQUATION 3.1 • Equation of exchange is the money supply (M) times its velocity (V) equals nominal GDP. • Velocity is the number of times the money supply is spent to obtain the goods and services that make up GDP during a particular time period. • EQUATION 3.2 • EQUATION 3.3 • EQUATION 3.4 • EQUATION 3.5**3.2 Money, Nominal GDP, and Price-Level Changes**EQUATION 3.6 Inflation, M2 Growth, and GDP Growth**3.2 Money, Nominal GDP, and Price-Level Changes**• EQUATION 3.7 • EQUATION 3.8 • EQUATION 3.9 • The quantity theory of money states that in the long run, the price level moves in proportion with changes in the money supply, at least for high inflation countries.**3.3 Why the Quantity Theory of Money is Less Useful in**Analyzing the Short Run The Velocity of M2, 1960-2007 EQUATION 3.10