Chapter 19: Monetary Policy and. the Federal . Describe the structure and responsibilities of the. Federal Reserve . Analyze how changes in real interest rates. affect planned aggregate expenditure and. short-run equilibrium . Show how the demand for money and the. supply of money interact to determine the. equilibrium nominal interest . Discuss how the Fed uses its ability to control. the money supply to influence nominal and real. interest rates. McGrawHill/Irwin Copyright © 2011 by The McGrawHill Companies, Inc. All rights reserved. The Federal Reserve.• Responsibilities of the Federal Reserve:. – Conduct monetary policy. – Oversee and regulate financial markets. • Central to solving financial crises.• The Federal Reserve System began operations. in 1914 The Federal Reserve Organization.• 12 Federal Reserve Bank districts.• Leadership is provided by the Board of Governors.• The Federal Open Market Committee (FOMC) reviews. economic conditions and sets monetary policy 192 Stabilizing Financial Markets. • Motivation for creating the Fed was to stabilize the. financial markets and the economy. • Banking panics occurred when customers believe one. or more banks might be bankrupt. • Fed prevents bank panics by. – Supervising and regulating banks. – Loaning banks funds if needed Targeting Interest Rates: Real or Nominal.• Fed controls the money supply to control the nominal. interest rate, i. – Investment and saving decisions are based on the real interest. rate, r. • Fed has some control over the real interest rate. r=i-. where is the rate of inflation 193Role of the Federal Funds Rate.• The federal funds rate is the rate commercial. banks charge each other on short-term (usually. overnight) loans. – Banks borrow from each other if they have. insufficient funds. – Market determined rate. – Targeted by the Fed.• To decrease the federal funds rate the Fed. conducts open market purchases. – Reserves increase.• Interest rates tend to move together. 194 Planned Spending and Real. Interest Rate.• Planned aggregate expenditure has components. that are affected by r. – Saving decisions of households. • More saving at higher real interest rates. • Higher saving means less consumption. – Investment by firms. • Higher interest rates mean less investment. – Investments are made if the cost of borrowing is less. than the return on the investment.• Both consumption and planned investment. decrease when the interest rate increases. 195 Fed Fights Inflation.• Expansionary gap can lead to inflation. – Planned spending is greater than normal output. levels at the established prices. – Short-run unplanned decreases in inventories. – If gap persists, prices will increase.• The Fed attempts to close expansionary gaps. – Raise interest rates. – Decrease consumption and planned investment. – Decrease planned aggregate expenditure. – Decrease equilibrium output. 196 Inflation and the Stock Market.• Bad news about inflation causes stock prices to. decrease.• Investors anticipate the Fed will increase interest. rates. – Slows down economic activity, lowering firms sales. and perhaps profits. • Lower profits mean lower dividends which mean. lower stock prices. – Higher interest rates make non-stock financial. instruments more attractive. • Reduces the demand for stocks and the stock prices. 197 Monetary Policy and the Stock. Market.• The F
