lectures in macroeconomics- charles w. upton can the federal reserve system set interest rates?
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Lectures in Macroeconomics- Charles W. Upton
Can The Federal Reserve System set interest rates?
Y
M
Po
ror1
P1
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Can the Federal Reserve System Set Interest Rates
Newspapers and Interest Rates
• The FOMC meets, and makes a decision about monetary policy.
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Can the Federal Reserve System Set Interest Rates
Setting Interest Rates
• The FOMC meets, and makes a decision about monetary policy.
Fed Cuts Interest Rates!
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Can the Federal Reserve System Set Interest Rates
Interest Rate Management
• The Economy is humming along nicely, but not nicely enough that someone doesn’t want lower interest rates.
• Can it be done?
Y
M
Po
ro
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Can the Federal Reserve System Set Interest Rates
Increase the Money Supply!
• Y curve shifts up and to the right
• M curve shifts up and to the left.
• P up; r falls. Y
M
Po
ror1
P1
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Can the Federal Reserve System Set Interest Rates
The Newspaper Headline
• Y curve shifts up and to the right
• M curve shifts up and to the left.
• P up; r falls. Y
M
Po
ror1
P1Fed Cuts Interest Rates!
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Can the Federal Reserve System Set Interest Rates
Not so fast!
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Can the Federal Reserve System Set Interest Rates
Orders to New York
• FOMC sets a target for r, say r1.
• New York Trading Desk then increases the money supply enough to reach r1
Y
M
Po
ror1
P1
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Can the Federal Reserve System Set Interest Rates
Orders to New York
• FOMC sets a target for r, say r1.
• New York Trading Desk then increases the money supply enough to reach r1
Y
M
Po
ror1
P1
Note: the FOMC sets a target for a nominal rate.
Holding expected inflation constant, we
can translate that into a target for the real rate.
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Can the Federal Reserve System Set Interest Rates
What does this mean?
• FOMC sets a target for r, say r1.
• New York Trading Desk then increases the money supply enough to reach r1
Y
M
Po
ror1
P1
In our terms:
The Federal Reserve System is changing the money supply,
but they target an interest rate – a nominal interest rate
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Can the Federal Reserve System Set Interest Rates
Does this Mean they Set r?
• FOMC sets a target for r, say r1.
• New York Trading Desk then increases the money supply enough to reach r1
Y
M
Po
ror1
P1
Not Exactly
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Can the Federal Reserve System Set Interest Rates
Permanent Effects
• The Quantity Theory works.
• In time, we move to 2Po and no change in r.
Y
M
Po
ro
2Po
Recall this slide
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Can the Federal Reserve System Set Interest Rates
Continually Increasing M
• Suppose the Federal Reserve System keeps increasing the Money Supply to keep r at r1.
Y
M
Po
ror1
P1
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Can the Federal Reserve System Set Interest Rates
Lincoln’s Law
eRN rr
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Can the Federal Reserve System Set Interest Rates
Lincoln’s Law
eRN rr
Continuing to increase the money supply is inflationary and that will boost expected
inflation!
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Can the Federal Reserve System Set Interest Rates
In for a dime, in for a dollar…
eRN rr
If e is going up, and the FOMC wants to keep rN
constant, they must reduce rR.
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Can the Federal Reserve System Set Interest Rates
Continually Increasing M
• If inflationary expectations rise by e, the target real interest rate is reduced by e.
• More money is required
Y
M
Po
ror1
P1
e
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Can the Federal Reserve System Set Interest Rates
Lincoln’s Law
eRN rr
Round 2!
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Can the Federal Reserve System Set Interest Rates
Lincoln’s Law
eRN rr
When the government tries to cut interest rates,
it may end up raising them.
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Can the Federal Reserve System Set Interest Rates
The Late 1970’s
• High– Interest rates– Inflation rate– Rate of growth of money supply
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Can the Federal Reserve System Set Interest Rates
The Late 1970’s
• High– Interest rates– Inflation rate– Rate of growth of money
supply
• Paul Volker’s solution– Cut rate of growth of money
supply
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Can the Federal Reserve System Set Interest Rates
Cut the Money Supply!
• This is a 100% recycled graph.
Y
M
Po
ror1
P1
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Can the Federal Reserve System Set Interest Rates
Cut the Money Supply!
• This is a 100% recycled graph.
Y
M
Po
ror1
P1eRN rr
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Can the Federal Reserve System Set Interest Rates
The Problem
• Volker had no credibility• For a while,
e >
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Can the Federal Reserve System Set Interest Rates
The Impact
• Volker had no credibility
• For a while, e >
U
-e
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Can the Federal Reserve System Set Interest Rates
Conclusion
• In the Short run, increases (decreases )in the money supply can cut (increase) interest rates.
• Any effect is temporary.
• And don’t forget about changing inflationary expectations.
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Can the Federal Reserve System Set Interest Rates
Conclusion
• In the Short run, increases (decreases )in the money supply can cut (increase) interest rates.
• Any effect is temporary.
• And don’t forget about changing inflationary expectations.
Back to the demand and
supply of loans!
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Can the Federal Reserve System Set Interest Rates
End
©2003 Charles W. Upton. All rights reserved