16 Domestic and International Dimensions

Key factors that influence the institutions were typically less than $45 billion.

By the time affect equilibrium real GDP and the price level in the short run, you will understand the equation of exchange.

The Fed confronted in selecting this target.

These weren't the highest daily inflation rates in recorded history.

In the summer of 1946, the rate of inflation in Hungary was 195 percent.

One of the objectives of this chapter is to answer this question.

Let's look at how people determine the amount of money they want to hold.

The Federal Reserve's open market operations can increase or decrease money supply.

We focused on the effects of the Fed's actions on the banking system.
In this chapter, we look at how Fed monetary policy actions have an impact on the economy by influencing market interest rates.
You need to understand the factors that determine how much money people want to hold.

There is a flow of transactions.

We buy and sell everything.

One needs to hold money.

People don't want to hold money just to look at pictures of past leaders.

They hold it so that it can be used to purchase goods and services.

Money stock, money Individuals and firms could try to do without non-interest-bearing money balances.

Without a ready supply of money balances, life is inconvenient.

The public has a demand for money.

Money can be used to purchase goods and services, which is the main reason people hold money.

People are paid at specific intervals, but they want to make purchases more or less frequently.
People find it beneficial to hold money so that they don't have to buy goods and services on a regular basis.

They forgo interest earnings in order to avoid the hassle of cashing in nonmoney assets whenever they want to buy something.

People will want to hold more money as GDP increases.

The level will change as more transactions are made.

People hold money for emergencies.

The higher the rate of interest, the lower the precautionary money balances are.

Money serves as a store of value.

Money balances can be held as a store of value or as interest-earning assets.

The interest on other assets such as corporate bonds and earnings forgone is a disadvantage of holding money balances as an asset.

The amount of money that can be held as stocks is decided by each individual or business.

The higher the interest rate, the lower the money balances people will want to hold as assets.

The higher the money balances people want to hold as assets, the lower the interest rate is.

For simplicity's sake, assume that the amount of money demanded is proportional to income.

The opportunity cost of holding money determines the precautionary and asset demands for money.
We can graph the relationship between the interest rate and the amount of money demanded if we assume that the interest rate is the cost of holding money balances.

The horizontal axis shows the amount of money demanded, while the vertical axis shows the interest rate.

The cost of holding money is the rate of interest.
A lower quantity of money is demanded when the interest rate is higher.

Imagine two scenarios to see this.

If you put your funds into purchases of U.S. government securities, you can earn 20 percent a year.
If you put your funds into purchases of U.S. government securities, you can earn 1 percent.
If you have $1,000 average cash balances in a non-interest-bearing checking account, in the second scenario over a one-year period, your opportunity cost would be 1 percent of $1,000, or $10.
In the first scenario, the opportunity cost is 20 percent of $1,000.

The answers can be found on page 369.

People have to hold money.

The cost of holding money is related to the money balances.

The demand for money balances is determined by balances demanded and the interest rate slopes it.

The Fed wants to influence investment, consumption, and total aggregate expenditures when it takes actions that alter the rate of growth of the money supply.

In taking monetary policy actions, the Fed has four tools at its disposal: open market operations, changes in the reserve ratio, changes in the interest rates paid on reserves, and discount rate changes.
Chapter 15 introduces the first three tools.
The discount rate will be discussed later in the chapter.
The effects of open market operations are something the Fed uses on a daily basis.

The amount of reserves in the Federal Reserve's current policy banking system is changed by the Fed's purchases and sales of government bonds in the U.S.

In order to understand how the Fed's actions affect the market, we need to start with an equilibrium in which all individuals, including the holders of the most recent date, are included.

There is an equilibrium level of bond prices and interest rates.

If the Fed wants to conduct open market operations, it needs to convince individuals, businesses, and foreign residents to hold fewer U.S. Treasury bonds.
Making people better off is the form of the inducement.
If the Fed wants to buy bonds, it will have to offer a higher price than is currently available in the marketplace.
If the Fed wants to sell bonds, it will have to offer them at a lower price than in the marketplace.
An open market operation can change the price of bonds.

The bonds the Fed sells are in its portfolio.

The supply of bonds is shown as a vertical line.

There is a downward sloping demand for bonds.

The Fed has more bonds for sale.

To clear the market.

Private investors hold quantity of bonds in the private marketplace.

To get people to give up these bonds, the Fed needs to offer them a more attractive price.

The rate of interest is related to the price of bonds.

The average yield on bonds is 5 percent.
You buy a bond.
A local corporation will pay you $50 a year for the rest of your life.
$50 divided by $1,000 equals 5 percent, which is as good as the best return you can get elsewhere.
The bond is purchased by you.
You can get bonds that have an effective yield of 10 percent if there is an event in the economy in the next year.

If you try to sell the bond for $1,000, no investors will buy it from you.

No buyers will be forthcoming unless you offer your bond for sale at a price that is no higher than $500.
The market value of your existing bond has fallen because of an increase in the interest rate.

The Fed is able to influence the interest rate by engaging in open market operations because of the inverse relationship between the price of existing bonds and the interest rate.

An increase in the interest rate is caused by a Fed open market sale.
A decrease in the interest rate is caused by a Fed open market purchase.

The answers can be found on page 369.

When the Fed sells bonds, it must offer them at an open market sale.

To understand how monetary policy works in its simplest form, we are going to run an experiment in which you increase the money supply directly.

The government has given you hundreds of millions of dollars.
You fly around the country in a helicopter, dropping money out of the window.
People put it in their pockets.
Some people deposit money into their accounts.
They now have too much money, not because they want to throw it away, but because they own other assets.
There are many ways to dispose of new money.

People with excess money balances can spend it on goods and services.

There is a direct impact on demand here.
People want to purchase more output of real goods and services when the money supply increases.

Some people won't spend the money on goods and services.

Some people may want to put some of their excess money in the bank.

The recipient banks have more reserves than they want to hold.
Banks can lend out excess reserves if they want to get higher-earning assets.
Banks can't force people to borrow more money if they have to pay higher interest rates on loans.
The lower interest rate encourages people to take out loans.
Businesses will invest with the funds that are lent.

Individuals will purchase more durable goods such as housing, autos, and home entertainment centers.

The increase in loans causes a rise in demand.
Even those who didn't pick up any of the money that was dropped out of your helicopter will be involved in more spending.

In this situation, the economy is operating at less than full employment.

The Fed increases money supply.
The new equilibrium has an output rate of 15 trillion of real GDP per year and a price level of 125.

This inflationary gap can be eliminated by contractionary monetary policy.

2 is at a lower price level.
The real GDP has fallen from 15 trillion to 15 trillion.

A reduction in the money supply leads to a decline in the price level.

Increasing the rate of growth of the money supply is a real-world expansionary monetary policy.

The answers can be found on page 369.

The increase in money supply encourages businesses to make new investments because people want to spend more money on real goods.

Individuals will engage in more services when they have more money.

Monetary policy can be discussed in a closed economy.

Monetary policy has an effect on exports.

If the Federal Reserve implements a contractionary policy that increases the market interest rate, we can see how a change in monetary policy can affect net exports.

Foreign investment in the U.S. tends to be attracted by the higher U.S. interest rate.

If more residents of foreign countries decide to purchase U.S. assets, they need to get U.S. dollars.

The demand for dollars increases in foreign exchange markets.
Foreign residents demand less of our goods and services.

There will be a negative net export effect when the U.S. interest rate increases because foreign residents will want more U.S. financial instruments.

The international price of the dollar will rise when they demand additional dollars.

Our exports are more expensive for the rest of the world because of this.
We demand more imports because foreign goods and services are less expensive in the United States.

Monetary policy can cause interest rates to rise.

The net export effect of monetary policy will be the same as the monetary policy effect.

The Federal Reserve wants to pursue an expansionary monetary policy if the economy is in a recession.

It will cause interest rates to fall in the short run.
Funds will flow out of the United States when interest rates go down.
The international price of dollars will go down.
Foreign goods will be more expensive for U.S. residents.
Foreign residents will want more of our exports.
The result will be an increase in exports.
The domestic consequences of monetary policy are reinforced by the international consequences.

As U.S. money markets become less isolated, the Fed's ability to control the rate of growth of the money supply may be hampered.

Billions of dollars can change hands with the push of a computer button.
Individuals and firms in the United States can get dollars from other sources if the money supply is reduced by the Fed.
People in the United States can get dollars from foreign residents.
As world markets become more integrated, U.S. residents who hold U.S. bank accounts in foreign currencies are more likely to use other nations' currencies.

The answers can be found on page 369.

Our exports are more expensive for the rest of the net.

When expansionary monetary policy causes interest rates to go up, foreign residents will want U.S. financial instruments.

The international price of the dollar will rise due to the reduction in the dollar's value in foreign exchange caused by the resulting demand instruments.

Oil price shocks, labor union strikes, and discoveries of large amounts of new natural resources can cause the price index to fluctuate.

In the long run, empirical studies show that inflation is caused by excessive growth in the money supply.

People have more money balances than they want if the supply of money goes up.

Money balances are reduced in favor of other items.
Spending on goods and services increases as a result of this.
A rise in the price level is called inflation.

The nominal GDP is divided by the money supply.

Take a look at a numerical example of the economy.

Each dollar is spent an average of 1.67 times a year.

The flow of funds can be seen from either side.

The value of goods purchased is the same as the value of goods sold.

The simple equation of exchange tells us that a change in the money supply can lead to an equiproportional change in the price level.

The price must increase by 20 percent.

The equation is no longer balanced.

If we plot rates of inflation and rates of monetary growth for different in the rate of growth of the money supply leads to an increase in the rate countries, we come up with a scatter diagram that shows an obvious of inflation.

There is a lot of empirical evidence that supports the idea of Zimbabwe expegating the relationship between monetary growth and high rates of inflation.

The answers can be found on page 369.

According to the quantity theory of money and prices, the equation of exchange change will always bring about a change in the amount of funds.

We talked about the effects of monetary policy earlier in the chapter.

People have excess money balances because of an increase in the money supply.
People increase their expenditures to get rid of excess money balances.
The price of bonds goes up.
The interest rate in the economy falls because of the inverse relationship between the price of bonds and the interest rate.
People and businesses spend more money because of the lower interest rate.

The interest rate is reduced by an increase in the money supply.

The money supply curve intersects the money demand curve.

Assume that the Fed increases the money supply.

People have too much cash.
They purchase bonds.
They bid up the prices of bonds to lower the interest rate.
The effect of 2 on planned investment can be seen in the panel.

An increase in investment will increase demand.

2 shifts the aggregate demand curve.

The investment will be fifteen trillion dollars per year at this rate of interest.

There is a tension between controlling the money supply and targeting the interest rate.

The Fed has control over the money supply.
The Fed allows the interest rate to fluctuate by targeting the money supply.

Money supply changes can move the demand for money curve.

It must increase the money supply to get a lower interest rate.

The Fed must give up control of the money supply by targeting an interest rate.

The answer depends on monetary policy actions.

If spending variations are large and commonplace, a money supply target should be set and pursued because it would cause maximum volatility of real GDP if the interest rate were targeted.

Md Quantity of Money supplied and Demanded suppose that firms will decrease their investment spending if profit expectations are changed.

The equilibrium interest rate is pushed down by the demand for money curve shifting left as a result of the decline in real GDP.
The Fed would have to cut the money supply in order to keep the interest rate from falling.
It would be better to keep the money supply unchanged at a target level.

The effect of changes in money demand is offset by an interest rate target.

Suppose people expect stock and bond prices to go down.
They shift more of their wealth from holdings of stocks and bonds to holdings of money.
This causes the money curve to shift.
The equilibrium interest rate would rise if the Fed kept the money supply unchanged.
GDP would decline.
When the demand for money increases, it would be better for the Fed to increase the money supply and keep the interest rate stable.

The answers can be found on page 369.

Monetary policy operates the quantity of __________ supplied according to the interest-rate-based monetary policy.

At the moment, the Fed has an interest rate target.

The Fed can only influence interest rates by entering the market for federal government securities.
If the Fed wants to raise the interest rate, it needs to engage in contractionary part 4 of money, solvency, and growth open market operations.
It must sell more Treasury securities than it buys in order to reduce the total reserves in the banking system.
This increases the rate of interest.
The Fed engages in expansionary open market operations when it wants to decrease the rate of interest.

Three interest rates are relevant.

Normally, depository institutions don't try to borrow directly from the Fed.

The Fed wouldn't lend them all they wanted to borrow in the past.

A private market made up of banks' reserves.

The federal funds market is an interbank market in reserves where one bank can borrow reserves from other banks if they want to.

The Federal Reserve uses the interest rate that depository institutions pay to raise funds as a way to measure the effects of its policies.

Borrowing from the Fed increases reserves.

Sometimes it expands the money supply and other things are equal.

The discount rate was set by the Fed slightly below the federal funds rate from the late 1960s through the early 2000s.

The Fed established tough lending conditions because it gave depository institutions an incentive to borrow from the Fed through the discount window.
When the Fed changed the discount rate, it was not necessarily to encourage or discourage depository institutions from borrowing from the Fed.
Changing the discount rate would signal to the banking system and financial markets that there had been a change in the Fed's monetary policy.

The Fed wanted to discourage depository institutions from applying for loans if they faced significant liquidity problems.

The differential between the discount rate and the federal funds rate has ranged from 0.25 percentage point to 1.0 percentage point.
A reduction in discount window borrowings is generated by an increase in the differential.

Congress gave the Fed authority to pay interest on excess reserves of depository institutions.

Since late 2008, the Fed has paid the same interest rate on both required and excess reserves.

The incentives that banks face when deciding whether to hold additional reserves or lend them out to other banks are changed by the interest rate on reserves.

Banks have less incentive to lend reserves in the federal funds market if the Fed raises the interest rate on reserves.
It is not surprising that the U.S. has excess reserves.

Figure 16-9 shows how the Federal Reserve can use open market operations to influence the federal funds rate.

The market for bank reserves is depicted in this figure.
These reserves are supplied by the Fed.
Federal Reserve district banks demand reserves to hold on reserve as vault cash or reserve deposits.

The equilibrium federal funds rate is determined in the market for bank reserves.

The amount of reserves supplied is equal to the amount of reserves created by the Fed through past open market operations and loans to banks.

The quantity of reserves supplied is unrelated to the federal funds rate because Fed actions determine this amount of reserves.

The supply curve is vertical at $800 billion.

The minimum quantity of reserves that a bank must hold is called the required reserves.

Many banks want to hold some excess reserves.

Banks who hold excess reserves forgo the opportunity to lend the reserves to other banks in the federal funds market and earn interest at the federal funds rate which is usually higher than the interest paid on the reserves held with the Fed.
Banks are more willing to hold additional excess reserves if the federal funds rate less the Fed's interest rate on reserves.
Banks hold more excess reserves when the federal funds rate is lower.

The minimum quantity of reserves demanded by banks is the same as the minimum quantity of reserves demanded by banks.

As the federal funds rate goes down, the Fed makes money.
The panel shows how the Fed can bring about a reduction in the federal funds rate by bringing the opportunity cost of holding excess reserves down.
Excess reserves are held by a reserve supply.
The total reduces the equilibrium federal funds rate to 1.9 percent.

A downward-sloping curve is shown in panel a.

The quantity of reserves demanded by banks is the same as the quantity of reserves supplied by the Fed.

The initial equilibrium federal funds rate is 2 percent.

The Fed wants the federal funds rate to be 1.9 percent.
The Fed can increase the supply of reserves by conducting an open market purchase or making loans in a total amount equal to $20 billion.
The supply schedule in panel (b) shifts by $20 billion.

Immediately following the Fed's action, the quantity of reserves supplied increased to $820 billion.

The amount of reserves demanded at the 2 percent rate is still $800 billion.

There is an excess quantity of reserves supplied equal to $20 billion, the amount of its purchase or loan, after the Fed's action.

Banks want to hold less reserves than the quantity given.
The federal funds rate will decline to a new equilibrium value of 1.9 percent when they lend more reserves to other banks.
The quantity of reserves demanded by banks is the same as the quantity of reserves supplied by the Fed.

The policy decisions that determine open market operations are made by the Federal Open Market Committee.

The Fed's general strategy of open market operations is determined every six to eight weeks by the voting members of the FOMC.

A document that summarizes the Federal document lays out the FOMC's general economic objectives, establishes short-term Open Market Committee's general policy federal funds rate objectives, and specifies target ranges for money supply growth.

After each meeting, the Federal Open Market Committee issues a brief statement to the media, which includes information about the Fed's actions and what it means for money supply growth.

The office at the Federal Reserve Bank of New York takes for granted that the Fed can implement the policies it has been announced to the public.

Each weekday morning, the Trading Desk's open market operations are usually confined to a one-hour interval.

The growth rate of real GDP is related to the expected rate of inflation, and the value of the interest rate on interbank loans is related to that.

The equilibrium federal funds rate is 2 percent, but the neutral federal funds rate is 1.9 percent.

Growth in interest-sensitive consumption and investment spending would be hampered by the higher federal funds rate.
Real GDP would grow at a slower pace because of the depressed short-run growth in aggregate demand.

To boost aggregate demand and increase real GDP growth to the long-run rate of real GDP growth, the Fed would seek to push the equilibrium federal funds rate down to the target level.

The rate of growth of real GDP is not constant.

The pace at which the economy's long-run aggregate supply increases over time depends on factors such as productivity growth and the pace of technological improvements.
Aggregate supply shocks can add to or subtract from the natural pace at which aggregate supply rises, causing the potential real GDP growth rate to speed up or slow down unexpectedly.

The value of the neutral federal funds rate is affected by the rate of growth of potential real GDP.

As economic conditions change, the FOMC tries to aim at a neutral federal funds rate.

John Taylor suggested a simple equation for the Fed to use.

The current deviation of the actual inflation rate from the Fed's objective inflation, as well as the gap between actual real GDP per year and the Fed's objective inflation, are all related to this equation.

An equation that specifies a federal funds rate value comes close to the actual targets the Fed has selected over time.

The Federal Reserve Bank of St. Louis Reserve's inflation objective and the gap now tracks target levels for the federal funds rate predicted by a basic Taylor between actual real GDP per year and a rule equation.

This figure shows the actual path of the federal funds rate since 2002 and the target paths specified by a Taylor-rule equation for alternative annual inflation objectives of 0, 1, 2, 3, and 4 percent.

The Taylor rule states that when the federal funds rate is in line with the goal of the Fed, it will cause inflation.

The Taylor rule states that the federal funds rate should be in line with a 4% inflation target.

The Taylor rule implies that the Fed's policymaking is expansionary.

The inflation rate will rise above the Fed's goal.
The federal funds rate was below the inflation rate during the 2003-2005 interval.
This means that the Fed's policymaking was expansionary so that it was expected to yield a long-run inflation rate in excess of 4% per year.
The Taylor-rule graph shows that in late 2006 the Fed's policy stance became much more contractionary, with the federal funds rate above the level of inflation.
The graph shows that Fed policymaking became expansionary in early 2008.

The federal funds rate was close to the Taylor-rule predictions until the early 2000s.

The Fed has failed to set its federal funds rate target in a way that is consistent with the Taylor rule.

The Taylor rule was not feasible for the Fed after the Great Recession.

The closest the Fed could have come to following the Taylor rule was in early 2009, but it couldn't because it didn't want to do so.

The answers can be found on page 369.

The appropriate target for the federal funds Committee is the federal funds rate.

Some economists want to change the supply of reserves to the banking system because of the diffi of the __________ __________ rate.

Donald MacTavish, a collector of and dealer in currency notes, has to explain why Zimbabwe's inflation rate became the second acquired note that he hopes eventually may be prized by money highest in recorded history.

Zimbabwe's one-trillion-dollar notes are so abundant that they can lose half their value in a single day.
They may never exceed what he paid for them.

The residents of Zimbabwe used currency notes to buy goods and services after the hyperinflation.

In the summer of 2008, the equilibrium quantity of reserves determined in the U.S. market was no higher than $45 billion.

The difference between total reserves and excess reserves has not changed noticeably since the middle of 2008.

The excess reserves have increased.

This differential has been made into holdings of excess reserves.

The difference between excess reserves and total reserves and excess reserves have not changed much since banks are required to hold the Fed small.
The Fed gets the reserves over time.
In contrast, excess reserves have risen from a wish to lend to struggling banks and a nonfinancial average of just over $2 billion prior to the fall of 2008 to panies and simultaneously attains a level of total reserves more than $1 trillion today.

The money multiplier analysis was discussed in Chapter 15.

The quantity theory of money government-sponsored enterprises, and purchases of debts and prices suggest would happen to the level of prices as a private company if you described the scenario in your answer to ing programs to struggling banks.

There are changes in total reserves and excess reserves.

Economists had predicted that the market clearing federal The Trading Desk at the Federal Reserve Bank of New funds rate would never drop to or below the interest rate that York conducts these operations in accordance with the Fed pays on reserves.

Federal funds loans are made by the Fed.

You should know what to know after reading this chapter.

They want to hold more money when nominal GDP increases.

Money is a store of value that can be held alongside bonds, stocks, and other earning assets.

As the market interest rate increases, the quantity of money demanded declines, because the opportunity cost of holding money as an asset is the interest rate.

Reserve buyers can purchase bonds.

When the Fed sells bonds, the market interest rate goes up because the market price of bonds is related to the economy's interest rate.
The Fed has to offer a higher price to induce sellers to part with bonds.
The market interest rate declines when the Fed purchases bonds because of the inverse relationship between the market price of existing bonds and the prevailing rate of interest.

An expansionary monetary policy action increases the money supply.

A short-run recessionary gap can be eliminated by the aggregate demand curve.
A contractionary monetary policy action causes an increase in market interest rates.
A leftward shift in the aggregate demand curve can eliminate a shortrun inflationary gap.

The quantity theory of money and prices assumes that GDP is stable and the income velocity of money is constant.

Reserve monetary policy actions on market interest rates bring about changes in desired investment and thus affect equilibrium real GDP.

The Fed has to let the market interest rate change whenever the demand for money increases or decreases.
The money supply needs to be stable in order to have interest rate volatility.
When there are variations in the demand for money, the Federal Reserve must be willing to adjust the money supply.
Changing the money supply is needed to keep the interest rate stable.

The federal funds rate is the reserve.

When the quantity of neutral federal funds reserves demanded by banks equals the quantity of rate, the interest rate is called Trading Desk.
The Federal Reserve Bank of New York conducts open market purchases or sales to alter the supply of reserves as necessary to keep the equilibrium federal funds rate at the target.
The Federal Open Market Committee's target is the neutral federal funds rate, which means that the growth rate of real GDP tends not to rise above or fall below the rate of growth of long-run potential real GDP.

The Taylor rule specifies an equation for the federal funds rate target based on an estimated long-run real interest rate, the current deviation of actual inflation from the Fed's inflation goal, and the gap between actual real GDP and a measure of potential real GDP.

Log in to MyEconLab, take a chapter test, and get a personalized study plan that tells you which concepts you understand and which ones you need to review.

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The United States has an aggregate supply curve.

The Federal Reserve might be able to prevent the dollar's appreciation from the inflationary gap by taking a short policy action that reduces aggregate demand.

The inflationary gap in the short run can be eliminated by the quantity of money in circulation.

What way might society benefit from the Fed's actions?

In base-year dollars, GDP is $5 trillion.

There is a diagram on the next column.

The money supply increases by $100 billion and the income velocity remains the same as the federal funds rate target.

What is the percentage increase in the money Committee's target?

The effects of monetary policy actions will be reinforced through interest rate Bank of New York specifying new federal changes.

Should the Federal Reserve raise the federal funds rate, a new policy strategy should be put in place.

You can view the activities at www.econtoday.com/ch16.

The Federal Reserve's Monetary Policy Report can be used to learn about factors that affect Fed decisions.

The Congress used to be called the Humphrey-Hawkins Report.

What are the Fed's current decisions based on the report?

The Keynesian approach to monetary policy states that the level of aggregate demand can only be affected by the interest rates on the money supply.

The level of real planned investment spending is changed by interest rate changes.
Keynesians argue that there are plausible circumstances in which monetary policy may have little or no effect on interest rates and thus on aggregate demand.

Consumption depends on real GDP.

Spending will decline if real GDP is less than planned.

The Keynesian approach says that an increase in money supply causes interest rates to go down.

Interest rates go up when the money supply goes down.

Firms respond by reducing their investment spending.
Consumers respond to the lower real GDP by scaling back on their spending.
The decline in real GDP is larger than the drop in investment spending.

It is thought that monetary policy can be used to get the economy out of a recession.

Keynesians argue that monetary policy is not likely to be effective as a recession fighter.
During recessions, people try to build up as much liquid assets as they can to protect themselves from unemployment and other losses of income.
People are willing to allow most of the money to accumulate in their bank accounts when the monetary authorities increase the money supply.
This desire for increased liquidity prevents interest rates from falling very much, which in turn means that there will be almost no change in investment spending and thus little change in aggregate demand.

If each 0.1-percentage-point increase in plier is equal to 5, and the money multiplier is the equilibrium interest rate, a $5 billion is equal to 4.

Every $20 billion increase in real planned investment spending by in the money supply brings about a 0.1 percentage businesses.
The equilibrium interest rate is reduced by the investment multiplier.

Every $9 billion decrease in money tions under the assumption that all other things are supply brings about a 0.1-percentage-point increase equal.

If the Federal Reserve wants to bring tion that all other things are equal, how much investment must be made to answer the following questions?

How much must the Fed reduce interest rates in order for the money supply to change?

The money is worth more than 4.

Investment is always zero at excess reserves and 4 percent rate of interest.

The investment is more than $1 billion.

3 is the money multiplier.

The investment is increased by 5.

The initial equilibrium level of real GDP is a 6 percent rate of interest.

4 percent is the equilibrium rate of interest.

The investment is worth more than 3.

Policy is the initial equilibrium level of GDP.

It sells bonds for $12 trillion.

6 percent is the equilibrium rate of interest.

Now the Fed engages in expansionary monetary have decreased, and then trace out the numerical policy.

It buys $1 billion worth of bonds and the consequences of the increase in interest increases the money supply and lowers the rates on all the other variables.

Retailers' opportunity cost of devoting time to chang You ing prices increases during the holiday season according to researchers.

Restocking shelves, helping customers locate products, and scanning prices and bag items are some of the things retailers choose to do.
Retailers change prices less often during holiday periods due to the fact that it is higher than other times of the year.

All actions on the part of monetary and fiscal actions that monetary and fiscal policymakers undertake in reaction to or in anticipa policymakers that are undertaken in response to a change in economic performance.

It is not in response to the lags between the time when the national economy enters a recession or a boom and the time when that fact becomes known and acted on by policymakers.

The potential trade-offs that policymakers believe they face are the first thing you need to know if you want to take a stand on this debate.

You need to see what the data shows.
There is a trade-off between price stability and unemployment.

There are different types of unemployment: structural, seasonal, and frictional.

This type of unemployment only occurs when the economy is in a recession or a depression.

All of these factors make it difficult for people to choose employment over unemployment.

Consider the effect of unemployment insurance benefits on finding a job.

When unemployment benefits end, the probability of an unemployed person finding a job increases.
Unemployed workers are more serious about finding a job when they are no longer receiving benefits.

Frictional unemployment and structural unemployment exist even when the economy is in long-run equilibrium because of the need to conduct a job search and the existence of rigidities.

The unemployment rate is adjusted to any changes in the economy.

Unemployment tends to return to the economy.

The unemployment rate in 1982 was over 10 percent.

The natural rate of unemployment was rising until the late 1980s.
It was at this level again in the early 2010s.
Unemployment rates don't prove anything by themselves, even though these two nearly matching it trended downward until the late 2000s.

There is an estimate of the natural rate of unemployment and what has happened to the unemployment rate since 1950.

We get the line so labeled because the actual rate of unemployment has varied widely in the United States.

It rose from the 1950s to the late States.
The natural rate of unemployment would decline until the late 2000s, when it began to rise again.

Even though the unemployment rate has a tendency to stay at and return to the natural rate, it is possible for other factors, such as changes in private spending or fiscal and monetary policy actions, to move the actual unemployment rate away from the natural rate.

When the unemployment rate exceeds the natural rate, the unemployment rate is positive.
The unemployment rate can go below the natural rate during economic booms.
At times, unemployment is negative.

Let's look at two examples to see how departures from the natural rate of unemployment can occur.

Imagine if the government used fiscal or monetary policy to boost the economy.

For reasons that will soon become clear, suppose that this policy surprises decision makers throughout the economy because they did not anticipate that it would happen.

The price goes up from 118 to 120.

Real GDP increased from 15 trillion to 15.4 trillion.

In the labor market, people find that conditions have improved.

Firms want to hire more workers.
They might ask workers to work overtime in order to get more people in the labor market to work more hours.
The unemployment rate goes down as the average duration of unemployment goes up.

Workers and owners of capital and raw materials revise their expectations.

The long-run real GDP per year is fifteen trillion, but at a higher price level.

It is in both shortrun and longrun equilibrium.

The natural E3 ment rate is now below it.

Expec Price Level tations of input owners are revised over time.

The price goes up to 122.

The government could have decided to engage in deflationary policy instead of expansionary policy.

The price level has fallen from 120 to 118.

Fewer firms are hiring and those that are are not.
People looking for jobs find it takes longer than expected.
Unemployed individuals stay out of work longer.
The rate of unemployment goes up when the average duration of unemployment goes up.

2 is just a short-run situation.

As real GDP returns to $15 trillion, the price level will decline to 116.

The actual inflation rate and anticipated inflation rate are the same.

There is a decline in real GDP to $14.7 trillion.

The expectations of input owners are revised at the lower price level.

The unemployment rate is the same as the natural rate.

An unexpected increase in aggregate demand causes the price level to rise and the unemployment rate to fall.

In the short run, unexpected decreases in aggregate demand cause the price level to fall and the unemployment rate to rise above the natural rate.

Although the relationship between unemployment and wages was presented only as an empirical regularity, economists quickly came to view it as repre prices.

ThePhillips curve suggested that it was possible for discretionary policymakers to fine-tune the economy by selecting the policies that would produce the exact mix of unemployment and inflation that suited current government objectives.

It turned out that matters are not simple.

The rate of unemployment below which the rate of inflation tends to rise and above the rate of unemployment that corresponds to a stable rate of inflation.

The rate of inflation tends to fall when the unem are not present.

The rate of inflation decreases when the unemployment rate is more than the NAIRU.

Inflation continues at an unchanged rate if the unemployment rate is equal to the NAIRU.
The potential short-run trade-off between the rate of unemployment and the rate of inflation will be determined if thePhillips curve trade-off exists.

The natural rate of unemployment is not always the same as the NAIRU.

The natural rate of unemployment is the unemployment rate that is observed when all the factors have played themselves out.
The natural unemployment rate applies to a long-run equilibrium in which short-run adjustments have ended.

It depends on structural factors in the labor market.

The NAIRU is the rate of unemployment that is consistent with the rate of inflation.

The unemployment rate can change during the course of the economy's adjustments.
The natural rate of unemployment varies by a relatively greater amount than the NAIRU.

They reduce the duration of their job search because of this perception.

If aggregate demand fluctuates up and down at random, this is a good way for workers to view the world.

Figure 17-5 is a good example.

Money, solvency, and growth increase the rate of growth of the money supply enough to produce an inflation rate of 3 percent.

If this is an unexpected one-shot action in which the rate of growth of the money supply is first increased and then returned to its previous level, the inflation rate will temporarily rise to 3 percent, and the unemployment rate will temporarily fall to 5 percent.
After the money supply stops growing, the inflation rate will return to zero and unemployment will return to its natural rate, according to proponents of passive policymaking.

This will change the way policymaking is done in the United Kingdom.

When the expected inflation rate was zero, a 3 percent rise in nominal wages meant a 3 percent expected rise in real wages, and this was enough to induce some individuals to take jobs rather than remain unemployed.

When workers expect the inflation rate to go up, rising nominal wages will not be enough to get them out of unemployment.

The unemployment rate will go up if the authorities continue theStimulus in an effort to keep the unemployment rate down.

The inflation rate is 3 percent instead of zero.

The expected inflation rate is higher than the actual inflation rate because of the higher unemployment rate.

Policymakers consider inflation rates in news headlines to be more important than core inflation.

Economists exaggerate.
The effects of shocks on the core infla prefer to remove food and energy prices from the inflation rate for a long time.
The price index is volatile due to the fact that the prices tend to be highly moving in the headline inflation rate.
It is a good idea to keep an eye on the headline prices.
In the long run, headline inflation rate shocks are what really affect inflation.

The answers can be found on page 396.

Policymakers seek to take advantage of unforeseen changes in fiscal or monetary policy when there is a departure from the natural rate of unemployment.

The proposedPhillips curve trade-off between inflation and aggregate demand will reduce unemployment below the unemployment rate.

We assume that firms maximize profits when they choose today's rate of output and that consumers maximize satisfaction when they choose how much they consume.

The assumption that economic participants think rationally about the future as well as the present is one of the key features of current macro policy research.
Robert Lucas won the 1995 Nobel Prize for his work.

Individuals base their forecasts on the values of economic economic variables with their own judgement on all the available information.

Individuals understand how the econ policy changes.

The rational expectations hypothesis holds that Abraham Lincoln was correct when he said, "You can fool all the people."

You can fool people all the time.

The economy's response to a change in monetary policy is an example of how rational expectations operate in the new classical perspective.

The price level and real GDP are equal to $10 trillion.

The location of the short-run aggregate supply curve will cause the price level and real GDP to rise to 120 and $15.3 trillion, respectively.

A $1 trillion increase in money supply causes the demand curve to shift.

Workers will respond to the higher price level by demanding higher nominal wages.

The short-run aggregate supply curve will shift upward.
Even as real GDP declines back down to $15 trillion, the price level continues its rise to 122.
Even though an increase in the money supply can raise real GDP and lower unemployment in the short run, it has no effect on either variable in the long run.

The perspective given by the rational expectations hypothesis is that wages and prices are flexible in a purely competitive environment.

Workers and other input owners should be aware that the money supply is going to increase.
It will push the price level from 112 to 122 if they know when it will happen.
They will not according to the rational expectations hypothesis.
They will go to their employers and insist that their nominal wages move in line with the higher prices.
This is the only way to protect real wages from falling due to the increase in money supply.

The expected money supply and actual money supply are equal.

The aggregate supply curve will shift when the money supply changes in a way that is anticipated by the economy.

When considering this proposition, there are two important matters to keep in mind.

Our discussion assumed that economic participants knew in advance exactly what the change in monetary policy would be and when.
The future course of monetary policy is not announced by the Federal Reserve.
The Fed tries to keep most of its plans secret, announcing only in general terms what policy actions are intended for the future.

It is tempting to conclude that the Fed's policies are not available because they are not fully known.

It would be wrong to conclude.
Economic participants have great incentives to learn how to predict the future behavior of the monetary authorities, just as businesses try to forecast consumer behavior and college students do their best to forecast what their next economics exam will look like.
Even if the economic participants are not perfect at forecasting the course of policy, they are likely to come a lot closer than they would be.

The second point is brought to us by this.

It is likely that the Federal Reserve makes mistakes, meaning that the money supply may change in ways that the Fed does not predict.
There is no guarantee that other economic participants would fully forecast the actions of the Fed.

The result is a rise in real GDP in a short period of time.

The rise in real GDP will lead to an increase in employment and a fall in the unemployment rate.

The effect on real variables will disappear in the long run because people will think that the Fed increased the money supply in a way that fooled them.

The short-run aggregate supply curve will shift upward if people revise their money supply expectation to match the actual money supply.

When confronted with the policy irrelevance proposition, many economists began to reexamine the first principles of macroeconomics with fully flexible wages and prices.

Some economists argue that real forces can help explain economic fluctuations.

These shocks can be caused by technological advances that improve productivity, changes in the composition of the labor force, or changes in availability of a key resource.
The price level is 118 and the level of real GDP is 15 trillion.
The unemployment rate must be in line with the long-run equilibrium of the economy.

There will be less goods for sale.

The new long-run aggregate supply curve is associated with the lowered output of oil.

Two adjustments begin to occur at the same time.

The overall price level rises to 121 when the prices of oil and petroleum-based products start to rise.
Second, the higher costs of production occasioned by the rise in oil prices induce firms to cut back production, so real GDP falls to $14.7 trillion in the short run.

This isn't the full story.

The reduction in oil supplies affects the owners of nonoil inputs.
Not every worker will tolerate reduced real payments in the long run, even though most individuals are willing to put up with them in the short run.
Some workers who were willing to continue on the job at lower real wages in the short run will eventually decide to switch from full-time to part-time employment or to drop out of the labor force altogether.

The downward force on real GDP is trillions.

Lower employment and a higher unemployment rate are associated with the decline in real GDP.

There is higher inflation.

The situation was characterized by lower real during the 1970s and early 1980s.

The unemployment rate during the same period that the rate of inflation increases was caused by sharp reductions in the supply of oil.

In the early 1970s, Congress enacted steep increases in marginal tax rates and implemented a host of new federal regulations on firms.

Stagflation was caused by all these factors reducing long-run aggregate supply.
Stagflation episodes were prevented by increases in oil supplies, cuts in marginal tax rates, and deregulation during the 1980s and 1990s.

The answers can be found on page 396.

Even if prices and wages are flexible, shocks such as sudden changes in tech information, an understanding of government nology or the supply of factors of production can affect the economy.

Monetary policy actions can't change the rate of unemployment or real GDP.

The policy irrelevance proposition and the idea that real shocks are important causes of business cycles are major attacks on the desirability of trying to stabilizing economic activity with activist policies.

The rational expectations hypothesis is combined with the assumptions of pure competition and flexible wages and prices to create anti-activism suggestions.
Market clearing models of the economy are not believed to explain business cycles by economists who see a role for activist policymaking.
Keynes assumed sticky wages and prices in his major work, which they argue is important in today's economy.

One approach to explaining why many prices are sticky is that the economy is characterized by imperfect competition and that it is costly for firms to change their prices in response to changes in demand.

The costs of changing contracts, printing price lists, and telling customers of price changes are included.

Some of the costs of changing prices, such as those incurred in bringing response to demand changes, together business managers from points around the nation or the world for meetings, may be.

The Federal Reserve Bank of New York estimates the costs weeks at a time for Pinelopi Goldberg and Rebecca beers.

Retailers change their prices slightly more often than the market for beer imported into the United States.

To pass before adjusting the prices of imported beers.

The argument favoring active policymaking as a means of preventing substantial short-run swings in real GDP and employment is strengthened by sticky prices.

In the short run, the aggregate supply curve is horizontal if a significant portion of prices don't adjust quickly.

The largest decline in equilibrium real GDP will be caused by 2 shown in panel a.
Aggregate demand shocks are as severe as they can be when prices are sticky.

The new Keynes ian sticky-price theory indicates that the economy will find its own way back to a long-run equilibrium, in contrast to the traditional Keynesian theory.

The theory presumes that small menu costs cause firms to keep their prices the same.
In the long run, the profit gains to firms from reducing their prices to induce purchases of more goods and services cause them to cut their prices.

Real GDP would rise in the short run if aggregate demand increases.

Firms would gain sufficient profits from raising their prices to compensate for menu costs in the long run, and the short-run aggregate supply curve would shift upward.

The Keynesian sticky-price theory supports the argument for higher inflation later.

Panel (b) shows the same decline in aggregate demand as panel (a) and the resulting maximum contractionary effect on real GDP.

Panel (a) shows that when prices are sticky, the short-run aggregate supply is horizontal, so that the price level falls to 116 and real GDP returns to $15 trillion at the point curve.

Producers think that they can increase their degree by cutting prices and paying menu costs, in the long run.
There is a recession.

When prices are sticky and short-run aggregate supply is horizontal, monetary and fiscal policy actions that influence aggregate demand are as potent as possible.

The period of contraction experienced by the economy may be brief if the policymaker acts quickly.
It is possible for active policymaking to moderate or even eliminate recessions.

Early in 2009, the federal government increased its spending by the largest real GDP.

Each $1 of government expenditures percentage in a single year since World War II was the worst he could find.
The Economic Advisers issued a report that provided a justification for the government's very active fiscal policymaking.
The ultimate payoff of the Great Recession was suggested by the CEA.

The government spending had failed to boost money, solvency, and growth according to his judgement.

By "exploitable," economists mean a relationship that is sufficiently predictable and long-lived to allow enough time for policymakers to reduce unemployment or to push up real GDP when economic activity falls below its long-run level.

The existence of a policy-exploitablePhillips curve relationship between inflation and unemployment has been debated by economists for more than 40 years.

The public's expectations of inflation will soon prevent any attempt to reduce unemployment by boosting inflation.

The figure 17-9 appears to show support for the proposition.

It shows that a number of inflation rates have been feasible at the same rates of unemployment.

The lack of a long-lived relationship between inflation and unemployment is not a concern for today's Keynesian theorists.

According to the new Keynesians, the most important thing for policymakers is whether the relationship is exploitable in the near term.

Policymakers can intervene in the economy if unemployment and real GDP vary from long-run levels.
New Keynesians conclude that activist policies can make fluctuations shorter-lived.

To assess the predictions of new Keynesian inflation dynamics, economists look at whether inflation is related to two key factors that theory suggests should determine the inflation rate.

Future inflation is the first of these factors.

Menu costs reduce firms' incentive to adjust their prices according to the new Keynesian theory.
Firms take the expected future inflation rate into account when setting prices at the present time, as it signals how much equilibrium prices are likely to increase during future months.

The average inflation-adjusted per-unit costs that firms incur in producing goods and services should affect current inflation, according to new Keynesian theory.

Keynesians propose a positive relationship between inflation and an aggregate measure of real per-unit costs faced by firms throughout the economy.
If firms' average inflation-adjusted per-unit costs increase, the prediction is that there will be higher prices charged by that portion of firms that do adjust their prices in the current period.

Higher observed rates of inflation are associated with increases in expected future inflation and greater real per-unit production costs.

The new Keynesian theory is having an effect on U.S. policymakers.
Media reports often refer to changes in inflation expectations and firms' production costs as signals of altered inflationary pressures.

Some economists don't think the new Keynesian theory is correct.

Increased inflation should be a result of a decline in aggregate supply.

How often firms adjust their prices is at the center of the issue.

The horizontal new Keynesian aggregate supply curve will remain in place if the average interval between firms' price adjustments is long.

Real GDP will be negatively affected by a decline in aggregate demand.
There will be more scope for activist policymaking to be able to boost aggregate demand and stabilization of real GDP.
If the average interval between changes in prices is long, prices will adjust quickly to a change in demand.
There will be less scope for activist policies to stabilizing the economy because of the fact that faster adjustments of prices will tend to reduce movements in real GDP and the unemployment rate.

Calculating the average interval between price changes in national economies is difficult.

The conclusions are mixed so far.
New Keynesian inflation dynamics yielded estimates of average price PART 4 # money, solvency, and growth adjustment intervals for the United States for two years.
Estimates of price-adjustment intervals have been produced by more recent studies.

The average periods between price adjustments are shorter.

There isn't much agreement about how much scope activist policymakers might have to fix the economy under the new Keynesian theory.

Many people who have never taken a principles of economics course think that the world's governments should work to achieve high and stable real GDP growth and a low and stable unemployment rate.

The advisability of policy activism is not obvious.

There are a number of factors involved in assessing whether policy activism is better than passive policymaking.

Table 17-1 summarizes the issues involved in evaluating the case for active policymaking.

You may be frustrated by the current state of thinking on the relative desirability of active or passive policy making.

Most economists agree that active policymaking is unlikely to have long-run effects on the economy.
Most agree that business cycles are affected by aggregate supply shocks.

In the second column, have little or no.

There are limits to the effectiveness of monetary and fiscal policies.

A number of economists continue to argue that there is evidence that prices and wages stay the same.
Monetary and fiscal policy actions can offset shocks in the short run and possibly even in the long run, the effects that aggregate demand would otherwise have on real GDP and unemployment, they argue.

The diverging perspectives help explain why economists differ about the advisability of pursuing active or passive approaches to macroeconomic policymaking.

Different interpretations of evidence on the issues summarized in Table 17-1 on the facing page will likely continue to divide economists for years to come.

The answers can be found on page 396.

The short-run aggregate supply curve can be stable if activist policymaking is stickiness.

There are variations in aggregate demand.
This is possible, according to the theory, the largest possible effects on real GDP in the short run, if policymakers can exploit the trade-off greatest ability to stabilizing real GDP.

During the years leading up to and including the American Economic Association annual meetings, the Fed's forecasts of inflation listen to Ben Bernanke discuss Fed policymaking prior to and during the financial meltdown.

If the Fed had a crisis, it is likely that the policymaking would have been more effective.
The Fed adjusted the growth of the discretionary policies on the inflation rates it actually money supply in a way that moved market interest rates tolev observed instead of on inflation forecasts that were nearly always wrong.

According to the theory of new Keynesian inflation dynamics, there is a lot of price stickiness that comes from small menu costs of changing prices.

If the Fed permits rapid growth in the money supply, revenue gains from changing prices can be more important than small menu costs.

Inflation will occur when the hypothesis adjusts their prices.

According to the theory of new Keynesian inflation dynamics, when expected future inflation rises, actual current inflation will also increase.

The theory predicts that the current inflation rate will be pushed up by measures of expectations of future inflation.

The rate has increased recently.

The fact that people anticipate method for measuring inflation expectations is a signal that Treasury inflation-protected securities offer many economists.
There is a guaranteed fixed inflation-adjusted fuel inflation throughout the coming decade for people who hold TIPS.
According to return, the interest rate they require from these securities the theory of new Keynesian inflation dynamics, a conse is lower than the rate people require to hold non-inflation protected Treasury securities.

The rate securities require higher interest rates on traditional trea of inflation that people anticipate over the next year.

The average securities measure is at www.econtoday.com/ch17.

The Federal Reserve Bank of Cleveland uses TIPS to calculate inflation expectations between interest rates on traditional securities and TIPS.

You should know what to know after reading this chapter.

The unemployment figure causes the actual unem figure to rise above the natural unemploy figure.

The equilibrium rate of unemployment price level and inflation are caused by the Study Plan 17.2 aggregate demand that causes a drop in the unem nonaccelerating inflation.

The downward-sloping relationship is called thePhillips curve.

When expectations are not changed, there will be aPhillips curve relationship.

If people anticipate policymakers' efforts to exploit thePhillips curve trade-off via inflationary policies aimed at pushing down the unemployment rate, input prices such as nominal wages will adjust more rapidly to an increase in the price level.
The economy will adjust more quickly to the natural rate of unemployment as a result of the shift in thePhillips curve.

Wages and other input prices adjust immediately if people completely anticipate the actions of policymakers.

The case for active policymaking can be weakened by real business cycles caused by technological changes and labor market shocks.

Real GDP can be affected by changes in aggregate demand in the short run.

Discretionary policy actions can stabilization real GDP if prices and wages are too inflexible in the short run.

Log in to MyEconLab, take a chapter test, and get a personalized study plan that tells you which concepts you understand and which ones you need to review.

MyEconLab will give you further practice, as well as videos, animations, and guided solutions.

If the government changed the compu factors that affect the behavior of both workers and firms, it would affect the unemployment rate.

List possible factors affecting the military as part of the labor force.

The natural rate of unemployment would be affected by this.

There is a sudden increase in classified as part of unemployment.

The current group of Fed officials is following Chapter 11 and the new Keynesian theory indicates that the short-run to reduce the unemployment rate is possible.

The Fed aggregate supply curve is horizontal.

economists to use U.S.

The rational short-run increases in real GDP largely to expectations hypothesis is shown to be true by the real-business-cycle approach.

Would it be aggregate supply shocks?

The diagram below is a small-menu-cost explanation for price stickiness and assumes that the new Keynesian theory of aggregate supply will cause firms to keep their prices the same.

Questions are likely if firms anticipate a rise in demand.

If you notice an inverse relationship between inflation and ployment, it's time to look at the data.

The indicated operations and ment rate should be performed.

Is it possible to answer these questions.