FS - Monetary Policy (Lesson)

Monetary Policy

Introduction

Pictorial representation of definitions in paragraph preceding it. The Fed.

Monetary Policy is the action of the Federal Reserve (the Fed) to prevent or address extreme economic fluctuations. The Fed uses its monetary policy tools to influence equilibrium interest rates in the money market through its control of bank reserves. The Fed lowers interest rates through expansionary monetary policy to prevent or address recessions, and it raises interest rates through contractionary monetary policy to prevent or address inflation.

Monetary policy is transmitted to the economy through changes in aggregate demand.
Monetary policy will have both short-run and long-run effects in the economy.

Real vs Nominal Interest Rates

If you bought a one-year bond for $1,000 and the bond paid an interest rate of 10%, at the end of the year would you be 10% wealthier? You will certainly have 10% more money than you did a year earlier, but can you buy 10% more? If the price level has risen, the answer is that you cannot buy 10% more. If the inflation rate were 8%, than you could buy only 2% more; if the inflation rate were 12%, you would be able to buy 2% less! The nominal interest rate is the rate the bank pays you on your savings or the rate that appears on your bond or car loan. The real interest rate represents the change in your purchasing power. The expected real interest rate represents the amount you need to receive in real terms to forgo consumption now for consumption in the future.

Let's first take a look at an overview of monetary policy. Watch the video below.

The Fisher Equation

The Fisher Equation shows the relationship between the nominal interest rate, the real interest rate, and the inflation rate as shown below:

r equals i minus pi
where r equals the real interest
i equals the nominal interest and pi equals the inflation rate

Let's work out an example:

In the previous example with the 10% bond, if the inflation rate were 6%, then your real interest rate (the increase in your purchasing power) would be 4% (6 = 10-4). Obviously banks and customers do not know what inflation is going to be, so the interest rate on loans, bonds, and so forth are set based on expected inflation.

The expected real interest rates is:

re equals i minus pi e
where r equals the real interest
i equals the nominal interest and e pi equals the expected inflation rate

it can be rewritten as i = re plus pi e

A bank sets the nominal interest rate equal to its expected real interest rate plus the expected inflation rate. However, the real interest rate it actually receives may be different if inflation is not equal to the bank’s expected inflation rate.

According to the Fisher Equation, if the Federal Reserve increases the money supply, the price level will increase. The resulting inflation will increase the nominal interest rate, decrease the real interest rate, or some combination of the two. This is known as the Fisher Effect. In the short run, increases in the money supply decrease the nominal interest rate and real interest rate. In the long run, an increase in the money supply will result in an increase in the price level and nominal interest rate.

The presentation below will cover the monetary policy.

Review

Review what you have learned by completing the activity below.

In Summary . . .

The BIG Picture of Monetary Policy

Multipliers related to taxing and spending:

Basic concept – spending (consumption) becomes somebody else’s income, which is in turn split between further consumption and saving.

The fraction of the next bit of income that is spent is called the Marginal Propensity to Consume (MPC), whereas the fraction of the next bit of income that is saved is called the Marginal Propensity to Save (MPS).

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