Chapter 8

Policy Preview

Introduction

Focus of this chapter is monetary policy

Examine how the central bank sets interest rates in order to

control aggregate demand

Begin with a description of the operation of central bank

policy (who, what, why, when, and how)
Central bank moves interest rates in response to deviations of
output and inflation from desired levels
the Taylor rule

Finally, discuss how the central bank decides how much

to move interest rates
8-2

The Who of Policy

Both fiscal and monetary policy can be used to fine tune

the economy
Most short-run fine tuning is done with monetary policy
The who of stabilization policy = central bank

In the U.S., the central bank is the Federal Reserve Bank

Formally, U.S. monetary policy is established by vote of the
Feds Open Market Committee (FOMC)
UK: interest rates by the Monetary Policy Committee of Bank
of England
BoE Governor has the casting vote in case of a tie
8-3

The What of Policy

The CB sets the interest rate

Base rate (UK) or Federal Funds Rate (US)

Rate at which banks borrow overnight from CB

Lower interest rates encourage greater investment

spending and greater spending on some consumption
goods, thus increasing AD

Monetary policy works through AD

Monetary policy has little influence on AS

8-4

The Why of Policy

Central banks goals:

1.
2.

Maintain low inflation rates

Promote economic activity

Obvious conflict between these goals Phillips Curve

Also conflict between CBs preferences and capabilities

Boosting economic activity does much more to enhance

economic welfare than does controlling inflation (except at
high inflation rates)
CB can stimulate economic activity in the SR but this only
causes inflation in the LR
This is because of different slopes of the SRAS and LRAS
Central banks focus on maintaining low inflation while
stabilizing economic activity around Y* inflation targeting
8-5

When Policy Is Made

FOMC meets every six weeks

BoE MPC: every month

8 members, BoE Governor has tie-breaking vote

8-6

How Policy Is Implemented

CB sets the interest rate

Lowering interest rates means increasing the money supply

The increased money supply results, eventually, in increased
prices

Chapter 10: money supply moves and the LM curve

8-7

Policy as a Rule

Monetary policy rule: setting the interest rate reflecting

the current economic situation
Taylor Rule:
*

Yt Yt (1)

it r t ( t ) 100
*
Yt

i nominal interest rate

r* real, natural rate of interest, corresponding to the real
interest rate we would observe if the economy were at the full
employment level of output
* CBs target rate of inflation
*

8-8

Policy as a Rule

Y
*
*
t
t

it r t ( t ) 100
*
Yt

If and are large, then the monetary rule dictates

aggressive responses to excess inflation and to businesscycle fluctuations
If is large relative to , then the monetary authority will
respond much more aggressively to inflation than it will
to the level of economic activity
The case of =0 corresponds to pure inflation targeting

8-9

Interest Rates and Aggregate

Demand

Higher interest rates raise the

opportunity cost of purchasing
goods for investment and
consumption reducing
demand
Ignoring all other elements that
affect aggregate demand, we
can write:

[Insert Figure 8-1 here]

Y C (i ) I (i ) G NX AD(i ) (2)
If the Fed raises interest rates, the
AD curve shifts to the left, as
shown in Figure 8-1
Higher interest rates lower prices,
but also reduce economic activity
8-10

Calculating How to Hit the Target

[Insert Box 8-3 here]

8-11