Can The Federal Reserve System set interest rates

Can The Federal Reserve System set interest rates? Lectures in Macroeconomics- Charles W. Upton

Newspapers and Interest Rates • The FOMC meets, and makes a decision about monetary policy. 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! 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 Po want lower interest rates. • Can it be done? Can the Federal Reserve System Set Interest Rates M Y ro

Increase the Money Supply! • Y curve shifts up and to the right • M curve shifts up P 1 and to the left. Po • P up; r falls. M Y r 1 Can the Federal Reserve System Set Interest Rates ro

The Newspaper Headline • Y curve shifts up and to the right • M curve shifts up P 1 and to the left. Po • P up; r falls. M Fed Cuts Interest Rates! r 1 Can the Federal Reserve System Set Interest Rates ro Y

Not so fast! Can the Federal Reserve System Set Interest Rates

Orders to New York • FOMC sets a target for r, say r 1. • New York Trading P 1 Desk then increases the money supply Po enough to reach r 1 M Y r 1 Can the Federal Reserve System Set Interest Rates ro

Orders to New York • FOMC sets a target for r, say r 1. Note: the FOMC sets a • New York Trading P 1 target for a nominal rate. Desk then increases Holding expected the money supply Po inflation constant, we can enough to reach r 1 translate that into a target r 1 for the real rate. Can the Federal Reserve System Set Interest Rates M Y ro

What does this mean? • FOMC sets a target for r, say In r 1. our terms: • The New. Federal York Trading P 1 System is Reserve Desk then increases changing the money supply, P the money supply o but they target an interest rate enough to reach r 1 – a nominal interest rate Can the Federal Reserve System Set Interest Rates r 1 M Y ro

Does this Mean they Set r? • FOMC sets a target for r, say r 1. • New York Trading P 1 Desk then. Not increases Exactly the money supply Po enough to reach r 1 M Y r 1 Can the Federal Reserve System Set Interest Rates ro

Permanent Effects • The Quantity Recall Theory works. this 2 Po • In time, we slide move to 2 Po Po and no change in r. M Y ro Can the Federal Reserve System Set Interest Rates

Continually Increasing M • Suppose the Federal Reserve System keeps increasing the. P 1 Money Supply to Po keep r at r 1. M Y r 1 Can the Federal Reserve System Set Interest Rates ro

Lincoln’s Law Can the Federal Reserve System Set Interest Rates

Lincoln’s Law Continuing to increase the money supply is inflationary and that will boost expected inflation! Can the Federal Reserve System Set Interest Rates

In for a dime, in for a dollar… If e is going up, and the FOMC wants to keep r. N constant, they must reduce r. R. Can the Federal Reserve System Set Interest Rates

Continually Increasing M • If inflationary expectations rise by e, the target real P 1 interest rate is reduced by e. Po • More money is required Can the Federal Reserve System Set Interest Rates e M Y r 1 ro

Lincoln’s Law Round 2! Can the Federal Reserve System Set Interest Rates

Lincoln’s Law When the government tries to cut interest rates, it may end up raising them. Can the Federal Reserve System Set Interest Rates

The Late 1970’s • High – Interest rates – Inflation rate – Rate of growth of money supply 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 Can the Federal Reserve System Set Interest Rates

Cut the Money Supply! • This is a 100% recycled graph. M P 1 Po Y r 1 Can the Federal Reserve System Set Interest Rates ro

Cut the Money Supply! • This is a 100% recycled graph. M P 1 Po Y r 1 Can the Federal Reserve System Set Interest Rates ro

The Problem • Volker had no credibility • For a while, > e Can the Federal Reserve System Set Interest Rates

The Impact • Volker had no credibility • For a while, e > - e U 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. Can the Federal Reserve System Set Interest Rates

Conclusion • In the Short run, increases (decreases )in the money supply can cut (increase) interest rates. Back to the • Any effect is temporary. demand • And don’t forget about changing supply of loans! inflationary expectations. Can the Federal Reserve System Set Interest Rates

End © 2003 Charles W. Upton. All rights reserved Can the Federal Reserve System Set Interest Rates