Outline:

•How does the Fed change the interest rate?

•The monetary “transmission mechanism”

•Potential breakdowns of the transmission mechanism.

•Brief review of the Fed policy record

InterestRate

Money($Billions)

0

Ms1 Ms

2

Md

E

F

6%

4%

500 800

Fed open market operations bid up the prices of bonds, and drive yields down.

Open Market Operations and the Money Market

InterestRate

Money($Billions)

0

Ms1 Ms

2

Md

E

F

6%

4%

500 800

Fed open market sale depresses bond prices, and drives yields upward.

Fed “Pulls the String”

Question: How is Fed policy “transmitted” to macroeconomic variables such as real GDP, employment, and the general price level?

Fed Open Market Purchase of Securities

Increase in the Money Supply

Decrease in the interest rate

Increase in components of spending that are sensitive to interest rates—specifically, investment and consumer durable goods

Multiplier Effect

Real GDP

00

i

M

AE

Y

450

bIaY p

1

1)(

6%

4%

Ms1 Ms

2

Y1 Y2

AE1

AE2

Md

Diagrammatic explanation of the transmission mechanism

pIa

Some economists(notably

Keynesians) are skeptical about the

effectiveness of expansionary

monetary policy

Breakdowns in the Transmission Mechanism

Breakdowns include:

• Non-responsiveness of aggregate expenditure (AE) to changes in the rate of interest.

• The liquidity trap

i

Investment($Billions)

I2I1

6%

4%

70 74 95

Not interest-sensitive The FED may besuccessful in decreasing interest rates. But what if

investment spending fails torespond?

Ms1 Ms

2

Md

InterestRate

Money($Billions)

i*

0

At an interest rate equal to or below i*, wealth holders wish to hold ALL money and NO bonds.

The FOMC sets a target for the “federal funds” rate, which is the rate that banks

charge other banks for “borrowed” reserves.

The Fed pulled on the string big time

beginning in 1979—it was an anti-inflation

strategy under Chairman Paul Volcker

8

10

12

14

16

18

20

79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01

Federal Funds

Recessions are shaded

6

8

10

12

14

16

18

20

80 82 84 86 88 90 92

Mortgage Interest Rates

Recessions are shadedConventional 30 year

www.economagic.com

Mortgage rate

Monthly Payment1

8% $807.14

10% $965.33

12% $1,131.47

14% $1,303.36

16% $1,479.23

1 Does not include prorated insurance or property taxes.

Monthly payments on a $110,000 30 year mortgage note

400

800

1200

1600

2000

2400

80 82 84 86 88 90 92

Monthly Housing Starts

Recessions are shadedData in thousands of units

www.economagic.gov

More recently, the Fed raised the

federal funds rate six times between May 99 and May 2000—from 4.75% to 6.5

%.

The Fed reversed course at the

beginning of 2001

4.5

5.0

5.5

6.0

6.5

7.0

99:01 99:07 00:01 00:07 01:01

Federal Funds