Chapter Twelve:

The Federal Reserve and

Monetary Policy

Monetary Policy

Table 12.1: A Simplified Balance Sheet of the Federal Reserve

Table 12.2: An Open Market Purchase of Government Bonds by the Fed

Table 12.3: A Loan by ABC Bank Becomes a Deposit in XYZ Bank

The Theory of Money, Interest Rates, and Aggregate Demand

Quantity of Federal Funds Borrowed and Lent

Fe

de

ral F

un

ds

Ra

te

6 %

Supply of Federal Funds

Demand for Federal Funds

E

Figure 12.1a: The Market for Federal Funds

Fe

de

ral F

un

ds

Ra

te

6 %

New Supply of Federal Funds

Demand for Federal Funds

E1

E0

5 %

Original Supply of Federal Funds

Quantity of Federal Funds Borrowed and Lent

Figure 12.1b: An Open Market Purchase Lower the Federal Funds Rate

Quantity of federal funds borrowed and lent

Fe

de

ral F

un

ds

Ra

te

Demand for Federal Funds

E1

A

E0

5 %

Supply of Federal Funds

Target Rate

B

Figure 12.2: Maintaining the Federal Funds Target Rate

Prime Rate

Fed Funds Rate

Figure 12.3: The Federal Fund and Prime Rates

Source: Federal Reserve Board, monthly data

Intended Investment (II )

Inte

res

t ra

te (

r )

II

r0

II0 II1

r1

Figure 12.4: The Intended Investment Schedule

Intended Investment (II )

Inte

res

t ra

te (

r )

II

I* I**

r

II’

Figure 12.5: An Increase in Investor Confidence

Expansionarymonetary policy

Lowersinterest rates

Investment isencouraged

Aggregatedemand rises

EquilibriumGDP rises

45

Income

Ag

gre

gat

e D

em

an

d a

nd

Ou

tpu

t

AD1 (with new, lower

interest rate, r1)E1

E0

AD0 (with old

interest rate, r0)

Y1Y0

Figure 12.6: Expansionary Monetary Policy and the AD Curve

Monetary Policies in Practice

Fed

eral

Fu

nd

s R

ate

(%)

Figure 12.7a: Monetary Policy and Investment, 2000-2012

Pri

vate

Fix

ed I

nve

stm

ent

(bil

lio

ns

of

2005

ch

ain

ed d

oll

ars)

Nonresidential Investment

Figure 12.7b: Monetary Policy and Investment, 2000-2012

Intended Investment (II)

Inte

res

t ra

te (

r )

I*I**

5%

A

II’

8%Original Target Rate

New Target Rate

II

B

Figure 12.8: Expansionary Monetary Policy in an Environment of Pessimism

Appendices

Quantity of Bonds

Pri

ce o

f B

on

ds

(an

d

inte

rest

rat

e)

$ 100 (i = 5%)

Supply of Bonds

Demand for Bonds

E

Figure 12.9a: The Market for Government Bonds

Quantity of Bonds

Pri

ce o

f B

on

ds

(an

d i

nte

rest

rat

e)

$ 100 (i = 5%)

Supply of Bonds

Original Demand for Bonds

E0

E1$103 (i = 2%)

New Demand for Bonds

Figure 12.9b: The Market for Government Bonds

Inte

rest

Rat

e (%

)Figure 12.10: The Federal Funds and Three-Month

Treasury Bill Rates, 2000-2012