Outline:

1
The Fed and the Interest Rate

• 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

2
Open Market Operations and the Money Market
InterestRate
Ms1
Ms2
Fed open market operations bid up the prices of
bonds, and drive yields down.
E
6
F
4
Md
0
Money(Billions)
500
800
3
Fed Pulls the String
InterestRate
Ms1
Ms2
Fed open market sale depresses bond prices, and
drives yields upward.
E
6
F
4
Md
0
Money(Billions)
500
800
4
The transmission mechanism
Question How is Fed policy transmitted to
macroeconomic variables such as real GDP,
employment, and the general price level?
5
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 ratesspecifically,
investment and consumer durable goods
Multiplier Effect
Real GDP
6
Diagrammatic explanation of the transmission
mechanism
Ms1
Ms2
i
AE
AE2
AE1
6
4
Md
450
0
0
Y1
Y2
M
Y
7
Breakdowns in the Transmission Mechanism
Some economists(notably Keynesians) are
skeptical about the effectiveness of expansionary
monetary policy

• Breakdowns include
• Non-responsiveness of aggregate expenditure (AE)
  to changes in the rate of interest.
• The liquidity trap

8
Why expansionary monetary policy may be
ineffective, part 1
The FED may be successful in decreasing interest
rates. But what if investment spending fails
to respond?
Not interest-sensitive
i
6
4
I2
I1
70
74
Investment(Billions)
95
9
Liquidity Trap
InterestRate
Ms1
Ms2
At an interest rate equal to or below i, wealth
holders wish to hold ALL money and NO bonds.
Md
i
0
Money(Billions)
10
Fed "target" rate
The FOMC sets a target for the federal funds
rate, which is the rate that banks charge other
banks for borrowed reserves.
11
The Fed pulled on the string big time beginning
in 1979it was an anti-inflation strategy under
Chairman Paul Volcker
12
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13
Conventional 30 year
www.economagic.com
14
Monthly payments on a 110,000 30 year mortgage
note
1 Does not include prorated insurance or property
taxes.
15
Data in thousands of units
www.economagic.gov
16
More recently, the Fed raised the federal funds
rate six times between May 99 and May 2000from
4.75 to 6.5 .
17
The Fed reversed course at the beginning of 2001
18
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