CHAPTER 15 | Monetary Policy
Brief Chapter Summary and Learning Objectives
The authors use the dynamic aggregate demand-aggregate model to discuss monetary policy in section 4
of this chapter. This section is self-contained so you can omit it without any loss of continuity in your
discussion of monetary policy.
15.1 What Is Monetary Policy? (pages 896–898)
15.2 The Money Market and the Fed’s Choice of Monetary Policy Targets
(pages 898–904)
Describe the Federal Reserve’s monetary policy targets and explain how expansionary
15.3 Monetary Policy and Economic Activity (pages 904–912)
Use aggregate demand and aggregate supply graphs to show the effects of monetary
15.4 Monetary Policy in the Dynamic Aggregate Demand and Aggregate
Supply Model (pages 912–917)
15.5 A Closer Look at the Fed’s Setting of Monetary Policy Targets
(pages 917–922)
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15.6 Fed Policies during the 2007–2009 Recession (pages 923–929)
Describe the policies the Federal Reserve used during the 2007–2009 recession.
▪ In addition to the policies it typically uses during recessions, the Federal Reserve used
new policies to combat the financial crisis that accompanied the recession of 2007–2009.
Key Terms
Contractionary monetary policy, p. 906. The
Federal Reserve’s policy of increasing interest
rates to reduce inflation.
Expansionary monetary policy, p. 906. The
Monetary policy, p. 896. The actions the
Federal Reserve takes to manage the money
supply and interest rates to achieve
macroeconomic policy goals.
Chapter Outline
Why Would a Bank Pay a Negative Interest Rate?
In 2015, some banks in Europe were receiving negative nominal interest rates on their loans. The interest
rates on these loans were not fixed but were adjusted based on changes in short-term interest rates that
15.1
What Is Monetary Policy? (pages 896–898)
Learning Objective: Define monetary policy and describe the Federal Reserve’s
monetary policy goals.
In 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (the Fed). The
main responsibility of the Fed was to make discount loans to banks to prevent bank panics. As a result of
354 CHAPTER 15 | Monetary Policy
A. The Goals of Monetary Policy
The Fed has four monetary policy goals that are intended to promote a well-functioning economy:
1. Price stability
Extra Solved Problem 15.1
Monetary Policy and Economic Growth
The textbook lists the Federal Reserve’s four monetary policy goals: (1) price stability, (2) employment,
(3) stability of financial markets and institutions, and (4) economic growth. The control the Fed has over
the supply of money and interest rates is the source of its ability to achieve goals (1) and (3), but how
much control does the Fed have over real variables such as employment and economic growth? The
Is Lawrence Meyer correct in stating that the Federal Reserve cannot affect output (or economic growth)
and employment?
Solving the Problem
Step 1: Review the chapter material.
This problem is about monetary policy, so you may want to review the section “What Is
Monetary Policy?” which begins on page 896 in the textbook.
Step 2: Is Lawrence Meyer correct in stating that the Federal Reserve cannot affect output
(or economic growth) and employment.
An important phrase was left out of Meyer’s comments: “…monetary policy cannot influence
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Extra Making
the
Connection
The Federal Reserve System’s Monetary Policy Goals
In its publication “Purposes & Functions,” the Federal Reserve System offers a detailed description of the
operations of the central bank. The following is a passage from that publication describing the Fed’s
monetary policy goals.
The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the
Teaching Tips
The end of the chapter in the main text includes a special category of exercises titled Real-Time Data
Exercises. These exercises help students become familiar with a key data source, learn how to locate data,
and develop skills in interpreting data. Those exercises marked with a red circle allow students and
instructors to use the very latest data from the web site of the Federal Reserve Bank of St. Louis (FRED).
Many RTDA exercises require more elaborate calculations than other problems and the use of Excel
spreadsheets.
15.2
The Money Market and the Fed’s Choice of Monetary Policy Targets
(pages 898–904)
Learning Objective: Describe the Federal Reserve’s monetary policy targets and
explain how expansionary and contractionary monetary policies affect the interest
rate.
A. Monetary Policy Targets
The Fed can’t affect unemployment and inflation rates directly. The Fed uses variables called monetary
356 CHAPTER 15 | Monetary Policy
B. The Demand for Money
The demand curve for money slopes downward because a lower interest rate causes households and firms
C. Shifts in the Money Demand Curve
The two most important variables that cause the money demand curve to shift are real GDP and the price
level. An increase in real GDP means that the amount of buying and selling of goods and services has
D. How the Fed Manages the Money Supply: A Quick Review
Eight times per year, the FOMC meets in Washington, D.C. If the FOMC decides to increase the money
supply, it orders the trading desk at the Federal Reserve Bank of New York to purchase U.S. Treasury
E. Equilibrium in the Money Market
For simplicity, we assume that the Fed can fix the money supply. Therefore, the money supply curve is a
vertical line and changes in the interest rate have no effect on the quantity of money supplied. Equilibrium
in the money market occurs where the money demand curve crosses the money supply curve. When the
Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which
households and firms are willing to hold the additional money.
F. A Tale of Two Interest Rates
We need two models of the interest rate. The loanable funds model is concerned with the long-term real
G. Choosing a Monetary Policy Target
The Fed chooses the money supply or the interest rate as its monetary policy target. The Fed has generally
focused more on the interest rate than on the money supply. There are many interest rates in the economy
but for purposes of monetary policy, the Fed has targeted the interest rate known as the federal funds rate.
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H. The Importance of the Federal Funds Rate
The Fed pays banks a low interest rate on their reserves, so banks have an incentive to invest reserves
above the 10 percent reserve requirement. During the financial crisis, reserves soared as banks attempted
Extra Making
the
Connection
Why Did the Fed’s Monetary Policy Fail During the Great
Depression?
Many economists have criticized the Federal Reserve for its monetary policy decision-making during the
Great Depression. Instead of pursuing an expansionary monetary policy, as the Federal Reserve typically
does now during recessions, critics claim that the Fed “sat on its hands.” Allan H. Meltzer of Carnegie
Mellon University has written A History of the Federal Reserve in which he studies why the Federal
Reserve acted as it did. In an interview that appeared in The Region, a magazine published by the Federal
Reserve Bank of Minneapolis, Professor Meltzer was asked about the Fed’s behavior during the Great
Depression.
Region: [In your book] you clearly…describe the Fed’s early failures to do precisely what it
15.3
Monetary Policy and Economic Activity (pages 904–912)
Learning Objective: Use aggregate demand and aggregate supply graphs to show the
effects of monetary policy on real GDP and the price level.
The ability of the Fed to use monetary policy to affect economic variables depends on its ability to affect
real interest rates. Because the federal funds rate is a short-run nominal interest rate, the Fed sometimes
has difficulty affecting long-term interest rates.
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A. How Interest Rates Affect Aggregate Demand
Changes in interest rates affect aggregate demand, which is the total level of spending in the economy.
Changes in interest rates will not affect government purchases, but will affect consumption, investment,
and net exports in the following ways:
• Consumption: Lower interest rates lead to increased spending on durables and reduce the return
B. The Effects of Monetary Policy on Real GDP and the Price Level
Expansionary monetary policy is the Federal Reserve’s policy of decreasing interest rates to increase
real GDP. Contractionary monetary policy is the Federal Reserve’s policy of increasing interest rates to
reduce inflation. The Fed can use monetary policy to affect the price level and, in the short run, the level
of real GDP.
C. Can the Fed Eliminate Recessions?
Keeping recessions shorter and milder than they would otherwise be is usually the best the Fed can do.
D. Fed Forecasts
Because it can take a long time for a change in monetary policy to affect real GDP, the Fed tries to set
E. A Summary of How Monetary Policy Works
A contractionary monetary policy does not cause the price level to fall, but causes it to rise by less than it
would have without the policy. An expansionary monetary policy is sometimes called a loose or easy
policy. A contractionary policy is sometimes called a tight policy.
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Before most meetings of the FOMC, newspapers report stock traders’ predictions of possible Fed actions
and whether those actions will cause stock prices to increase or decrease. Some Wall Street analysts are
known as Fed watchers because they study the Fed and attempt to forecast future changes in the target for
the federal funds rate. Why do changes in the federal funds rate affect the stock market? There are two
The second reason that stock prices react to changes in interest rates is that changes in interest rates make
it more or less attractive for people to invest in stocks rather than in other financial assets. Investors look
for the highest return possible on their investments, holding constant the risk level of the investments. If
the interest rates on Treasury bills, bank certificates of deposit, and corporate bonds are all low, an
investment in stocks will be more attractive. When interest rates are high, an investment in stocks will be
less attractive.
Question
The following excerpt is from an article in the Wall Street Journal:
The immediate catalyst for yesterday’s gains [in stock prices] was a Federal Reserve report…
Some investors interpreted the comments to mean that if the economy proves resilient, the Fed
won’t stifle it with a rate increase and if it proves weaker than expected, the Fed might even cut
rates.
Source: Peter A. McKay and E. S. Browning, “S&P Joins Record Club,” Wall Street Journal, May 31, 2007.
Why would stock prices increase if investors believe that the Federal Reserve will not be raising interest
rates and may even be cutting them?
Answer
Two reasons why stock prices rise if investors believe that the Fed will not raise interest rates or will even
360 CHAPTER 15 | Monetary Policy
Still, discount loans remain an effective way for the Fed to make funds available quickly to banks in an
emergency. The banks can use these funds to provide cash or loans to households and firms. The day after
the terrorist attacks of September 11, 2001 in New York, Washington, D.C., and Pennsylvania, the Fed
made massive discount loans to banks. Discount loans rose from $99 million on September 5 to $45.5
Question
Some economists and members of Congress have argued that because of deposit insurance, bank runs and
bank panics no longer occur, and the Fed no longer needs to act as a lender of last resort. Therefore, the
Federal Reserve Act should be amended to eliminate the ability of the Fed to make discount loans. Briefly
evaluate this argument.
Answer
Discount loans are an effective way for the Fed to make funds available to banks in an emergency, and
15.4
Monetary Policy in the Dynamic Aggregate Demand and Aggregate
Supply Model (pages 912–922)
Learning Objective: Use the dynamic aggregate demand and aggregate supply model
to analyze monetary policy.
In Chapter 13, we developed a dynamic aggregate demand and aggregate supply model to take account of
the following facts: (1) The economy experiences continuing inflation, and (2) the economy experiences
long-term growth, with the LRAS curve shifting to the right every year.
A. The Effects of Monetary Policy on Real GDP and the Price Level: A More
Complete Account
During some periods, aggregate demand (AD) does not increase enough to keep the economy at potential
B. Using Monetary Policy to Fight Inflation
The Fed can also use a contractionary monetary policy to keep aggregate demand from expanding so
CHAPTER 15 | Monetary Policy 361
target for the federal funds rate to 5.25 percent, where it remained until September 2007, when concern
about financial markets led it to cut the target to 4.75 percent. Because the Fed kept aggregate demand
from increasing as much as it otherwise would have, short-run equilibrium occurred closer to potential
GDP and the inflation rate was held to 3 percent.
the following companies:
1. Bank of Nova Scotia, New York Agency
2. BMO Capital Markets Corp.
3. BNP Paribas Securities Corp.
4. Barclays Capital Inc.
12. Jefferies LLC
13. J. P. Morgan Securities LLC
14. Merrill Lynch, Pierce, Fenner & Smith Incorporated
15. Mizuho Securities USA Inc.
The Web page of Federal Reserve Bank of New York explains that primary dealers:
…serve as trading counterparties of the New York Fed in its implementation of monetary policy.
This role includes the obligations to: (i) participate consistently in open market operations to
362 CHAPTER 15 | Monetary Policy
15.5
A Closer Look at the Fed’s Setting of Monetary Policy Targets
(pages 917–922)
Learning Objective: Describe the Fed’s setting of monetary policy targets.
A. Should the Fed Target the Money Supply?
Some economists have argued that rather than using an interest rate as its monetary policy target, the Fed
B. Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate?
Most economists believe that an interest rate is the best monetary policy target. The Fed can’t target both
C. The Taylor Rule
The Taylor rule is a rule developed by John Taylor that links the Fed’s target for the federal funds rate to
economic variables. According to the Taylor rule, the Fed should set the target for the federal funds rate
so that it is equal to the sum of the inflation rate, the equilibrium real federal funds rate, and two
During the mid-2000s, the actual federal funds rate was lower than the predicted federal funds rate. Some
economists, including Taylor, argue that these low targets for the federal funds rate contributed to an
excessive increase in spending on housing.
D. Inflation Targeting
Inflation targeting is a framework for conducting monetary policy that involves the central bank
announcing its target level of inflation. After many years of not having an inflation target, the Fed
announced in 2012 that it would attempt to maintain an average inflation rate of 2 percent per year. With
inflation targeting, the Fed can still respond to periods of economic problems without following an
CHAPTER 15 | Monetary Policy 363
Extra Solved Problem 15.5
Targeting Inflation
On February 1, 2006, Ben S. Bernanke was sworn in as chairman of the Federal Reserve Board. Although
Bernanke is a respected macroeconomist, he succeeded a chairman, Alan Greenspan, who was given high
marks for his leadership of the Fed during a period (1987–2006) of prosperity and low inflation. In the
months leading up to the end of Greenspan’s tenure, much speculation surrounded how the Reserve Board
would operate under its new chairman. Long before his appointment as chairman, Bernanke proposed that
the Fed engage in inflation targeting. In a 2004 interview, Bernanke was asked if the Fed’s prior
commitment to price stability was not a de facto inflation targeting policy. Bernanke gave the following
response.
It’s true that the Federal Reserve is already practicing something close to de facto inflation
targeting…My main suggestion is to…give an explicit objective…to provide the public with a
Solving the Problem
Step 1: Review the chapter material.
This problem is about the monetary policy targets of the Federal Reserve System, so you may
want to review the section “A Closer Look at the Fed’s Setting of Monetary Policy Targets,”
which begins on page 917 of the textbook.
Step 2: What purpose will be served by setting an explicit target for inflation?
The main reason for establishing an inflation rate target is that it strengthens the commitment
of the Federal Reserve to price stability. Central banks can come under political pressure to
364 CHAPTER 15 | Monetary Policy
15.6
Fed Policies during the 2007–2009 Recession (pages 923–929)
Learning Objective: Describe the policies the Federal Reserve used during the 2007–
2009 recession.
The severity of the recession of 2007–2009 complicated the Fed’s job.
A. The Inflation and Deflation of the Housing Market Bubble
The Fed lowered the target for the federal funds rate during the 2001 recession to stimulate the demand
for housing. The policy was successful, but by 2005 many economists argued that a “bubble” had formed
B. The Changing Mortgage Market
Until the 1970s, the commercial banks and savings and loans that granted mortgages kept the loans until
the borrowers paid them off. Many members of Congress believed that home ownership could be
increased by creating a secondary market in mortgages. If a bank or savings and loan granted a mortgage
C. The Role of Investment Banks
By the 2000s, further changes had taken place in the mortgage market. First, investment banks became
significant participants in the secondary market for mortgages. Investment banks bought mortgages,
bundled large numbers of them together as bonds known as mortgage-backed securities, and resold them
to investors. Mortgage-backed securities became popular with investors because they paid higher interest
rates than other securities with comparable default risk.
CHAPTER 15 | Monetary Policy 365
D. The Fed and the Treasury Department Respond
The Fed entered into an unusual partnership with the U.S. Treasury Department to develop new policies.
The financial crisis significantly worsened after the bankruptcy of the investment bank Lehman Brothers
in September 2008. Prior to this, some economists criticized the Fed and Treasury for arranging the sale
of Bear Stearns to JP Morgan Chase. They were concerned with the moral hazard problem, which is the
Extra Solved Problem 15.6
The Fed Uses New Policy Tools to Respond to Financial Crisis
Ben Bernanke, while he served as chairman of the Board of Governors of the Federal Reserve System,
explained how the Federal Reserve used new policy tools to respond to the financial crisis and recession
that occurred between 2007 and 2009. The following are excerpts from a speech Bernanke gave at the
London School of Economics in January 2009:
The Federal Reserve has responded aggressively to the crisis since…the summer of 2007…One
important tool is communication…the [FOMC] should be able to influence longer-term interest
rates by informing the public’s expectations about the future course of monetary policy…the
366 CHAPTER 15 | Monetary Policy
Some observers have expressed concern that, by expanding its balance sheet, the Federal Reserve
is effectively printing money, an action that will ultimately be inflationary. The Fed’s lending
activities have indeed resulted in a large increase in excess reserves held by banks …. However,
banks are choosing to leave the great bulk of their excess reserves idle…
As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline,
implying a reduction in excess reserves…the Federal Reserve will be able to return to its
traditional means of making monetary policy—namely, by setting a target for the federal funds
rate.
Solving the Problem
Step 1: Review the chapter material.
This problem is about the policies the Federal Reserve used during the 2007–2009 recession
Step 2: Explain how the policies the Federal Reserve used to respond to the financial crisis
differed from policies it used during earlier recessions.
The Federal Reserve: (a) allowed primary securities dealers (broker-dealers that trade in
Treasury securities with the Federal Reserve Bank of New York) to borrow from the Fed’s
Step 3: Discuss the risk the Federal Reserve took by “responding aggressively” to the
economic crisis of 2007–2009.
Most of the actions Ben Bernanke described caused an increase in bank reserves. There was a
large increase in banks’ excess reserves, which can be used to expand deposits and the money
supply. So, the Fed was risking an increase in the inflation rate.