Monetary Policy Flashcards
What is most important reason for US economy’s downward slope of AD curve
1) interest rate effect
What is the theory of liquidity preference
1) Interest rate adjusts to bring money supply + money demand into balance
2) Hold inflation constant –> explain real + nominal interest rates
Explain the parts of the theory of liquidity preference
1) Money Supply = Dictated by the fed + doesn’t depend on interest rates (vertical line)
2) Money Demand = Interest rates –> opportunity cost of holding money, so if interest rates go up, the cost of holding money and not having it in a bank increases –> demand for money goes down
3) Equilibrium interest rate = when quantity demanded = quantity supplied
How does quantity money demanded + supplied reach equilibrium based on theory of liquidity preference
1) People holding too little money –> many people buy bonds BUT in response interest rates for bonds fall –> people hold more money until equals amount fed supplied
2) People holding too much money –> fewer people buying bonds SO interest rates rise –> people buy more bonds + reduce money they are holding until equals amount fed supplied
Summarize interest rate effect for increase in price level
1) Higher price level raises money demand (since need more money for every transaction)
2) Higher money demand –> higher interest rate
3) Higher interest rate –> reduces quantity of goods/services demanded
MOVEMENT ALONG CURVE
Summarize interest rate effect for increase in money supply
1) Fed increases money supply
2) Lowers interest rate + increases quantity of goods/services demanded for any level
3) Shifts AD curve to right
SHIFT OF CURVE
Why would fed target federal funds rate
1) Difficult to measure money supply precisely
2) Money demand fluctuates
SO by targeting fed funds rate –> accommodates day-to-day shifts in money demand
What can monetary policy be described in terms of?
1) Money supply
2) Interest rate
Expanding AD –> inject money supply or reduce interest rate
Contracting AD –> decrease money supply or increase interest rate
What is the liquidity trap?
1) If interest rates fall to 0 –> then monetary policy may not be effective (cannot reduce to below 0)
What are actions the fed can take despite liquidity trap
1) Forward guidance = promise that they will keep interest rates low for extended period –> should stimulate investment
2) Using variety of financial instruments –> quantitative easing by buying mortgage backed securities
