The document summarizes how monetary policy works to influence interest rates and aggregate demand. The Federal Reserve uses open market operations and the money supply to target a federal funds rate, thereby affecting investment, GDP, and inflation in pursuit of price stability and full employment. While the Taylor Rule provides a model for predicting interest rate decisions, central banks now focus on inflation targeting by announcing and aiming to hit a specific inflation target.

2.  In the short run, the interest rate is
determined in the money market and
the loanable funds market adjusts in
response to changes in the money
market.
 However, in the long run, the interest rate
is determined by matching supply and
demand of loanable funds that arise
when real GDP equals potential output.

3.  The Federal Reserve can use changes in
the money supply to change the interest
rate.
 An increase in the money supply drives
the interest rate down, and a decrease
in the money supply drives the interest
rate up.
 So, by adjusting the money supply up or
down, the Fed can set the interest rate.

4.  The Federal Open Market Committee
meets every six weeks to decide on the
interest rate by targeting a target federal
funds rate, which is a desired level for the
federal funds rate.
 This target is then enforced by the Open
Market Desk of the Federal Reserve Bank
of New York, which adjusts the money
supply through open-market operations.
 Open market operations are purchase or
sale of Treasury bills on the open market.

5.  The Fed purchases or sells Treasury bills
until the actual federal funds rate equals
the target rate.
 The other tools of monetary policy,
lending through the discount window or
changes in the reserve requirements, are
not used regularly.

6.  Monetary policy, as with fiscal policy,
can be used to stabilize the economy.
 Monetary policy shifts the aggregate
demand curve through the effect of
monetary policy on the interest rate.

7.  When the Fed expands the money supply,
this leads to a lower interest rate.
 A lower interest rate leads to more
investment spending, which leads to a
higher real GDP, which leads to higher
consumer spending, and so on through the
multiplier process.
 The total quantity of goods and services
demanded at any given aggregate price
level rises when the quantity of money
increases, and the AD curve shifts to the
right.
 This is called expansionary monetary policy.

8.  When the Fed contracts the money supply,
this leads to a higher interest rate.
 A lower interest rate leads to lower
investment spending, which leads to a
lower real GDP, which leads to lower
consumer spending, and so on.
 The total quantity of goods and services
demanded falls when the money supply is
reduced, and the AD curve shifts to the left.
 This is called contractionary monetary
policy.

9.  Policy makers try to fight recessions; they
also try to ensure price stability, with low
(but not zero) inflation.
 In general, central banks engage in
expansionary monetary policy when the
actual GDP is below potential output.
 The output gap is the percentage
difference between actual real GDP and
potential output; it is positive when actual
real GDP exceeds potential output, and
negative when actual real GDP lies below
potential output.

10.  The Fed has tended to raise interest rates
when the output gap is rising (inflationary
gap) and cut rates when the output gap is
falling (recessionary gap).
 One exception was in the late 1990s when
the Fed left rates steady for several years
even as a positive output gap developed,
which went along with a low
unemployment rate. This was because the
inflation rate was low.
 Low inflation during the mid-1990s helped
encourage loose monetary policy both in
late 1990s and in 2002-2003.

11.  In 1993, Stanford economist John Taylor
suggested that monetary policy should
follow a rule that takes into account
concerns about both the business cycle
and inflation.
 The Taylor Rule for monetary policy is a
rule for setting the federal funds rate that
takes into account both the inflation rate
and the output gap.

12.  Taylor suggested that the actual
monetary policy often looks as if the Fed
was following this rule.
 The rule Taylor suggested was:
Federal Funds Rate =
1 + (1.5 * inflation rate) + (0.5 * output gap)
 Taylor’s rule does a pretty good job at
predicting the Fed’s actual behavior.

13.  However, in 2009, a combination of low
inflation and a large and negative
output gap put Taylor’s rule of prediction
of the federal funds rate into the
negative numbers, which is impossible to
target.
 The Fed responded by cutting rates
aggressively and the federal funds rate
fell to almost zero.

14.  Monetary policy, rather then fiscal
policy, is the main tool of stabilization
policy.
 Like fiscal policy, it is subject to lags: it
may take time for the Fed to recognize
economic problems and time for
monetary policy to affect the economy.
 However, the Fed can move more
quickly than Congress, so monetary
policy is the preferred tool.

15.  The Fed tries to keep inflation low, but
positive. Although the Fed does not target
any specific rate of inflation, it is widely
believed to prefer inflation at about 2% per
year.
 However, other central banks do have
explicit inflation targets, so they don’t use
any rule to set monetary policy.
 Instead, they announce the inflation rate
that they want to achieve (the inflation
target), and set policy in an attempt to hit
that target; this is called inflation targeting.

16.  The central bank of New Zealand was
the first to adopt inflation targeting, for a
range between 1-3%.
 Central banks with a target range for
inflation seem to aim for the middle of a
range between 1-3%, and central banks
with a fixed target tend to give
themselves considerable wiggle room.

17.  The difference between inflation
targeting and the Taylor rule is that
inflation targeting is forward-looking and
the Talylor rul is backward-looking.
 The Taylor rule adjusts monetary policy in
response to past inflation, but inflation
targeting is based on a forecast of future
inflation.

18.  Inflation targeting has two key
advantages:
1. Transparency: the public knows the
objective of an inflation-targeting
central bank.
2. Accountability: the success of a central
bank can be judged by seeing how
closely actual inflation rates have
matched the inflation target, so central
bankers are accountable.

19.  Inflation-targeting is criticized as being
too restrictive; there are times when
other concerns should take priority over
any particular inflation rate, when the
stability of the financial system is at risk.
 For example, in 2007-8 the Fed cut rates
more than either the Taylor rule or
inflation targeting would dictate
because of the fear of turmoil in the
financial markets leading to a major
recession (which it did).