Prepared By Brock Williams

Chapter 17
Monetary Policy
and Inflation
Little did Ben S. Bernanke know
when he took over the reins as
chairman of the Federal Reserve on
February 1 !""# that he would
face a novel and comple$ crisis
brou%ht on by the fall in housin%
prices and its reverberations
throu%hout the entire financial
system in !""& and !""'.
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.!
1. +$plain the role of demand and supply in the
money market.
!. List the tools that the Fed can use to chan%e short.
term interest rates.
/. 0emonstrate usin% supply and demand curves how
the Fed can determine short.term interest rates.
*. 0escribe both the domestic and international
channels throu%h which monetary policy can affect
real 10P.
2. -ssess the challen%es the Fed faces in
implementin% monetary policy.
Learning Objectives
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&./
money market
The market for money in which the
amount supplied and the amount
demanded meet to determine the
nominal interest rate.
transaction demand for money
The demand for money based on
the desire to facilitate transactions.
The Demand for Money
INTEREST RTES !!E"T M#NE$ DEMND
17.1 TH MO!" M#$%T
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.*
The Demand for Money

FIGURE 17.1
Demand for Money
P R I N C I P L E O F O P P O R U N I ! C O "
#e o$$ort%nity cost of somet#in& is '#at yo% sacrifice to &et it.
s interest rates increase
from r
%
to r
&
' the (uantity of
money demanded falls from
M
%
to M
&
.
17.1 TH MO!" M#$%T &cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.2
The Demand for Money
T)E *RI"E +E,E+ ND -D* !!E"T M#NE$ DEMND

FIGURE 17.(
"#iftin& t#e
Demand for Money
R E ) L * N O M I N ) L P R I N C I P L E
+#at matters to $eo$,e is t#e rea, -a,%e of money or income. its $%rc#asin&
$o'er.not t#e face -a,%e of money or income.
"han.es in prices
and real -D* shift
the demand for
money.
17.1 TH MO!" M#$%T &cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.#
/E!OND PURC0)"ING RE)"UR! "ECURIIE"
)PPL!ING 0E CONCEP" 112 0o' #as t#e Fed
recent,y e3$anded its ro,e in financia, markets4
Traditionally' to e/pand the money supply' the !ed purchased Treasury Securities.
The !ed did not inter0ene directly in security or credit markets.
fter the financial crisis of 1%%2' they chan.ed their policies.
The !ed increased its assets from less than 3& Trillion to o0er 31 Trillion.
In 1%&% The !ed held o0er 3& Trillion in mort.a.e4backed securities.
The !ed desi.ned a wide 0ariety of pro.rams to channel funds to particular credit
markets.
"ritics are worried the !ed crossed a political threshold that may pose a risk to its
lon.4term independence.
) P P L I C ) I O N 1
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.&
The Demand for Money
#T)ER "#M*#NENTS #! M#NE$ DEMND
i,,i5%id
Not easily transferable to money.
,i5%idity demand for money
The demand for money that represents
the needs and desires indi0iduals and
firms ha0e to make transactions on short
notice without incurrin. e/cessi0e costs.
s$ec%,ati-e demand for money
The demand for money that arises
because holdin. money o0er short
periods is less risky than holdin.
stocks or bonds.
17.1 TH MO!" M#$%T &cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.'
o$en market o$erations
The purchase or sale of 5.S.
.o0ernment securities by the !ed.
#pen Market #perations
o$en market $%rc#ases
The !ed6s purchase of .o0ernment
bonds from the pri0ate sector.
o$en market sa,es
The !ed6s sale of .o0ernment
bonds to the pri0ate sector.
17.( HO) TH *+$#L $,$-
C#! CH#!. TH MO!" ,/PPL"
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.3
disco%nt rate
The interest rate at which banks
can borrow from the !ed.
#ther Tools of the !ed
federa, f%nds market
The market in which banks borrow
and lend reser0es to and from one
another.
federa, f%nds rate
The interest rate on reser0es
that banks lend each other.
")N-IN- RESER,E RE75IREMENTS
")N-IN- T)E DIS"#5NT RTE
If the !ed wishes to increase the supply of money' it can reduce banks6 reser0e
re(uirements so they ha0e more money to loan out.
17.( HO) TH *+$#L $,$- C#!
CH#!. TH MO!" ,/PPL" &cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1"
DID FED POLIC! C)U"E 0E COMMODI! /OOM
)PPL!ING 0E CONCEP" 1(2 +#at is t#e ,ink 6et'een a
do,,ar de$reciation and increases in commodity $rices4
Startin. in the summer of 1%&%' there was a rise in prices of commodities such as oil
and food worldwide. These increases in prices helped some economies8producers
of these commodities8but hurt others. Some economists su..ested that monetary
policy in the 5nited States was the cause of the worldwide commodity boom. They
noticed that commodity prices rose when the 5.S. dollar depreciated. nd they
noticed that the 5.S. dollar fell lar.ely because monetary policy in the 5.S. had dri0en
interest rates down 0ery low because the !ed was usin. (uantitati0e easin. to further
stimulate the economy.
,ice4"hair of the 9oard of -o0ernors' :anet +. $ellen' .a0e her own perspecti0e in a
speech in pril 1%&& to the Economic "lub of New $ork. She noted that the sharp rise in
commodity prices was many times lar.er than the dollar depreciation. Moreo0er' she
pointed to increases in worldwide demand and shorta.es of supply that were the primary
cause of these price increases.
$ellen did note that when the 5.S. lowered interest rates' other countries also
followed for fear that too much capital would flow into their countries if their interest
rates were hi.her than those in the 5.S.
) P P L I C ) I O N (
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.11

FIGURE 17.7
E5%i,i6ri%m in t#e
Money Market
E(uilibrium in the money
market occurs at an
interest rate of r;' at
which the (uantity of
money demanded e(uals
the (uantity of money
supplied.
17.0 HO) I!T$,T $#T, #$
+T$MI!+1 COM2I!I!. TH +M#!+
#!+ ,/PPL" O* MO!"
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1!

FIGURE 17.8
Federa, Reser-e and Interest Rates
"han.es in the supply of money will chan.e interest rates.
17.0 HO) I!T$,T $#T, #$
+T$MI!+1 COM2I!I!. TH +M#!+
#!+ ,/PPL" O* MO!" &cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1/

FIGURE 17.9
#e Money Market and In-estment "$endin&
The e(uilibrium interest rate r; is determined in the money market.
t that interest rate' in0estment spendin. is .i0en by I;.
17.3 I!T$,T $#T, #!+ HO) TH"
CH#!. I!-,TM!T #!+ O/TP/T &.+P'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1*

FIGURE 17.:
Monetary Po,icy and Interest Rates
s the money supply increases' interest rates fall from r
%
to r
&
. In0estment spendin. increases
from I
%
to I
&
.
17.3 I!T$,T $#T, #!+ HO) TH"
CH#!. I!-,TM!T #!+ O/TP/T &.+P'
&cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.12

FIGURE 17.7
Money "%$$,y and )&&re&ate Demand
<hen the money supply is increased' in0estment spendin. increases' shiftin. the AD cur0e to
the ri.ht. #utput increases and prices increase in the short run.
17.3 I!T$,T $#T, #!+ HO) TH"
CH#!. I!-,TM!T #!+ O/TP/T &.+P'
&cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1#
17.3 I!T$,T $#T, #!+ HO) TH"
CH#!. I!-,TM!T #!+ O/TP/T &.+P'
&cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1&
Monetary *olicy and International Trade
e3c#an&e rate
The rate at which currencies
trade for one another in the
market.
de$reciation of a c%rrency
decrease in the 0alue of a
currency.
17.3 I!T$,T $#T, #!+ HO) TH"
CH#!. I!-,TM!T #!+ O/TP/T &.+P'
&cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.1'
Monetary *olicy and International Trade
a$$reciation of a c%rrency
n increase in the 0alue of a
currency.
17.3 I!T$,T $#T, #!+ HO) TH"
CH#!. I!-,TM!T #!+ O/TP/T &.+P'
&cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.13
0E EFFECI;ENE"" OF COMMIEE"
)PPL!ING 0E CONCEP" 172 Is it 6etter for decisions a6o%t
monetary $o,icy to 6e made 6y a sin&,e indi-id%a, or 6y a
committee4
<hen *rofessor lan 9linder returned to teachin. after ser0in. as 0ice4chairman of the
!ederal Reser0e from &==> to &==?' he was con0inced that committees were not effecti0e
for makin. decisions about monetary policy. <ith another researcher' 9linder de0eloped
an e/periment to determine whether indi0iduals or .roups make better decisions.
The results of the e/periment showed that committees make decisions as (uickly as' and
more accurately than' indi0iduals makin. decisions by themsel0es. Moreo0er' it was not
the performance of the indi0idual committee members that contributed to the superiority of
committee decisions8the actual process of ha0in. meetin.s and discussions appears to
ha0e impro0ed the .roup6s o0erall performance.
In later research' 9linder also found that it did not really matter whether the committee had
a stron. leader. )is findin.s su..est it is the wisdom of the .roup' not its leader' that really
matters. nd to the e/tent the leader has too much power8and the committee functions
more like an indi0idual than a .roup8monetary policy will actually be worse@
) P P L I C ) I O N 7
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.!"
+a.s in Monetary *olicy
Inside lags are the time it takes for policymakers to reco.niAe and
implement policy chan.es.
Outside lags are the time it takes for policy to actually work.
17.4 MO!T#$" POLIC" CH#LL!.,
*O$ TH *+
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.!1
E/pectations of Inflation
No Bma.icC inflation rate is necessary to sustain full employment.
In the lon. run' chan.es in a..re.ate demand only affect prices
and not output.
If the !ed increased the money supply D percent a year and we had
D percent inflation lon. term' people would come to e/pect this
inflation.
E/pectations of inflation affect all aspects of economic life.
"ontinued inflation becomes normal and is built in to decision
makin..
17.4 MO!T#$" POLIC" CH#LL!.,
*O$ TH *+ &cont.'
(opyri%ht )!"1* Pearson +ducation ,nc. -ll ri%hts reserved. 1&.!!
a$$reciation of a c%rrency
de$reciation of a c%rrency
disco%nt rate
e3c#an&e rate
federal funds market
federal funds rate
illiquid
liquidity demand for money
money market
open market operations
open market purchases
open market sales
speculative demand for money
transaction demand for money
E E $ T E R M S