13e

Chapter 15:
Monetary Policy

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy
Control over the money supply is a
critical policy tool for altering
macroeconomic outcomes.
The quantity of money in circulation
influences its value in the marketplace.
Interest rates and access to credit are
basic determinants of spending behavior.

Therefore, the effectiveness of

monetary policy is of significance.
15-2

Monetary Policy
In this chapter we explore the
effectiveness of monetary policy.
Specifically
Whats the relationship between money
supply, interest rates, and aggregate
demand?
How can the Fed use its control of the money
supply or interest rates to alter macro
outcomes?
How effective is monetary policy compared to
fiscal policy?
15-3

Learning Objectives
15-01. Explain how interest rates are set in
the money market.
15-02. Describe how monetary policy affects
macro outcomes.
15-03. Summarize the constraints on
monetary policy impact.
15-04. Identify the differences between
Keynesian and monetarist monetary
theories.
15-4

The Money Market

Money is like any other commodity. It is
traded in the marketplace.
There is a money supply (controlled by the
Fed) and a money demand by the people.
They determine the price of money: the
interest rate.

At high interest rates, money is

expensive to acquire.
At low interest rates, money is cheap to
acquire.
15-5

The Money Market

If people hold cash as M1, they suffer an
opportunity cost: the forgone interest
they could have earned.
Money demand: the quantities of money
people are willing and able to hold at
alternative interest rates, ceteris paribus.
At low interest rates, the opportunity cost of
holding money is low, so people will hold
more of it, and vice versa.

15-6

The Demand for Money

Why would people want to hold money
that is, have a demand for money?
Transactions demand: people need to hold
money for the purpose of making everyday
market purchases.
Precautionary demand: people also hold
money for unexpected market transactions
or for emergencies.
Speculative demand: some people also hold
money to be able to take advantage of an
investment opportunity in the near future.
15-7

Money Market Equilibrium

Money demand: the
quantity of money
people are willing and
able to hold
(demand) increases
as interest rates fall,
and vice versa.
Money supply: since
the Fed controls the
money supply, it is
represented by a
vertical line.
15-8

Money Market Equilibrium

The intersection of
money demand
and money supply
(E1) establishes the
equilibrium rate of
interest.

15-9

Money Market Equilibrium

If interest rates are
higher than
equilibrium, there is
a money surplus.
People must hold
more money as M1
than they wish.
They will move
money out of M1 into
M2 or other assets
(such as bonds).
The interest rate will
then fall to E1.
15-10

Money Market Equilibrium

If interest rates are
lower than
equilibrium, there is a
money shortage.
People must hold less
money as M1 than they
wish.
They will move money
into M1 from M2 or
other assets (such as
bonds).
The interest rate will
then rise to E1.
15-11

Changing Interest Rates

The Fed controls the money supply.
By using the Fed policy tools, it can
alter the equilibrium rate of interest.
By increasing the money supply (causing
a surplus), the Fed tends to lower the
equilibrium rate of interest.
By decreasing the money supply
(causing a shortage), the Fed tends to
raise the equilibrium rate of interest.
15-12

Interest Rates and Spending

Lowering interest rates is a tactic of
monetary stimulus, the purpose of which is
to increase aggregate demand (AD).
Lower interest rates reduce the cost of
investment spending (most of which is done with
borrowed funds) and the cost of holding
inventory. Investment spending will increase.
An investment spending increase is an injection
into the circular flow, and will kick off the
multiplier effect. AD will shift right because of
this.

15-13

Interest Rates and Spending

Raising interest rates is a tactic of
monetary restraint, the purpose of which
is to decrease aggregate demand (AD).
Higher interest rates increase the cost of
investment spending (most of which is done
with borrowed funds) and the cost of holding
inventory. Investment spending will decrease.
An investment spending decrease will kick off
a negative multiplier effect. AD will shift left
because of this.

15-14

Summary
Goal: to stimulate the economy.
An increase in the money supply leads to
Lower interest rates, which lead to ...
An increase in aggregate demand.

Goal: to restrain the economy.

A decrease in the money supply leads to
Higher interest rates, which lead to ...
An decrease in aggregate demand.

15-15

Policy Constraints
Short- vs. long-term rates.
The Fed has greater influence on short-term
rates (that is, the Fed funds rate) than longterm rates (mortgages and installment
loans).
The Feds monetary stimulus will be most
effective is long-term interest rate changes
mirror short-term rate changes.
If not, the AD increase will be less than
hoped for.
15-16

Policy Constraints
Reluctant lenders.
The banking system must be willing to
increase lending activity.
Banks may pile up excess reserves instead
of making loans.
They might have concerns about their
financial well-being and about making loans
to those who might not pay back the money.
They might be uncertain about how new
bank regulations may affect profitability.
15-17

Policy Constraints
Liquidity trap.
When interest rates are low, the opportunity
cost of holding money is also low.
Lowering interest rates further might not elicit
the response desired by the Fed because people
and firms simply hold the money instead of
investing.
This is the liquidity trap:
People are willing to hold unlimited amounts of money
at some low interest rate.
The money demand curve becomes horizontal.
15-18

Policy Constraints
Low expectations:
Investment decisions are influenced by
expectations.
In a recession, firms have little incentive to expand
production capability.
There would be little expectation of future profit, or
payoff, from new investment.

Consumers may be reluctant to take on added

debt when future income prospects are
uncertain.

Thus AD does not increase when interest

rates are reduced.
15-19

Policy Constraints
Time lags:
It takes time to develop and implement
new investments in response to lower
interest rates.
Consumers also may take time to decide
to increase their borrowing.
It may take 6 to 12 months before market
behavior responds to monetary policy.

15-20

The Monetarist Perspective

The Keynesian view of monetary policy
says that changes in the money supply
affect macro outcomes primarily
through changes in interest rates.
The monetarist view is different. They
believe that only the price level is
affected by Fed policy and then only
by changes in the money supply.
They say monetary policy is not effective
for fighting recession, but is a powerful tool
for managing inflation.
15-21

The Equation of Exchange

The equation of exchange is
MV = PQ
where M is the money supply, V is its velocity in circulation,
P is the average price, and Q is the quantity of goods sold.

In this equation, total spending is price

(P) times quantity (Q). This spending is
financed by the money supply (M) times
the velocity of its circulation (V).
Velocity (V): the number of times per year,
on average, that a dollar is used to
purchase final goods and services.
15-22

The Equation of Exchange

MV = PQ

PQ is the same as nominal GDP.

The quantity of money in circulation and
the velocity with which it exchanges
hands will always be equal to the value
of nominal GDP.
Monetarist view: If M increases, P or Q
must rise, or V must fall.
15-23

The Equation of Exchange

MV = PQ

Assume V is stable that is, does not change.

V is a function of how people handle their
money and the institutions they use to do so.
Neither should change much in the short run.
Thus total spending (PQ) must rise if money
supply (M) grows and velocity (V) is stable,
regardless of interest rates.

15-24

Money Supply Focus

If spending increases when the
money supply grows, then the Fed
should focus on the money supply,
not interest rates.
Fed policy should not be to manipulate
interest rates.
Fed policy should focus on the size and
growth of the money supply.
15-25

Natural Unemployment
MV = PQ

Monetarists insert another perspective:

Q is stable also. It is a function of productive capacity,
labor efficiency, and other structural forces.
This leads to a natural rate of unemployment that is
fairly immune to short-run policy intervention.

Natural rate of unemployment: the long-term rate

of unemployment determined by structural forces.
Thus if both V and Q are stable, any increase in M
in the long run only increases P.

15-26

Natural Unemployment
MV = PQ

If both V and Q are stable, any increase in

M in the long-run only increases P.
If prices rise, costs of production will rise also,
so there is no profit incentive to increase Q.
In the long run, the aggregate supply is
vertical.
Any increase in AD directly increases the price
level.
15-27

Monetarist: Fighting
Inflation
The policy goal is to reduce
aggregate demand.
Keynesians: shrink the money supply
and drive up interest rates.
Monetarists: interest rates are likely to
be high already. A decrease in the
money supply will lower nominal interest
rates, not raise them.

15-28

Monetarist: Fighting
Inflation
Interest rates are likely to be high already.
A decrease in the money supply will lower
nominal interest rates, not raise them.
Nominal interest rate: the interest rate we
actually see and pay.
Real interest rate: the nominal rate minus the
anticipated inflation rate.

As the money supply shrinks, the price

level falls and anticipated inflation
decreases, so nominal interest rates fall,
not rise.
15-29

Monetarist: Fighting
Inflation
To close an inflationary GDP gap using monetary
policy, reduce the money supply.
Keynesians: interest rates rise, reducing spending.
Monetarists: once the people are convinced the Fed is
reducing money supply, anticipated inflation falls and
nominal interest rates will fall. Short-term rates will rise in
response to the Fed action, but long-term rates will react
more slowly.

Monetarists advise steady and predictable

changes in the money supply, to reduce
uncertainty and thus stabilize both long-term
interest rates and GDP growth.
15-30

Monetarist: Fighting
Unemployment
The policy goal is to increase aggregate
demand.
Keynesians: expand the money supply and drive down
interest rates.
Monetarists: increased money supply leads to higher
prices, immediately raising peoples inflationary
expectations. Long-term interest rates might actually
rise, defeating the purpose of monetary stimulus.

Monetarists conclude that expansionary

monetary policy cant lead us out of recession.

15-31

The Economy Tomorrow

In the equation of exchange (MV =
PQ), Keynesians fiscal policy relies on
changes in V while monetarists
assume V is stable and rely on
changes in M.
The two tables following summarize
their views on how fiscal and
monetary policies work.
15-32

How Fiscal Policy Matters:

Monetarist vs. Keynesian Views

15-33

How Money Matters:

Monetarist vs. Keynesian Views

15-34

The Economy Tomorrow

Which policy lever to pull?

Monetarists favor a fixed money supply.

Keynesians reject a fixed money supply.
Keynesians advocate targeting interest rates.
Keynesians advocate liberal use of fiscal policy.
Currently the Fed favors inflation targeting.
If inflation stays below a certain level, the Fed need
not adjust its policy.
Once inflation rises above that level, the Fed will go
into action to fight inflation.

15-35

Revisiting the Learning

Objectives
15-01. Explain how interest rates are set
in the money market.
People have a money demand that is, a
need to hold money as M1.
The Fed determines the money supply that
is, the amount of money people must hold.
The intersection of money demand and
money supply determines the price of
money that is, the interest rate.

15-36

Revisiting the Learning

Objectives
15-02. Describe how monetary policy
affects macro outcomes.
By altering the money supply, the Fed can
determine the amount of purchasing power
available.
An increase in money supply causes short-term
interest rates to fall and spending to increase, and
vice versa.
An increase in money supply can trigger inflationary
expectations and cause the nominal interest rates
to rise due to anticipated inflation, and vice versa.

15-37

Revisiting the Learning

Objectives
15-03. Summarize the constraints on
monetary policy impact.
For monetary policy to be fully effective,
interest rates must respond to changes in
the money supply, and spending must
respond to changes in the interest rate.
In a liquidity trap, this will not happen.
Investor and buyer expectations may
override interest rate considerations in
buying decisions.
15-38

Revisiting the Learning

Objectives
15-04. Identify the differences between
Keynesian and monetarist monetary
theories.
Monetarists emphasize long-term linkages.
Using the equation of exchange (MV = PQ), and
asserting V is stable, they say changes in M must
influence spending (PQ).
Structural forces make Q stable in the long run, so
changes in M directly affect P.

Keynesians believe changes in the money

supply affect (short-term) interest rates
and thus affect spending decisions.
15-39