Monetary Policy

Chapter 15
McGraw-Hill/Irwin
Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Monetary Policy
Control over the money supply is a critical policy tool for altering macro outcomes
Whats the relationship between the 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

15-2

Monetary Policy
Some economists argue that monetary policy is more effective than fiscal policy; others contend the reverse is true Monetary policy: The use of money and credit controls to influence macroeconomic outcomes

15-3

The Money Market

Like other goods, theres a supply of money and a demand for money The price of money is determined in the money market
Interest rate: The price paid for the use of money

15-4

Money Balances
Most of the money in the money supply is in the form of bank balances
Money Supply (M1): Currency held by the public, plus balances in transactions accounts Money Supply (M2): M1 plus balances in most savings accounts and money market mutual funds

15-5

The Demand for Money

Demand for money: The quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus Portfolio decision: The choice of how (where) to hold idle funds

15-6

The Demand for Money

Transactions demand for money: Money held for making everyday market purchases Precautionary demand for money: Money held for unexpected market transactions or for emergencies Speculative demand for money: Money held for speculative purposes, for later financial opportunities
15-7

The Money Market

The quantity of money that people are willing and able to hold (demand) increases as interest rates fall, ceteris paribus The money supply curve is assumed to be a vertical line
The Federal Reserve has the power to regulate the money supply through its policy tools

15-8

Equilibrium
Equilibrium rate of interest occurs at the intersection of the money-demand and moneysupply curves Equilibrium rate of interest: The interest rate at which the quantity of money demanded in a given time period equals the quantity of money supplied

15-9

Money Market Equilibrium

Money supply Interest Rate (%)
The amount of money demanded (held) depends on interest rates

E1

Money demand

g2

g1

Quantity Of Money

15-10

Changing Interest Rates

The Federal Reserve can alter the money supply through changes in reserve requirements, the discount rate, or through open market operations This changes the equilibrium rate of interest

15-11

Changing Interest Rates

Money supply
Money supply and demand set interest rates

Interest Rate (%)

7 6

E1 E3 Demand for money

g1

g3

Quantity Of Money

15-12

Federal Funds Rate

The federal funds rate is most directly affected when the Fed injects or withdraws reserves from the banking system The federal funds rate reflects the cost of funds for banks
Federal Funds Rate: The interest rate for interbank reserve loans

15-13

Interest Rates and Spending

When the cost of funds for banks changes, they change the rates they charge on loans Changes in interest rates affect consumer, investor, government, and net export spending

15-14

Monetary Stimulus
The goal of monetary stimulus is to increase aggregate demand Stimulating the economy is achieved through
An increase in the money supply A reduction in interest rates An increase in aggregate demand

15-15

Monetary Stimulus
An increase in the money supply lowers the rate of interest A reduction in the rate of interest stimulates investment More investment increases aggregate demand (including multiplier effects) AS
Interest Rate Interest Rate

7 6

E1
Demand for money

7 6

E2

Price Level

Investment demand

AD1

AD2

g1 g2
Quantity Of Money

I1

I2
Income (Output)

Rate Of Investment

15-16

Monetary Restraint
To lessen inflationary pressures, the Fed will apply a policy of monetary restraint This is achieved through
A decrease in the money supply An increase in interest rates A decrease in aggregate demand

15-17

Policy Constraints
Several constraints can limit the Feds ability to alter the money supply, interest rates, or aggregate demand
Short- vs. long-term rates Reluctant lenders Liquidity trap Low expectations Time lags

15-18

Short- vs. Long-Term Rates

Feds open market operations have the most direct effect on short-term rates The success of Fed intervention depends in part on how well changes in long-term interest rates mirror changes in short-term interest rates

15-19

Reluctant Lenders
Banks themselves must expand the money supply by making new loans Banks may be unwilling to make new loans even when the Fed is injecting excess reserves into the banking system

15-20

Liquidity Trap & Low Expectations

Liquidity trap: The portion of the money demand curve that is horizontal; people are willing to hold unlimited amounts of money at some (low) interest rate Gloomy expectations deter borrowing Investment demand that is slow to respond to lower interest rates is said to be inelastic

15-21

Constraints on Monetary Stimulus

A liquidity trap can stop interest rates from falling Inelastic investment demand can also impede monetary policy

Interest Rate

Interest Rate

Demand for money

7 6

Inelastic demand

E1 E2 The liquidity trap g1 g2

Quantity Of Money

Investment demand

0
Rate Of Investment

15-22

Time Lags
There is always a time lag between interestrate changes and investment responses It may take 612 months before market behavior responds to monetary policy

15-23

Limits on Monetary Restraint

It is also harder for the Fed to restrain demand
Expectations - Optimistic consumers and investors may continue borrowing even though interest rates are higher Global money - U.S. borrowers might tap global sources of money or local non-bank lenders not regulated by the Fed

15-24

How Effective?
Keynes believed that monetary policy would not be effective at ending a deep recession Combination of reluctant bankers, the liquidity trap, and low expectations could render monetary stimulus ineffective Limitations on monetary restraint are not considered as serious

15-25

The Monetarist Perspective

Keynesians believe that changes in the money supply affect macro outcomes primarily through changes in interest rates Monetarists believe monetary policy cannot effectively fight the short-run business cycle but is a powerful tool for managing inflation

15-26

The Equation of Exchange

Monetarists use the equation of exchange to express the potential of monetary policy Equation of exchange: Money supply (M) times velocity of circulation (V) equals level of aggregate spending (P Q)

MV PQ
15-27

The Equation of Exchange

Income velocity of money (V): The number of times per year, on average, a dollar is used to purchase final goods and services
How often a dollar changes hands

PQ V M

15-28

The Equation of Exchange

The quantity of money in circulation and its velocity in product markets will always equal total spending and income (nominal GDP) The equation implies that if M increases, then prices (P) or output (Q) must rise or V must fall

M V P Q

15-29

Money-Supply Focus
Monetarists assume velocity (V) is stable If so, changes in money supply must alter total spending, regardless of interest rates Then the Fed should focus on the money supply itself, not interest rates

15-30

Natural Unemployment
Some monetarists assert that Q, as well as V, is stable at the natural rate of unemployment
Natural rate of unemployment: Long-term rate of unemployment determined by structural forces in labor and product markets

The most extreme perspective concludes that changes in the money supply only affect prices

15-31

The Monetarist View

Long-run Aggregate Supply PRICE LEVEL

P2 P1 AD2 AD1 QN REAL OUTPUT

Fluctuations in aggregate demand affect the price level but not real output.

15-32

Monetarist Policies
Monetarists and Keynesians disagree on how to stabilize the economy
Keynesians concentrate on how the money supply affects interest rates, which affects spending, which affects output Monetarists use a simple equation (MV=PQ) to produce straightforward monetary policy

15-33

Fighting Inflation
Keynesian anti-inflation policy is to shrink the money supply to drive up interest rates to slow spending Monetarists argue that this policy will push interest rates down rather than up Monetarists distinguish between nominal and real interest rates

15-34

Real vs. Nominal Interest

Real nominal anticipated interest rate interest rate inflation rate

Monetarists believe that real interest rates are stable, so changes in the nominal interest rate reflect changes in anticipated inflation
Nominal real anticipated interest rate interest rate inflation rate

15-35

Short- vs. Long-Term Rates (again)

According to Monetarists, reducing money supply growth may increase short term rates Long term rates wont change unless people expect inflation to worsen The best policy is steady and predictable changes in money supply

15-36

Fighting Unemployment
The Keynesian cure for unemployment is to expand M and lower interest rates Using the equation of exchange, Monetarists fear an increase in M will lead to higher P
Rather than leading us out of recession, expansionary monetary policies heap inflation on top of our unemployment woes

15-37

The Concern for Content

Monetary policy, like fiscal policy, can affect the content of GDP as well as its level When interest rates change, not all spending decisions will be affected equally Monetary policy also redistributes money between lenders and borrowers

15-38

Which Lever to Pull?

The success in managing the macro economy depends on pulling the right policy levers at the right time Keynesians and Monetarists argue about which of the policy levers M or V is likely to be effective in altering aggregate spending

15-39

The Policy Tools

Monetarists point to money supply (M) as the principal macroeconomic policy lever Keynesian fiscal policy must rely on changes in velocity (V), as tax and expenditure policies have no direct impact on money supply

15-40

Crowding Out
If V is constant, changes in total spending can come about only through changes in money supply Increased G effectively crowds out some C or I, leaving total spending unchanged If the government raises taxes, households will have less money to spend

15-41

How Fiscal Policy Matters

Do changes in G or T affect: Aggregate demand? Monetarist View No (stable V causes crowding out) No (aggregate demand not affected) No (aggregate demand not affected) Yes (crowding out) Real interest rates? No (determined by real growth) Keynesian View Yes (V changes) Maybe (if at capacity) Yes (output responds to demand) Maybe (may alter demand for money) Yes (real growth and expectations may vary)

Prices?

Real output?

Nominal interest rates?

15-42

How Money Matters

Do changes in M affect: Aggregate demand? Prices? Real output? Monetarist View Yes (V stable) Yes (V and Q stable) No (rate of unemployment determined by structural forces) Yes (but direction unknown) Keynesian View Maybe (V may change) Maybe (V and Q may change) Maybe (output responds to demand) Maybe (liquidity trap)

Nominal interest rates? Real interest rates

No Maybe (depends on real growth) (real growth may vary)

15-43

Is Velocity Stable?
The critical question of monetary policy appears to be whether V is stable or not The historical pattern justifies the Monetarist assumption of a stable V over long periods of time There is a pattern of short-run variations in velocity

15-44

The Velocity of M2

Source: Federal Reserve

15-45

Money Supply Targets

The differing views of Keynesians and Monetarists lead to different conclusions about which policy lever to pull
Monetarists favor fixed money supply targets Keynesians advocate targeting interest rates, not the money supply

15-46

Inflation Targeting
The Fed has tried both Monetarist and Keynesian strategies Price stability is current Feds primary goal Inflation targeting: The use of an inflation ceiling (target) to signal the need for monetary policy adjustments

15-47

Monetary Policy
End of Chapter 15
McGraw-Hill/Irwin
Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.