Download lesson 6

UNIT
4 Macroeconomics
LESSON 6
Interest Rates and Monetary Policy in the Short Run
and the Long Run
Introduction and Description
This lesson explores the relationship between the
nominal interest rate and the real interest rate, the
implications for monetary policy, and the shortrun and long-run effects of monetary policy on
real output and the price level. The students need
to understand the relationship between real and
nominal interest rates because the real interest rate
determines the level of investment, whereas the
nominal interest rate determines the demand for
money. Further, the Fisher Effect demonstrates
how changes in the money supply affect the nominal interest rate in the long run. The discussion of
the short-run and long-run effects on interest rates
leads to the discussion of the effects of monetary
policy in the short run and long run. Student
understanding of the dynamics of the macroeconomic model over time is essential to explaining the effects of monetary policy on the economy.
Activity 41 helps the students gain an understanding of the difference between nominal interest rates and real interest rates, and the effect of
monetary policy on both in the short and long
run. Activity 42 is designed to bring the dynamic
macroeconomic model together with monetary
policy actions and to help the students integrate
the effects of monetary policy in the short and long
run with their understanding of how the economy
works. This will help them to analyze current
monetary policy and understand monetary policy
discussions.
Objectives
1. Define the real interest rate and the nominal
interest rate.
2. Explain the relationship among the real interest
rate, the nominal interest rate and the inflation
rate. This is also known as the Fisher Equation.
3. Explain the Fisher Effect, or how changes in the
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money supply are transmitted to the nominal
interest rate in the long run.
4. Explain the effects of monetary policy in the
short run and the subsequent changes in the
model as the economy moves to the long run.
Define neutrality of money.
Time Required
Three class periods or 135 minutes
Materials
1. Activities 41 and 42
2. Visual 3.13
Procedure
1. Define the nominal interest rate and the real
interest rate. The nominal interest rate is the rate
that appears on the financial pages of newspapers and on the signs and ads of financial
institutions. Emphasize that the real interest
rate is the increase in purchasing power the
lender wants to receive to forego consumption
now for consumption in the future.
2. Stress that there are two relationships between
the real and nominal interest rates. There is the
ex ante real interest rate, which is the expected
interest rate and equals the nominal interest rate
minus the expected inflation rate. There is the
ex poste real interest rate, which is the real interest rate actually received and equals the nominal
interest rate minus the actual rate of inflation.
The ex poste real interest rate will equal the ex
ante interest rate if people accurately anticipate
the inflation rate. The relationship between the
real and nominal interest rate is called the
Fisher Equation.
3. Explain the Fisher Effect. Looking at the equation of exchange, we see that changes in the
money supply — holding velocity and real out-
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
4 Macroeconomics
put constant — lead to changes in the price
level. These changes in the price level change the
nominal interest rate once they are anticipated.
4. Have the students complete Activity 41, and
review the answers with the students. Emphasize the need to be able to work through and
explain exactly the transmission mechanism of
money supply changes to changes in the economy. This is an area where students frequently
miss points in answering questions on the
Advanced Placement Examination.
5. Review the effects of increases and decreases in
the money supply in the short-run aggregate
supply and aggregate demand model.
LESSON 6
6. Project Visual 3.13. Have the students work
through and explain money supply changes in
the aggregate demand and aggregate supply
model over the long run. The students should be
able to do more than simply shift the curves; they
should be able to explain why the curves shift.
Emphasize that changes in the money supply
over time result in changes in the price level and
no change in the output level. Monetary policy
is neutral. The Appendix to Lesson 4 in Unit 3
graphically presents the shifts in SRAS and the
movement from the short run to the long run.
7. Have the students complete Activity 42. Review
the answers to Activity 42 with the students.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
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UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 41
Answer
Key
Real Interest Rates and Nominal Interest Rates
Figure 41.1
Real and Nominal Interest Rates
Year
Nominal Interest Rate
Inflation Rate
1991
5.41%
3.12%
1992
3.46
2.30
1993
3.02
2.42
1994
4.27
2.05
1995
5.51
2.12
1996
5.02
1.87
1997
5.07
1.85
1998
4.78
1.14
1999
4.64
1.56
2000
5.82
2.29
2001
3.39
1.96
Real Interest Rate
2.29%
1.16
0.60
2.22
3.39
3.15
3.22
3.64
3.08
3.53
1.43
1. Figure 41.1 provides the nominal interest rates and inflation rates for the years 1991 through 2001.
(A) Compute the actual real interest rates for 1991 through 2001.
(B) Graph the nominal interest rates and the actual real interest rates on Figure 41.2.
Figure 41.2
Real and Nominal Interest Rates
7%
INTEREST RATES
6
5
4
3
2
Nominal Interest Rates
1
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
Real Interest Rates
0
YEAR
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 41
(C) Has the actual real interest rate stayed constant?
Answer
Key
No
(D) If it has not, explain why you think the real rate has not been constant. The actual real interest
rate has not been constant because the inflation rate has changed often. The money supply
growth rate has also changed during the period shown in the graph.
(E) For what years has the actual real interest rate remained nearly constant? During the 1995 to
2000 period, the actual real interest rate fluctuated within a small range. The result is probably
because of the reasonably steady inflation rate and the announced desire by the Fed to control
inflation.
2. Frequently, economists argue that the monetary authorities should try to maintain a steady real
interest rate. Explain why you think a steady real rate of interest is important to the economy.
A steady interest rate is important to induce firms to invest and expand the capital stock.
Figure 41.3
Expansionary Monetary Policy
LRAS
PRICE LEVEL
SRAS
AD
REAL GDP
3. Suppose that initially the economy is at the intersection of AD and SRAS as shown in Figure 41.3. Now,
the Fed decides to implement expansionary monetary policy to increase the level of employment.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
569
UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 41
Answer
Key
(A) In the short run, what happens to real output? Explain why. Real output should increase.
With the decrease in interest rates because of the expansionary monetary policy, the interest
rate sensitive components of aggregate demand (consumption and investment) will increase,
thereby increasing output.
(B) In the short run, what happens to the price level? Explain why. The price level increases
because the increase in demand can only be met if firms have the incentive to produce more.
An increasing price level provides this incentive.
(C) In the short run, what happens to employment and nominal wages? Explain why.
Employment increases and nominal wages remain the same. Employment increases because
firms now have to produce more goods and services and they need people to do this. Nominal
wages stay the same because people do not realize that the average price level has increased.
(D) In the short run, what happens to nominal interest rates and real interest rates?
In the short run, the nominal and real interest rates decrease.
(E) In the long run, what happens to real output? Explain why. In the long run, the real output
will be at the full-employment level. So real output will fall relative to the level of output in the
short run. As employment increases, nominal wages increase, which raises the costs of production and the SRAS curve shifts to the left. The price level increases, and real output will fall
back toward its original level.
(F) In the long run, what happens to the price level? Explain why. The price level rises in the long
run because the SRAS curve shifted to the left in response to an increase in nominal wages.
(G) In the long run, what happens to employment and nominal wages? Explain why.
Employment is at full employment and nominal wages have risen so that the real income of
people has remained the same. To induce labor to work at the new higher level, firms must
increase the nominal wage.
(H) In the long run, what happens to the nominal interest rate and the real interest rate?
In the long run, the real interest rate goes to the long-run level and the nominal interest rate is
the real interest rate plus the inflation rate. In the United States, the long-run real interest rate
is about 2 percent to 3 percent.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 42
Answer
Key
Monetary Policy
We now bring together all of the pieces of the process by which monetary policy is transmitted to the
economy, and we examine both the short-run effects and the long-run effects of monetary policy.
Figure 42.1
Effects of Monetary Policy
LRAS
PRICE LEVEL
SRAS
AD
REAL GDP
1. Suppose that initially the economy is at the intersection of AD and SRAS in Figure 42.1.
(A) What monetary policy should the Fed implement to move the economy to full-employment
output?
Expansionary monetary policy
(B) If the Fed is going to use open market operations, it should (buy / sell) Treasury securities.
(C) What is the effect on Treasury security (bond) prices? Bond prices should rise.
(D) In the short run, what is the effect on nominal interest rates? Explain. Nominal interest rates
should fall because financial institutions have more funds to lend out because people have sold
their Treasury securities to the Fed.
(E) In the short run, what happens to real output? Explain how the Fed’s action results in a
change in real output. Real output should increase. With the decrease in interest rates, the
interest-rate sensitive components of aggregate demand (consumption and investment) will
increase, thereby increasing output.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
571
UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 42
Answer
Key
(F) In the short run, what happens to the price level? Explain how the Fed’s action results in a
change to the price level. The average price level increases because the increase in demand can
be met only if firms have the incentive to produce more. An increasing price level provides this
incentive.
Figure 42.2
Moving to Full Employment
LRAS
PRICE LEVEL
SRAS
AD
REAL GDP
2. Suppose that initially the economy is at the intersection of AD and SRAS in Figure 42.2.
(A) What monetary policy should the Fed implement to move the economy to full-employment
output?
Contractionary monetary policy
(B) If the Fed is going to use open market operations, it should (buy / sell) Treasury securities.
(C) What is the effect on Treasury security (bond) prices? Bond prices will decline.
(D) In the short run, what is the effect on nominal interest rates? Explain. In the short run, nominal interest rates will increase. When the public buys bonds, they pay for them by reducing
their demand deposits, decreasing the supply of money, which means the interest rate will
increase.
(E) In the short run, what happens to real output? Explain how the Fed’s action results in a
change in real output. In the short run, real output will decline. As a result of the Fed’s actions,
interest rates have increased; therefore the interest-sensitive components of aggregate demand
(consumption and investment) will decrease and thus, decrease aggregate demand. With a
reduced aggregate demand, firms will experience an increase in inventories, which in turn
leads to a decrease in production. Output decreases.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 42
Answer
Key
(F) In the short run, what happens to the price level? Explain how the Fed’s action results in a
change to the price level. The price level will fall as firms attempt to clear out inventory by
reducing prices, having a sale.
Figure 42.3
Expansionary Monetary Policy
LRAS
SRAS1
PRICE LEVEL
SRAS
AD2
AD1
AD
Y* Y1
REAL GDP
3. Suppose that in the situation shown in Figure 42.3, the aggregate supply and demand curves are
represented by LRAS, SRAS and AD. The monetary authorities decide to maintain the level of
employment represented by the output level Y1 by using expansionary monetary policy.
(A) Explain the effect of the expansionary monetary policy on the price level and output in the
short run. In the short run, the monetary authorities (the Fed) will expand the money supply,
which in turn increases the aggregate demand curve to AD1. The price level and output
increase.
(B) Explain the effect on the price level and output in the long run. The SRAS will shift leftward,
leading to a decrease in output and an increase in price level. Given the Fed’s desire to remain
at Y1, the Fed will continue to expand the money supply, shifting AD to AD2. With the decrease
in SRAS, the economy might be at a point like the intersection of AD2 and SRAS1. Thus, the
price level will continue to rise and the economy will experience inflation.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
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UNIT
4 Macroeconomics
LESSON 6 ■ ACTIVITY 42
Answer
Key
(C) Explain what you think will happen to the nominal rate of interest and the real rate of interest
in the short run as the Fed continues to increase the money supply. Explain why.
In the short run, both the nominal interest rate and the real interest rate will decline.
Consumers and financial intermediaries will not have correctly anticipated the inflation, and
both interest rates will decline. As consumers and producers recognize that the price level is
increasing, they will take steps to maintain their real income. Nominal wages will rise, and the
nominal and real interest rates will start to rise.
(D) Explain what you think will happen to the nominal rate of interest and the real rate of interest
in the long run. Explain why. In the long run, the real interest rate will return to its long-run
equilibrium, and the nominal interest rate will be the real interest rate plus inflation. Since
inflation is increasing, the nominal interest rate will increase as well. Producers and consumers
will adjust expectations to match reality.
4. Many economists think that moving from short-run equilibrium to long-run equilibrium may
take several years. List three reasons why the economy might not immediately move to long-run
equilibrium.
Wages will adjust slowly to changes in prices (inflation) because of wage contracts.
Prices adjust slowly because business is slow to change prices to maintain customer loyalty.
Both labor and firms have inaccurate expectations about inflation.
5. In a short paragraph, summarize the long-run impact of an expansionary monetary policy on the
economy. In the long run, increases in the money supply translate into increases in the price level
and no long-term increase in output. This is known as the neutrality of money. In the short run,
nominal and real interest rates decline. In the long run, nominal interest rates follow the Fisher
Equation and equal the real rate plus the inflation rate. Real interest rates return to their long-run
level: the rate people require to forgo consumption now for consumption in the future.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.