Download Monetary policy

Macroeconomics
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LECTURE IX – MONETARY POLICY
Syllabus (change!)
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Lecture I – Price level
Lecture II – Aggregate production
Lecture III – Money
Lecture IV (now in III) – Money supply
Lecture IV – Quantity theory of money
Lecture V – Aggregate demand and aggregate supply
Lecture VI – Aggregate supply in the short run
Lecuture VII - Say’s Law of Markets and Keynesian economics
Lecture VIII – Foreign exchange market
Lecture IX – Monetary policy
Lecture X – Fiscal policy and public debt
Lecture XI – Currency unions and currency separations
What you should already know
 PY=MV (Quantity theory of money)
 AD, SRAS, LRAS and their graphical representation
 Theoretical background
 Say’s Law
 Keynesianism
 Foreign exchange market theory
Monetary Policy
 Control over the money supply is a critical policy tool
for altering macro outcomes
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What’s 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
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
The Money Market
 Like other goods, there’s a supply of money and a
demand for money
 The price of money is determined in the money
market
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Interest rate: The price paid for the use of money
recap
The Demand for Money
 The price of holding money balances is the interest
rate.
 The interest rate is the opportunity cost of holding
money.
 As the interest rate increases, the opportunity cost of
holding money increases, and people choose to hold
less money.
Supply and Demand for Money
Equilibrium in the Money Supply
 The money supply is not
exclusively determined
by the Fed because both
the banks and the public
are important players
the money supply
process.
 Equilibrium in the
money market exists
when the quantity
demanded of money
equals the quantity
supplied.
Monetary policy
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
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Federal Funds Rate: The interest rate for interbank reserve
loans
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
Monetary Stimulus
 The goal of monetary stimulus is to increase
aggregate demand
 Stimulating the economy is achieved through
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An increase in the money supply
A reduction in interest rates
An increase in aggregate demand
The Keynesian Transmission Mechanism
Monetary Restraint
 To lessen inflationary pressures, the Fed will apply a
policy of monetary restraint
 This is achieved through
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A decrease in the money supply
An increase in interest rates
A decrease in aggregate demand
Policy Constraints
 Several constraints can limit the Fed’s ability to alter
the money supply, interest rates, or aggregate
demand
– Short- vs. longterm rates
– Reluctant lenders
– Liquidity trap
– Low expectations
– Time lags
Short- vs. Long-Term Rates
 Fed’s 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
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
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
Keynesian Transmission Mechanisms
Time Lags
 There is always a time lag between interest-rate
changes and investment responses
 It may take 6–12 months before market behavior
responds to monetary policy
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
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
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
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Monetary Policy and an Inflationary Gap
Monetary Policy and the Activist–
Nonactivist Debate
 Activists argue that
monetary and fiscal policies
should be deliberately used
to smooth out the business
cycle.
 They are in favor of
economic fine-tuning, which
is the frequent use of
monetary and fiscal policies
to counteract even small
undesirable movements in
economic activity.
 Nonactivists argue against
the use of deliberate fiscal
and monetary policies.
 They believe the
discretionary policies
should be replaced by a
stable and permanent
monetary and fiscal
framework and the rules
should be established in
place of activist policies.
The Case for Activist Monetary Policy
1.
2.
3.
The economy does not always equilibrate quickly
enough at Natural Real GDP.
Activist monetary policy works; it is effective at
smoothing out the business cycle.
Activist monetary policy is flexible; nonactivist
monetary policy, which is based on rules, is not.
The Case for Nonactivist Monetary Policy
In modern economies, wages and prices are
sufficiently flexible to allow the economy to
equilibrate at reasonable speed at Natural Real
GDP.
2. Activist monetary policies may not work.
3. Activist monetary policies are likely to be
destabilizing rather than stabilizing; they are
likely to make matters worse rather than better.
1.
Expansionary Monetary Policy and No
Change in the Real GDP
If expansionary monetary
policy is anticipated,
workers may bargain for
and receive higher wage
rates. It is possible that
the SRAS curve will shift
leftward to the degree that
expansionary monetary
policy shifts the AD curve
rightward. Result: no
change in Real GDP.
Monetary Policy May Destabilize the
Economy
In this scenario, the SRAS
curve is shifting
rightward, but Fed
officials do not realize this
is happening. They
implement expansionary
monetary policy, and the
AD curve ends up
intersecting SRAS2 at
point 2 instead of SRAS1
at point 1’. Fed officials
end up moving the
economy into an
inflationary gap and thus
destabilizing the economy
How Fiscal Policy Matters
Do changes in G or T
affect:
Monetarist View
Keynesian View
No
(stable V causes
crowding out)
Yes
(V changes)
Prices?
No
(aggregate demand
not affected)
Maybe
(if at capacity)
Real output?
No
(aggregate demand
not affected)
Yes
(output responds to
demand)
Yes
(crowding out)
Maybe
(may alter demand for
money)
No
(determined by real
growth)
Yes
(real growth and
expectations may vary)
Aggregate demand?
Nominal interest rates?
Real interest rates?
How Money Matters
Do changes in M affect:
Monetarist View
Keynesian View
Yes
(V stable)
Maybe
(V may change)
Yes
(V and Q stable)
Maybe
(V and Q may change)
Real output?
No
(rate of unemployment
determined by structural
forces)
Maybe
(output responds to
demand)
Nominal interest
rates?
Yes
(but direction unknown)
Maybe
(liquidity trap)
Real interest rates
No
Maybe
(depends on real growth) (real growth may vary)
Aggregate demand?
Prices?
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
The Velocity of M2
Source: Federal Reserve
Money Supply Targets
 The differing views of Keynesians and Monetarists
lead to different conclusions about which policy lever
to pull
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Monetarists favor fixed money supply targets
Keynesians advocate targeting interest rates, not the money
supply
Inflation Targeting
 The Fed has tried both Monetarist and Keynesian
strategies
 Price stability is current Fed’s primary goal
 Inflation targeting: The use of an inflation ceiling
(“target”) to signal the need for monetary policy
adjustments
Distorsions
 If the central bank issues money through the loans
market, it affects the market interest rate which can
cause overinvestment due to too low interest rates or
underinvestment due to too high interest rates. If the
central bank issues money through the foreign
exchange market it distorts the market exchange rate
and thus artificially encourages exports or imports.
Do we have to fear the deflation?
 Free economies grow in the long run. If the central
banks did nothing – if they never intervene in the
exchange rate, never lent or borrowed money, never
traded the bonds – the result of this doing nothing
would be deflation.
 Do we have to fear it?