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Macroeconomics LECTURE IX – MONETARY POLICY Syllabus (change!) 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 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 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 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 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 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 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?