Download monetary policy introduction the money market the price of money

INTRODUCTION

This chapter examines the following questions:
 What
is the relationship between the money supply
and aggregate demand?
 How can the Fed use its control of the money
supply to alter macro outcomes?
 How effective is monetary policy, compared to fiscal
policy?
Chapter 15
MONETARY POLICY
2
THE MONEY MARKET
THE PRICE OF MONEY
The price money is determined by the supply
and demand of money.
 The interest rate is the price paid for the use of
money.
money
 Monetary policy is the use of money and credit
controls to influence macroeconomic activity.

Foregone interest is the opportunity cost (price)
of money people choose to hold.
 The decision to hold (demand) money balances
is a portfolio decision.
decision

A
portfolio decision is the choice of how (where) to
hold idle funds.
3
THE DEMAND FOR MONEY

TRANSACTIONS DEMAND
Although holding money provides little or no
interest, there are reasons for doing so:
G
G
G
4
Transactions demand for money – Money held
for the purpose of making everyday market
purchases.
 People hold money so they can buy goods and
services.

Transactions demand.
Precautionary demand.
Speculative demand.
5
6
PRECAUTIONARY DEMAND
SPECULATIVE DEMAND
Precautionary demand for money – Money held
for unexpected market transactions or for
emergencies.
 Another reason people hold money is for
sudden emergency purchases.


Speculative demand for money – Money held
for speculative purposes, for later financial
opportunities.
 People also hold money for speculative
purposes, so they can respond to financially
attractive opportunities.
7
THE MARKET-DEMAND CURVE
8
MONEY MARKET EQUILIBRIUM
The quantity of money that people are willing
and able to hold (demand) increases as
interest rates fall (ceteris paribus).
 The intersection of the money-demand
y
and
money-supply curves establishes an
equilibrium rate of interest.
Interest Rate (perc
cent per year)

 The
equilibrium rate of interest is the interest rate
at which the quantity of money demanded in a
given time period equals the quantity of money
supplied.
Money supply
9
E1
7
The amount of money
demanded (held) depends
on interest rates
Money
demand
0
Q2
Q1
Quantity Of Money (billions of dollars)
9
CHANGING INTEREST RATES
10
By altering the money supply, Federal Reserve
is able to affect the equilibrium rate of interest.
 The Fed tends to lower the equilibrium rate of
interest when it increases the money supply.
supply

 People
are willing to hold larger money balances
only at lower interest rates.
Interest Rate(perrcent per year)
CHANGING INTEREST RATES
7
6
0
E1
E3
Q1
Demand for
money
Q3
Quantity Of Money (billions of dollars)
11
12
FEDERAL FUNDS RATE

MONETARY STIMULUS
When the Fed injects or withdraws reserves
from the banking system, the federal funds rate
is most directly affected.
 Federal
Funds Rate – The interest rate for interbank reserve loans.
loans

Any change in the federal funds rate is likely to
affect other interest rates as well.
 The
federal funds rate reflects the cost of funds for
banks.
 Changes in interest rates affect consumer, investor,
government, and net export spending.
The goal of monetary stimulus is to increase
aggregate demand by lowering interest rates.
 Lowering interest rates encourages investment
due to the lower cost of borrowing.
 The increased investment caused by lower
interest rates represents an injection of new
spending into the circular flow.
 The increase in investment will kick off
multiplier effects and result in an even larger
increase in aggregate demand.

13
AGGREGATE DEMAND
MONETARY STIMULUS
An increase in the
money supply lowers
the rate of interest
The Fed’s objective of stimulating the economy
is achieved in three steps:
G
More investment increases
aggregate demand
(including multiplier effects)
AS
An increase in the money
y supply.
pp y
A reduction in interest rates.
An increase in aggregate demand.
E1
7
6
E2
Demand
for money
7
Investment
demand
6
Price Level
G
A reduction in the rate
of interest stimulates
investment
Interest Ratee
G
Interest Ratee

14
AD1
g1 g2
0
Quantity Of Money
0
I1 I2
Rate Of Investment
Income (Output)
15
16
QUANTITATIVE IMPACT
REDUCED AGGREGATE DEMAND
According to Fed Chairman Alan Greenspan, a
reduction of 1/10 point in long-term interest
rates has the same stimulus effect of $10
billion of new government spending.
 To lessen inflationary pressures, the Fed will
apply a policy of monetary restraint.
 A Fed policy of higher interest rates is an
attempt to reduce aggregate demand.


AD2
Monetary restraint is achieved with:
A
decrease in the money supply.
increase in interest rates.
 A decrease in aggregate demand.
demand
 An
17
18
CONSTRAINTS ON MONETARY STIMULUS

SHORT- VS. LONG-TERM RATES
Several constraints can limit the Fed’s ability to
alter the money supply, interest rates, or
aggregate demand.
The success of Fed intervention depends in
part on how well changes in long-term interest
rates mirror changes in short-term interest
rates.
 Banks themselves must expand the money
supply by making new loans.
 Banks may be unwilling to make new loans
even though the Fed is injecting excess
reserves into the banking system.

19
20
LIQUIDITY TRAP
LOW EXPECTATIONS
When interest rates are low, people may decide
to hold all the money they can get – waiting for
opportunities to improve.
 The liquidity trap is the portion of the moneymoney
demand curve that is horizontal.
 People are willing to hold unlimited amounts of
money at some (low) interest rate.


Lower interest rates won’t always stimulate
investment.
 Gloomy expectations deter people from
borrowing and spending in spite of lower
interest rates.
 Investment demand that is slow to respond to
lower interest rates is said to be inelastic.
21
CONSTRAINTS ON MONETARY STIMULUS
Demand for
money
E1 E2
The liquidity trap
LIMITS ON MONETARY RESTRAINT

Inelastic investment demand can
also impede monetary policy
7
and investor optimism may induce them
to continue borrowing in the face of higher interest
charges.
 Market participants might tap global sources of
money or local non-bank lenders not regulated by
the Fed.
Inelastic demand
6
Investment
demand
g1 g2
Quantity Of Money
Two factors make it harder for the Fed to
restrain aggregate demand.
 Consumer
Interest Rate
e
Interest Rate
e
A liquidity trap can stop interest
rates from falling
22
0
Rate Of Investment
23
24
HOW EFFECTIVE?
THE MONETARIST PERSPECTIVE
Some economists consider monetary policies
undependable.
 Keynes believed that monetary policy would not
p recession.
be effective at endingg a deep
 However, the limitations on monetary restraint
are not considered as serious.
 The Fed has the power to reduce the money
supply.

the money supply shrinks far enough, the rate of
spending will have to slow.
In the Keynesian model, changes in the money
supply affect macro outcomes primarily through
changes in interest rates.
 Monetarists downplay the role of interest rates.
rates

 Monetarists
assert that the potential of monetary
policy can be expressed in a simple equation called
the equation of exchange.
 If
25
THE EQUATION OF EXCHANGE
THE EQUATION OF EXCHANGE

According to the equation of exchange, the
money supply (M) times velocity of circulation
(V) equals level of aggregate spending (P X Q).

The income velocity of money (V) is the
number of times per year, on average, a dollar
is used to purchase final goods and services.
The quantity of money in circulation and the
velocity with which it travels (changes hands) in
product markets will always equal the value of
total spending and income (nominal GDP).
 The equation implies that if M (the money in
circulation) increases, then prices (P) or output
(Q) must rise or (V) must fall.
 The goal of monetary policy is to change the
macro outcomes on the right side of the
equation.

MV = PQ
Income velocity of money (V) =
26
PQ
M
27
28
THE EQUATION OF EXCHANGE
STABLE VELOCITY
It is possible that a change in M might be offset
by a reduction in V leaving P and Q unchanged.
 If M increases, prices (P) or output (Q) must
rise or (V) must fall.
rise,
fall
 Monetarists add some important assumptions
to transform the equation of exchange into a
behavioral model of macro performance.


29
One of these assumptions is that the velocity of
money (V) is stable.
I
Accordingly, total spending must rise if the
Accordingly
money supply (M) grows and (V) is stable.

As Monetarists see it, changes in the money
supply must alter total spending, regardless of
how interest rates move.
30
MONEY-SUPPLY FOCUS
“NATURAL” UNEMPLOYMENT
Therefore, monetarists believe that the Fed
should not try to manipulate interest rates, but
should focus on the money supply itself.
 Some monetarists claim that Q, as well as V, is
stable.
 If true, changes in the money supply (M) would
affect only prices (P).

A stable Q means that the quantity of goods
produced is primarily dependent on production
capacity, labor-market efficiency, and other
structural forces.
 These structural forces establish a “natural”
rate of unemployment that is not effected by
short-run policy intervention.
 The natural rate of unemployment is the longterm rate of unemployment determined by
structural forces in labor and product markets.

31
32
“NATURAL” UNEMPLOYMENT
REAL VS. NOMINAL INTEREST
The most extreme monetarist perspective
concludes that changes in the money supply affect
prices only.
 Monetarists and Keynesians disagree on how
stabilize the economy.
economy


The Keynesian policy objective is to reduce aggregate
demand to fight inflation.
 Keynesians would recommend a reduction in the
money supply to drive up interest rates.
 Monetarists argue that rates are already likely to be
high and an effective anti-inflation policy will cause
rates to go down, not up.

Monetarists distinguish between nominal and
real interest rates.
Real interest rate = nominal interest rate –
anticipated inflation rate
 If the real interest rate is stable, changes in the
nominal interest rates reflect changes in
anticipated inflation.
 Monetarists believe nominal interest rates will
fall when the Fed reduces the money supply
once people reduce their inflation expectations.
33
34
SHORT- VS. LONG-TERM RATES (AGAIN)
FIGHTING UNEMPLOYMENT
The divergence of short-term and long-term
interest rates suggest that banks and
borrowers look beyond current economic
conditions in making long term commitments.
 Rather than risking upsetting these long-term
decisions, monetarists advocate steady and
predictable changes in the money supply.

The Keynesian cure for unemployment is to
expand M and lower interest rates.
 Monetarists fear that an increase in M will lead,
via the equation of exchange, to higher P.
 From a monetarists perspective, expansionary
monetary policies are not likely to lead us out of a
recession.
 Such policies might double our burden by heaping
inflation on top of our unemployment woes.

35
36
THE MIX OF OUTPUT
THE MIX OF OUTPUT
Monetary policy, like fiscal policy, can affect the
content of GDP as well as its level.
 Some industries, like the residential housing
market are more susceptible to monetary
market,
policy than others.


I

Monetary policy can affect the competitive
structure of the market.
Large, powerful corporations are more
Large
likely to obtain “tight” money than smaller
ones.
Monetary policy also redistributes money
between lenders and borrowers.
37
WHICH LEVER TO PULL?
38
CROWDING OUT
The success in managing the macro economy of
tomorrow depends on pulling the right policy levers
at the right time.
 What Keynesians and Monetarists argue about is
which
hi h off the
th policy
li levers
l
– (M) or (V) – is
i lik
likely
l tto
be effective in altering aggregate spending.
 Monetarists point to the money supply (M) as the
principal lever.
 Keynesians must rely on changes in (V) because
tax and expenditure policies have no direct impact
on the money supply.

If (V) is constant, changes in total spending can
come about only through changes in the money
supply.
 If the government raises taxes or borrows more
money, it effectively crowds out consumers and
investors who would otherwise be spending or
borrowing.

39
HOW FISCAL POLICY WORKS: TWO VIEWS
40
HOW FISCAL POLICY MATTERS
The central issue is whether and how a change
in G or T will alter macroeconomic outcomes.
 How well fiscal policy works depends on how
g byy
much the velocityy of moneyy can be changed
government tax and spending decisions.

 Keynesians
assert that aggregate spending will be
affected as the velocity of money (V) changes.
 Monetarists say no, because they anticipate an
unchanged (V).
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
Maybe
(may alter demand for
money)
Aggregate demand?
Nominal interest
rates?
Real interest rates
41
(crowding out)
No
(determined by real
growth)
Yes
(real growth and
expectations may vary 42
HOW MONETARY POLICY WORKS: TWO VIEWS
HOW MONEY MATTERS
Monetarist say a change in M must alter total
spending because V is stable.
 Keynesians assert that V may vary, so they
aren’tt convinced that monetary policy will
aren
always work.

Do changes in M
affect:
Monetarist View
Keynesian View
Yes
(V stable)
Maybe
(V may change)
Yes
(V and Q stable)
y
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
(depends on real growth)
Maybe
(real growth may vary)
Aggregate demand?
Prices?
ces
43
IS VELOCITY STABLE?
44
THE VELOCITY OF M2
The critical question of monetary policy
appears to be whether V is stable or not.
 The velocity of money turns out to be quite
stable over long periods of time.
time

2.0
1.9
9
 The
historical pattern justifies the Monetarist
assumption of a stable V.

Recession
1.8
Average
1.7
There is a pattern of short-run variations in
velocity.
 Velocity
RATIO OF GDP TO M2
2.1
1.6
1.5
tends to decline in recessions.
1960
1965
1970
1975
1980
1985
1990
45
The differing views of Keynesian and
monetarists clearly lead to different
conclusions about which policy lever to pull.
 Monetarists favor fixed money supply targets.
targets
 Keynesian reject fixed money supply targets.

advocate targeting interest rates, not
the money supply.
End of Chapter 15
MONETARY POLICY
47
2000
46
MONEY SUPPLY TARGETS
 Keynesians
1995