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Transcript
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