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CHAPTER 13 (24):
MONETARY POLICY
COREECONOMICS, 3RD EDITION BY ERIC CHIANG
Slides by Debbie Evercloud
© 2013 Worth Publishers
CoreEconomics ▪ Chiang/Stone
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CHAPTER OUTLINE
•
•
•
•
What is Monetary Policy?
Monetary Theories
Modern Monetary Policy
New Monetary Policy Challenges
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LEARNING OBJECTIVES
• At the end of this chapter, the student will
be able to:
– Explain the goals of monetary policy
– Describe the equation of exchange and its
implications for monetary policy
– Contrast the classical long-run monetary
theory with the effectiveness of monetary
policy in the short run
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LEARNING OBJECTIVES
• At the end of this chapter, the student will
be able to:
– Determine the effectiveness of monetary policy in
the face of demand shocks or supply shocks
– Describe the controversy over whether the Fed
should have discretion or should follow rules
– Explain why some policymakers have questioned
the role of the Fed after it used extraordinary
powers in response to the financial crisis of 2008
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EXAMPLE: AN FOMC MEETING
• Announcements of policy decisions from
the Federal Open Market Committee
(FMOC) are followed closely by investors,
business executives, and others.
• This chapter studies the remarkable
influence the Fed has to alter the
macroeconomy using the tools that form
the basis of monetary policy.
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BY THE NUMBERS: $100 BILLS
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INTEREST RATES
• The Fed uses its tools of monetary policy
to promote its twin goals of:
– Economic growth with low unemployment
– Stable prices with moderate long-term
interest rates
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INTEREST RATES
• Interest rates have a significant impact on
consumer and business spending.
– A reduction in interest rates promotes greater
consumption and investment, which leads to
an increase in aggregate demand.
– This will shift the aggregate demand curve to
the right.
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EXPANSIONARY MONETARY
POLICY
• In times of a recessionary gap, the Fed will
use an expansionary monetary policy.
– This means purchasing bonds through open
market operations.
– The bond purchase will increase the money
supply and lower interest rates.
The effect of an expansionary monetary policy is
to shift aggregate demand to the right.
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EXPANSIONARY MONETARY
POLICY
• The lower interest rates resulting from an
expansionary monetary policy will cause
an increase in:
– Consumption spending
– Investment spending
– Government spending
– Net exports
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CONTRACTIONARY
MONETARY POLICY
• In an inflationary period, the Fed will
pursue a contractionary monetary policy.
– The Fed will sell bonds in open market
operations.
– This has the effect of decreasing the money
supply and raising interest rates.
The effect of a contractionary monetary policy is to
shift aggregate demand to the left.
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CHECKPOINT: WHAT IS
MONETARY POLICY?
• Monetary policy involves the control of the
money supply to target interest rates.
• The Federal Reserve implements monetary
policy so as to maintain full employment,
stable prices, and moderate long-term
interest rates.
• By increasing or decreasing aggregate
demand, the Fed can move the economy
toward the long-run economic output level.
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THE QUANTITY THEORY OF
MONEY
• The quantity theory of money is a product
of the classical school of economics.
• It assumes that wages, prices, and interest
rates are flexible in the long run, allowing
the labor, product, and capital markets to
adjust to keep the economy at full
employment.
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THE EQUATION OF
EXCHANGE
• The quantity theory is defined by the
equation of exchange, which reads:
M×V=P×Q
– M is the supply of money
– V is the velocity of money
– P is the price level
– Q is the economy’s output level
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THE EQUATION OF
EXCHANGE
• If velocity and output are not variable,
then any increase in the money supply
translates directly into an increase in the
price level.
According to the quantity theory,
monetary policy is ineffective..
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THE CLASSICAL MODEL
Aggregate Price Level (P)
LRAS
P1
b
P0
a
In the classical model,
aggregate demand shifts
against a vertical LRAS.
AD (M = M1)
AD (M = M0)
Q0
Aggregate Real Output (Q)
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THE QUANTITY THEORY
• According to the quantity theory, a change
in the money supply will directly change
the aggregate price level and have no
effect on the real economy in the long run.
– An international comparison shows a positive
correlation between changes in the supply of
money and inflation rates.
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SHORT RUN VERSUS LONG RUN
• But the short run differs from the long run.
– People may suffer from money illusion in the
short run.
– Wages and prices are sticky in the short run.
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KEYNESIAN MONETARY
THEORY
• John Maynard Keynes thought that an
expansionary monetary policy:
– Could create more activity for a healthy economy
in the short run.
– Would have no effect even in the short run when
an economy is in the midst of a deep recession or
depression.
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LIQUIDITY TRAP
• A liquidity trap occurs when an increase
in the money supply does not reduce
interest rates.
• Under conditions of a liquidity trap, an
expansionary monetary policy does not
boost investment spending.
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MILTON FRIEDMAN
• Milton Friedman challenged the Keynesian
view by arguing that the crowding out
effect makes fiscal policy ineffective.
• Friedman pioneered the notion that
consumption is not only based on income,
but also based on wealth, an idea referred
to as the permanent income hypothesis.
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MONETARISM
• Friedman’s approach is known as
monetarism.
– Monetarists believe monetary policy can be
effective in the short run.
– They also believe that increases in the money
supply will cause inflation in the long run.
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LONG-RUN EFFECT IN
MONETARISM
LRAS
Aggregate Price Level (P)
AS1
c
AS0
110
105
b
100
a
In the monetarist model,
an increase in output
resulting from an expansion
in the money supply
is only temporary.
AD1
AD0
15
16
Aggregate Output (Q)
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GOALS OF MONETARY
POLICY
• The direction of monetary policy and its
extent depends on:
– Whether it focuses on the price level or
income and output
– Whether the shock to the economy comes
from the demand or supply side
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DEMAND SHOCKS
• Demand shocks can come from reductions in
consumer demand, investment, government
spending, or net exports.
• For example, the economy experienced a
demand shock in 2008 when households
increased saving.
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SUPPLY SHOCKS
• Supply shocks can arise from changes in:
– Resource costs
– Inflationary expectations
– Technology
• For a negative supply shock, a decline in
real output will be accompanied by an
increase in the overall price level.
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GOALS OF MONETARY
POLICY
• There is general agreement among
economists that monetary policy should
focus on:
– Price stability in the long run
– Output or income in the short run
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CHECKPOINT: MONETARY
THEORIES
• The classical equation of exchange is
MV=PQ
• Monetary policy can focus on either a stable
price level or output when the economy
experiences a demand shock.
• Supply shocks present a more serious
problem for monetary policy.
– A negative supply shock reduces output but
increases the price level.
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MODERN MONETARY POLICY
• When the Fed buys bonds, it adds to bank
reserves. This is called easy money,
expansionary monetary policy, or
quantitative easing.
– It is designed to increase excess reserves
and the money supply, and ultimately reduce
interest rates to stimulate the economy.
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MODERN MONETARY POLICY
• The opposite of an expansionary policy is
tight money or a restrictive monetary
policy.
– Tight money policies are designed to shrink
income and employment, usually in the
interest of fighting inflation.
– The Fed brings this about by selling bonds to
pull reserves from the financial system.
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RULES VERSUS DISCRETION
• The complexities of monetary policy have
led some economists, most notably Milton
Friedman, to call for a monetary rule to
guide monetary policymakers.
• Other economists argue that modern
economies are too complex to be
managed by a few simple rules.
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RULES VERSUS DISCRETION
• Monetary authorities around the world have
tried an alternative to monetary rules by using
the approach of inflation targeting.
• This sets targets for the inflation rate, usually
around 2% per year.
• If inflation exceeds the target, contractionary
policy is employed. When inflation falls below
the target, expansionary policy is used.
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TAYLOR RULE
• Professor John Taylor of Stanford University
studied decision making at the Fed and he
empirically found that the Fed tends to follow
a general rule that has become known as the
Taylor rule for federal funds targeting:
Federal funds target rate =
2 + current inflation rate + ½ (inflation gap)
+ ½ (output gap)
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TAYLOR RULE
• The Fed’s inflation target is typically 2%, the inflation
gap is the current inflation rate minus the inflation
target, and the output gap is current GDP minus
potential GDP.
• If the Fed targets inflation at 2%, the current inflation
rate is 4%, and output is 3% below potential, then
the Taylor rule’s target federal funds rate is:
FFTarget = 2 + 4 + ½ (4 − 2) + ½ (−3)
= 2 + 4 + 1 − 1.5 = 5.5%
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MODERN MONETARY POLICY
• Today, monetary authorities set a target
interest rate and then use open market
operations to adjust reserves and keep the
federal funds rate near this level.
• The Fed’s interest target is the level that
will keep the economy near potential GDP
or keep inflationary pressures in check.
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TRANSPARENCY
• For many years, decisions within the Fed
were made and executed in secrecy. The
public did not know when monetary policy
was being changed.
– In 1987, this policy of secrecy was modified.
– Fed transparency helps the public understand
why certain actions are taken.
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CHECKPOINT:
MODERN MONETARY POLICY
• In the long run, the Fed targets price
stability.
• In the past, the rate of growth of the money
supply was subject to a monetary target.
• The Fed sets a target federal funds rate and
then uses open market operations to adjust
reserves and keep the federal funds rate
near this level.
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CHECKPOINT:
MODERN MONETARY POLICY
• The Taylor Rule is a general rule that ties
the federal funds rate target to the inflation
gap and the output gap for the economy.
• Contractionary policy is used during
inflationary periods, whereas expansionary
policy is employed during recessions.
• Fed transparency helps us understand why
the Fed makes particular decisions.
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THE FINANCIAL CRISIS
OF 2008 –09
• The financial meltdown of the last decade
was caused by a perfect storm of conditions:
– A world savings glut and unusually low interest
rates from 2002 to 2005 led to a housing bubble.
– Financial risk was not properly accounted.
– Investors bought trillions of dollars of assets that
depended on housing values increasing
consistently over the years.
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THE FED’S RESPONSE
• In response to the financial crisis, the Fed
used its normal monetary policy tools and
some that it hadn’t used since the 1930s.
– By December 2008, the Fed had lowered its
federal funds target rate to essentially zero.
– The Fed also made massive loans to banks
and bought large amounts of risky mortgagebacked securities.
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THE EUROZONE CRISIS AND
THE ECB
• Member nations have to satisfy certain
criteria before joining the Eurozone.
• Why are the economic criteria necessary?
– When a common currency is adopted,
monetary policy becomes shared by all
members.
– Therefore, a monetary crisis in one country
can quickly spread to all countries.
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THE EUROZONE CRISIS AND
THE ECB
• For much of the first decade, the euro was
a success, as member nations complied
with debt limits while the European Central
Bank (ECB) implemented monetary policy
for the entire Eurozone.
• However, that changed in the mid-2000s,
when several member nations saw their
debts rise.
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THE EUROZONE CRISIS AND
THE ECB
• From 2008 to 2013, nearly half of the
Eurozone nations faced some sort of
financial crisis.
• The ECB used normal monetary policy
tools as well as extraordinary measures to
lessen the economic impact of the crisis.
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RECOVERY FROM CRISIS
• In the United States, the housing market
has started to recover, stock markets have
set new highs, and banks have
strengthened their balance sheets.
– Yet, both in Europe and the United States,
persistent unemployment and deficits remain.
• This means that the Fed will continue to
rely on monetary tools to prevent problems
from engulfing the economy.
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CHECKPOINT: NEW MONETARY
POLICY CHALLENGES
• To control the financial panic of 2008, the Fed
used its normal monetary policy tools and some
that it hadn’t used since the 1930s.
• A long and severe debt crisis occurred when
several European nations neared default on
their loans and came close to exiting the euro.
– This required extraordinary actions by the
European Central Bank to keep the effects of the
crisis from spreading to the entire Eurozone.
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CHAPTER SUMMARY
• The twin goals of monetary policy are:
– Economic growth and full employment
– Stable prices and moderate long-term
interest rates
• An expansionary monetary policy strives
to decrease interest rates and increase
aggregate demand.
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CHAPTER SUMMARY
• A contractionary monetary policy strives to
increase interest rates and decrease
aggregate demand.
• The quantity theory of money concludes
that monetary policy is ineffective.
• Keynesians and monetarists believe that
monetary policy can be effective in the
short run, but not in the long run.
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CHAPTER SUMMARY
• Demand shocks affect the AD curve.
– Monetary policy is easier because targeting one goal
automatically targets the other.
• Supply shocks affect the SRAS curve.
– Monetary policy is difficult because targeting one goal
makes the other target worse.
• The debate about monetary policy is often a
debate about rules versus discretion.
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CHAPTER SUMMARY
• The U.S. financial crisis in 2008 created a major
challenge for the Fed.
– To continue expansionary monetary policy with
interest rates at zero, the Fed engaged in various
quantitative easing strategies.
• The 17-member nations that form the Eurozone
share a monetary policy set by the ECB.
– In recent years, the ECB has used aggressive
monetary policy to prevent the effects of financial
crises from engulfing the entire region.
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DISCUSSION QUESTIONS
• Why are the effects of monetary policy
different in the long run versus the short run?
• Would your individual spending be affected
by a change in interest rates? How does a
change in interest rates affect aggregate
demand overall?
• How does Fed transparency influence the
effectiveness of monetary policy?
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