Download Document

ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 17: Dimensions
of Monetary Policy
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
Learning Objectives



Identify the key factors that influence the
quantity of money that people desire to hold
Describe how the Federal Reserve’s tools of
monetary policy affect the level of real GDP and
the price level
Evaluate how expansionary and contractionary
monetary policy actions affect equilibrium real
GDP and the price level in the short run
2
Learning Objectives



Understand the equation of exchange and its
importance in the crude quantity theory of
money and prices
Distinguish between the Keynesian and
monetarist views on the transmission
mechanism of monetary policy
Explain why the Federal Reserve cannot
stabilize both the money supply and the interest
rate simultaneously
3
What’s So Special About Money?

Money is the product of a “social contract”
in which we all agree to:


Express all prices in terms of a common
unit of account, which in the United States
we call the dollar
Use a specific medium of exchange for
market transactions
4
What’s So Special About Money?
Anything that affects the amount of money
in existence is going to affect all markets.
 Holding money



To use money, one must hold money.
If people desire to hold money, there is a
demand for money.
5
What’s So Special About Money?

The demand for money: the amount of
money people wish to hold



Transactions demand
Precautionary demand
Asset demand
6
What’s So Special About Money?

Transactions Demand


Holding money as a medium of exchange to
make payments
The level varies directly with nominal
national income
7
What’s So Special About Money?

Precautionary Demand


Holding money to meet unplanned
expenditures and emergencies
The level varies with the interest rate
8
What’s So Special About Money?

Asset Demand


Holding money as a store of value instead
of other assets
The level varies with the interest rate
9
What’s So Special About Money?

The demand for money curve


The amount of money demanded for
transactions purposes is fixed given the
level of income
Precautionary and asset demand are
determined by the opportunity cost of
holding money (the interest rate)
10
Interest Rate
The Demand for Money Curve
Md
Quantity of Money
Figure 17-1
11
The Demand for Money Curve
B
Interest Rate
r2
• When the interest rate rises the
opportunity cost of holding money
increases and the quantity of money
demanded falls
• The location of Md is determined by
the level of income
A
r1
Md
Q1
Q2
Quantity of Money
12
The Tools of Monetary Policy

Open market operations
 The
Fed changes reserves by buying and
selling government bonds issued by the U.S.
Treasury.
13
Determining the Price of Bonds
S1
Price of Bonds
P1
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (a)
14
Determining the Price of Bonds
S1
Price of Bonds
P1
S2
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
P2
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (a)
15
Determining the Price of Bonds
Price of Bonds
S1
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
P1
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (b)
16
Determining the Price of Bonds
S3
Price of Bonds
P3
S1
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
P1
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (b)
17
The Tools of Monetary Policy

Relationship between the price of existing
bonds and the rate of interest
 What
happens to the interest on a bond when
the price of a bond increases (decreases)?
18
The Tools of Monetary Policy

Example
 You
pay $1,000 for a bond that pays $50/year
in interest
$50
Rate of interest =
= 5%
$1000
19
The Tools of Monetary Policy

Example
 Now
suppose you pay $500 for the same
bond
$50
Rate of interest =
= 10%
$500
20
The Tools of Monetary Policy

The market price of existing bonds (and all
fixed-income assets) is inversely related to
the rate of interest prevailing in the
economy.
21
The Tools of Monetary Policy

Changes in the discount rate

Increasing the discount rate increases the
cost of borrowed funds for depository
institutions that borrow reserves
 Decreasing the discount rate decreases the
cost of borrowed funds for depository
institutions that borrow reserves
22
The Tools of Monetary Policy

Changing the discount rate relative to the
federal funds rate
 The
Fed has been keeping the discount rate
one percentage point above the federal funds
rate.
 This discourages borrowing from the Fed.
23
The Tools of Monetary Policy

Changes in the reserve requirements
 An
increase in the required reserve ratio
Makes it more expensive for banks to meet
reserve requirements
 Reduces bank lending

 A decrease
in the required reserve ratio
Makes it less expensive for banks to meet reserve
requirements
 Increases bank lending

24
Effects of an Increase
in the Money Supply

When the money supply increases, people
have too much money.
 How
can this be?
 Have you ever had too much money?
 If you have a savings account, then at some
point you had too much money.
 Money is not the same thing as income.
25
Monetary Policy During
Periods of Underutilized Resources

Monetary policy can generate increases in
the equilibrium level
of real GDP.
26
Expansionary Monetary Policy
with Underutilized Resources
Price Level
LRAS
SRAS
• The contractionary gap is
caused by insufficient AD
• To increase AD, use
expansionary monetary policy
• AD increases and real GDP
increases to full employment
E1
120
Recessionary gap
AD1
0
Figure 17-3
11.5
12.0
Real GDP per Year
($ trillions)
27
Expansionary Monetary Policy
with Underutilized Resources
LRAS
SRAS
Price Level
125
• The contractionary gap is
caused by insufficient AD
• To increase AD, use
expansionary monetary policy
• AD increases and real GDP
increases to full employment
E2
E1
120
AD2
Recessionary gap
AD1
0
Figure 17-3
11.5
12.0
Real GDP per Year
($ trillions)
28
Contractionary Monetary Policy
via Open Market Operations
Figure 17-4
29
Open Economy Transmission
of Monetary Policy

The net export effect
 Impact
of expansionary monetary policy
increase the money supply
 interest rates fall
 value of the dollar falls
 net exports increase
 the net export effect complements the
effectiveness of monetary policy

30
Open Economy Transmission
of Monetary Policy

The net export effect
 Impact
of expansionary fiscal policy revisited
 larger deficit
 higher interest rates
 attracts foreign capital
 value of the dollar appreciates
 net exports fall
 net export effect reduces the effectiveness of
fiscal policy
31
Open Economy Transmission
of Monetary Policy

Globalization of international money
markets
 How
will global money markets impact the
Fed's ability to control the rate of growth in the
money supply?
32
Monetary Policy and Inflation

Short-run inflation
 Temporarily

shocks the SRAS and AD
Long-run inflation
 The
supply of money expands relative to the demand
for money
 Takes more units of money to purchase given
quantities of goods and services (i.e., the price level
has risen)
33
Monetary Policy and Inflation

The Equation of Exchange
 The
formula indicating that the number of
monetary units times the number of times
each unit is spent on final goods and services
is identical to the price level times output (or
nominal national income)
MsV = PY
34
Monetary Policy and Inflation

The equation of exchange and the quantity
theory: MSV = PY

MS = actual money balances held by nonbanking public
 V = income velocity of money; the number
of times, on average, cash monetary units
are spent on final goods and services
35
Monetary Policy and Inflation

The equation of exchange and the quantity
theory: MSV = PY
P =
price level
 Y = real national output per year
36
Monetary Policy and Inflation

The equation of exchange as an identity
MsV = PY
PY = nominal national income
MsV = nominal national spending
37
Monetary Policy and Inflation

The crude quantity theory of money and
prices
 Assume:
V is constant and Y is stable
MsV = PY
38
Monetary Policy and Inflation

The crude quantity theory of money and
prices
 Increases
in Ms must be matched by equal
increases in the price level
MsV = PY
39
Adding Monetary Policy
to the Keynesian Model
Interest Rate
MS
M’S
r1
Md
Quantity of Money
Figure 17-7, Panel (a)
40
Adding Monetary Policy
to the Keynesian Model
Interest Rate
MS
M’S
At lower rates, a larger
quantity of money will
be demanded
r1
Interest rate falls
r2
Md
Quantity of Money
Figure 17-7, Panel (a)
41
Interest Rate
Adding Monetary Policy
to the Keynesian Model
r1
I
I1
Planned Investment
Figure 17-7, Panel (b)
42
Interest Rate
Adding Monetary Policy
to the Keynesian Model
The decrease in the
interest rate stimulates
investment
r1
r2
I
I1
I2
Planned Investment
Figure 17-7, Panel (b)
43
Adding Monetary Policy
to the Keynesian Model
LRAS
Price Level
SRAS
E1
AD1
0
Figure 17-7, Panel (c)
11.5 12.0
Real GDP per Year
($ trillions)
44
Adding Monetary Policy
to the Keynesian Model
LRAS
Price Level
SRAS
E2
E1
The increase in
investment shifts the
AD curve to the right
AD2
AD1
0
Figure 17-7, Panel (c)
11.5 12.0
Real GDP per Year
($ trillions)
45
Monetary Policy in Action:
The Transmission Mechanism

The monetarist’s views of money supply
changes
 Macroeconomists
who believe that inflation is
always caused by excessive monetary growth
and that changes in the money supply affect
AD both directly and indirectly
46
Monetary Policy in Action:
The Transmission Mechanism

The monetarist’s views of money supply
changes
 Increase
in the money supply increases
aggregate demand directly
 Based on the equation of exchange, prices
always rise when the money
supply is increased
47
Monetary Policy in Action:
The Transmission Mechanism

Monetarists’ criticism of monetary policy
 Time
lags are too long to use monetary policy
effectively
 Monetary policy is seen as a destabilizing
force
48
Monetary Policy in Action:
The Transmission Mechanism

Monetary Rule
 A monetary
policy that incorporates a rule
specifying the annual rate of growth
of some monetary aggregate
 Example

Increase in the money supply smoothly at a rate
consistent with the economy’s long-run average
growth rate
49
Monetary Policy in Action:
The Transmission Mechanism

What do you think?
 What
would happen to the effectiveness of the
monetary rule if the velocity of money is not
stable?
50
Fed Target Choice:
Interest Rates or Money Supply?

It is not possible to stabilize the money
supply and interest rate simultaneously.
51
Choosing a Monetary Policy Target
M’S
Interest Rate
MS
Md
Quantity of Money
Figure 17-8
52
Choosing a Monetary Policy Target
MS
M’S
Interest Rate
If the Fed selects re,
it must accept Ms
re
r1
A
D
C
B
If the Fed selects M’s,
it must allow the
interest rate to fall
Md
Quantity of Money
Figure 17-8
53
Fed Target Choice:
Interest Rates or Money Supply?

Target interest rates
 The

money supply will be unstable
Target the money supply
 The
interest rate will be unstable
54
Fed Target Choice:
Interest Rates or Money Supply?

Choosing a target
 Interest

When the demand for money is unstable
 Money

rates
supply
When variations in private spending occur
55
The Way Fed Policy
is Currently Announced



No matter what the Fed is actually targeting, it
only announces an interest rate target.
The current strategy is outlined in the FOMC
directive.
This strategy is implemented through open
market operations conducted by the Trading
Desk of the New York Federal Reserve.
56
Issues and Applications:
Maintaining Federal Reserve Targets


The Trading Desk of the New York Federal
Reserve Bank implements the Federal Open
Market Committee directives.
If a lowering of interest rates is called for, then
the Fed will purchase bonds, pumping reserves
into the banking system.
57
Issues and Applications:
Maintaining Federal Reserve Targets
The Fed sells bonds, drawing reserves
from the banking system, when a
contractionary measure in needed.
 The Fed does not set the federal funds
rate explicitly, but it changes the level of
reserves in depository institutions, and this
influences the money supply.

58
Summary Discussion
of Learning Objectives

Key factors that influence the quantity of
money that people desire to hold:
 To
make transactions
 To hold for precautionary reasons
 To hold as an asset (store of value)
59
Summary Discussion
of Learning Objectives

How the Federal Reserve’s monetary
policy tools influence market interest rates
 Open
market purchases, reducing the discount rate,
or reducing the required reserve ratio increases the
money supply and lowers the interest rate.
 Open market sales, raising the discount rate, or
increasing the required reserve ratio decreases the
money supply and raises the interest rate.
60
Summary Discussion
of Learning Objectives

How expansionary and contractionary
monetary policy affect equilibrium real
GDP and the price level in the short run
 Expansionary


monetary policy
Increase real GDP
Decrease the price level
 Contractionary


monetary policy
Decrease real GDP
Decrease the price level
61
Summary Discussion
of Learning Objectives

The equation of exchange and the crude
quantity theory of money
and prices
 Equation

MV = PY
 Crude


of exchange
quantity theory of money and prices
V is constant and Y is Stable
Increases in M cause proportionate increases in P
62
Summary Discussion
of Learning Objectives

Keynesian versus monetarist views
on the transmission mechanism
of monetary policy
 Keynesian

Changes in interest rates cause changes in investment which
change equilibrium real GDP
 Monetarist

transmission mechanism
transmission mechanism
Changes in the money supply change desired spending
63
Summary Discussion
of Learning Objectives
 Why
the Federal Reserve cannot
stabilize the money supply and the
interest rate simultaneously
 To
target a market interest rate the Fed
must adjust the money supply as necessary
when the demand for money changes
 To target the money supply the Fed must
permit the interest rate to vary when the
demand for money changes
64
ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 17: Dimensions
of Monetary Policy
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.