Download Chapter 17

ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 17: Domestic and International
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.
1
1
What’s So Special
About Money?

The demand for money, what people wish to
hold
 People have certain motivation that causes them
to want to hold money balances.
 There is a demand for money by the public,
motivated by several factors.
Transactions demand
 Precautionary demand
 Asset demand

17-2
What’s So Special
About Money? (cont'd)

Money Balances
 Synonymous
with money, money stock, and
money holdings

Transactions Demand
 Holding money as a medium of exchange to make
payments
 The level varies directly with nominal GDP.
17-3
What’s So Special
About Money? (cont'd)

Precautionary Demand
 Holding money to meet unplanned
expenditures
and emergencies

Asset Demand
 Holding money as a store of value instead of other
assets such as certificates of deposit, corporate
bonds, and stocks
17-4
What’s So Special
About Money? (cont'd)

The demand for money curve
 Assume the amount of money demanded for
transactions purposes is proportionate to income
 Precautionary and asset demand are determined
by the opportunity cost of holding money (the
interest rate).
17-5
Figure 17-1
The Demand for Money Curve
17-6
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
17-7
The Tools of Monetary Policy

The Fed seeks to alter consumption,
investment, and aggregate demand as a
whole by altering the rate of growth of the
money supply.
17-8
The Tools
of Monetary Policy (cont'd)

The Fed has three tools at its disposal as part
of its policymaking action.
 Open market operations
 Discount rate changes
 Reserve requirement changes
17-9
The Tools
of Monetary Policy (cont'd)

Open market operations
 Fed purchases and sells government bonds issued
by the U.S. Treasury

At first, there is some equilibrium level of interest rate
(and bond prices).
 An open market operation must cause a change in
the price of bonds.
17-10
Figure 17-2 Determining the Price
of Bonds, Panel (a)
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
17-11
Figure 17-2 Determining the Price
of Bonds, Panel (b)
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
17-12
The Tools
of Monetary Policy (cont'd)

Relationship between the price of existing
bonds and the rate of interest
 There is an inverse relationship between the price
of existing bonds and the rate
of interest.
17-13
The Tools of Monetary Policy (cont'd)

Example
 You pay $1,000 for a bond that pays $50/year in interest.
Bond yield
=
$50
= 5%
$1,000
 Now suppose you pay $500 for the
same bond.
Bond yield
=
$50
= 10%
$500
17-14
The Tools
of Monetary Policy (cont'd)

The market price of existing bonds (and all
fixed-income assets) is inversely related to
the rate of interest prevailing in the
economy.
17-15
The Tools
of Monetary Policy (cont'd)

Changes in the difference between the
discount rate and the federal funds rate
 The discount
rate is generally kept at 1
percentage point above the market-determined
federal funds rate.
 Increasing (decreasing) the discount
rate increases (decreases) the cost of borrowed
funds for depository institutions that borrow
reserves.
17-16
The Tools
of Monetary Policy (cont'd)

Changes in the reserve requirements
 An increase (decrease) in the required reserve
ratio

Makes it more (less) expensive for banks to meet
reserve requirements

Reduces (expands) bank lending
17-17
Effects of an Increase
in The Money Supply (cont'd)

Direct effect
 Aggregate demand rises because with an increase
in the money supply, at any given price level
people now want to purchase more output of real
goods and services.
17-18
Effects of an Increase
in The Money Supply (cont'd)

Indirect effect
 Not everybody will necessarily spend the
newfound money on goods and services.
 Some of the money gets deposited,
so banks have
higher reserves (and they lend the excess out).
17-19
Effects of an Increase
in The Money Supply (cont'd)

Indirect effect
 Banks lower rates to induce borrowing.
Businesses engage in investment.
 Individuals consume durable goods (like housing and
autos).

 Increased loans generate an increase in aggregate
demand.

More people are involved in more spending (even
those who didn’t get money from
the helicopter!).
17-20
Graphing the Effects of an
Expansionary Monetary Policy

Assume the economy is operating at less than
full employment
 Expansionary monetary policy can close the
recessionary gap.
 Direct and indirect effects cause the aggregate
demand curve to shift outward.
17-21
Figure 17-3 Expansionary Monetary
Policy with Underutilized Resources
• The recessionary gap is
due to insufficient AD
• To increase AD,
use expansionary
monetary policy
• AD increases and
real GDP increases
to full employment
17-22
Graphing the Effects of
Contractionary Monetary Policy

Assume there is an inflationary gap
 Contractionary monetary policy can eliminate this
inflationary gap.
 Direct and indirect effects cause the aggregate
demand curve to shift inward.
17-23
Figure 17-4 Contractionary Monetary Policy
with Overutilized Resources
• The inflationary gap is shown
• To decrease AD, use
contractionary monetary policy
• AD decreases and real
GDP decreases
17-24
Open Economy Transmission
of Monetary Policy

So far we have discussed monetary policy in a
closed economy.

When we move to an open economy,
monetary policy becomes more complex.
17-25
Open Economy Transmission
of Monetary Policy (cont'd)

The net export effect
 Impact of expansionary (contractionary) monetary

Lower (higher) interest rates

Financial capital flows out of (into) the United States

Demand for dollars will decrease (increase)

International price of dollar goes down (up)

Foreign goods look more (less) expensive in
United States

Net exports increase (decrease) and imports fall (go up)
17-26
Open Economy Transmission
of Monetary Policy (cont'd)

Globalization of international
money markets
 Global money markets reduce the Fed's ability to
control the rate of growth in the money supply.
 Foreign entities can influence both the supply of
and demand for U.S. dollars.
 Their actions can reinforce or offset the Fed
strategy.
17-27
Monetary Policy and Inflation

Most theories of inflation relate to the short
run and the price index in the short run can
fluctuate due to
 Oil price shocks, labor union strikes

In the long run, there is a more stable
relationship between growth in the money
supply and inflation.
17-28
Monetary Policy and Inflation
(cont'd)

Simple supply and demand analysis can be
used to explain
 Why the price level rises when the money supply
is increased

If the supply of money expands relative to the
demand for money
 It takes more units of money to purchase given
quantities of goods and services (i.e., the price
level has risen)
17-29
Monetary Policy and Inflation
(cont'd)

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
real GDP
MsV = PY
17-30
Monetary Policy and Inflation
(cont'd)

V = Income Velocity of Money
 The number of times per year the dollar
is spent on final goods and services;
equal to the nominal GDP divided by
the money supply.
17-31
Monetary Policy and Inflation (cont'd)

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 per year, each monetary unit is
spent on final goods and services
 P = price level or price index
 Y = real GDP per year
17-32
Monetary Policy and Inflation
(cont'd)

The equation of exchange as
an identity
 Total funds
spent on final output MsV equals total
funds received PY
 The value of goods purchased is equal to the value
of goods sold
 MsV = PY = nominal GDP
17-33
Monetary Policy and Inflation (cont'd)

Quantity Theory of Money and Prices
 The hypothesis
that changes in the money supply
lead to proportional changes in the price level
 Assume:
V is constant
Y is stable
 Increases in Ms must be matched by equal
increases in the price level
MsV = PY
17-34
Figure 17-5 The Relationship
Between Money Supply Growth Rates and Rates
of Inflation
17-35
Monetary Policy in Action:
The Transmission Mechanism

Recall we talked about the direct and indirect
effects of monetary policy.
 Direct effect: implies increase in money supply
causes people to have excess money balances.
 Indirect effect: occurs as people purchase
interest-bearing assets, causing the price of such
assets to go up.
17-36
Figure 17-6 The Interest-Rate-Based Money
Transmission Mechanism
17-37
Figure 17-7 Adding Monetary Policy
to the Aggregate Demand–Aggregate Supply
Model, Panel (a)
At lower rates, a larger
quantity of money will
be demanded
17-38
Figure 17-7 Adding Monetary Policy
to the Aggregate Demand–Aggregate Supply
Model, Panel (b)
The decrease in the interest
rate stimulates investment
17-39
Figure 17-7 Adding Monetary Policy
to the Aggregate Demand–Aggregate Supply
Model, Panel (c)
The increase in investment
shifts the AD curve to the right
17-40
Fed Target Choice: Interest Rates
or Money Supply?

It is not possible to stabilize the money supply and
interest rates simultaneously.

The Fed has often sought to achieve an interest rate
target.

There is a fundamental tension between targeting
interest rates and controlling the money supply.

The Fed, in the short run, can select an interest rate
or a money supply target but not both.
17-41
Figure 17-8
Choosing a Monetary Policy Target
If the Fed selects re, it
must accept Ms
If the Fed selects M’s,
it must allow the
interest rate to fall
17-42
Fed Target Choice: Interest Rates
or Money Supply? (cont'd)

The Fed, in the short run, can select
an interest rate or a money supply target but
not both.
17-43
Fed Target Choice: Interest Rates
or Money Supply? (cont'd)

Choosing a policy target
 Money supply

When variations in private spending occur
 Interest rates

When the demand for (or supply of) money
is unstable

Interest rate targets are preferred
17-44
The Way Fed Policy
is Currently Implemented

At present the Fed announces an interest rate
target.

The rate referred to is the federal funds rate
of interest.

Or, the rate at which banks can borrow excess
reserves from each other.
17-45
The Way Fed Policy
is Currently Implemented (cont'd)

If the Fed wants to raise “the” interest rate, it
engages in contractionary open market
operations.
 Fed sells more Treasury securities than it buys,
thereby reducing the money supply.

This tends to boost “the” rate of interest.
17-46
The Way Fed Policy
is Currently Implemented (cont'd)

Conversely, if the Fed wants to decrease “the”
rate of interest,
it engages in expansionary open market
operations.
 Fed buys more Treasury securities, increasing the
money supply.

This tends to lower “the” rate of interest.
17-47
The Way Fed Policy
is Currently Implemented (cont'd)

FOMC Directive
 A document that summarizes the
Federal Open Market Committee’s
general policy strategy
 Establishes near-term objectives for the federal
funds rate and specifies target ranges for money
supply growth
17-48
The Way Fed Policy
is Currently Implemented (cont'd)

Trading Desk
 An office at the Federal Reserve Bank of New York
charged with implementing monetary policy
strategies developed by the FOMC
17-49
ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 17: Domestic and International
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.
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