Download Monetary Policy - John Zietlow

Monetary Policy
Chapter 15
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy
• Control over the money supply is a critical
policy tool for altering macro outcomes
– What’s the relationship between the money supply,
interest rates, and aggregate demand?
– How can the Fed use its control of the money
supply or interest rates to alter macro outcomes?
– How effective is monetary policy, compared to
fiscal policy
15-2
Monetary Policy
• Some economists argue that monetary policy is
more effective than fiscal policy; others
contend the reverse is true
• Monetary policy: The use of money and
credit controls to influence macroeconomic
outcomes
15-3
The Money Market
• Like other goods, there’s a supply of money
and a demand for money
• The price of money is determined in the
money market
– Interest rate: The price paid for the use of money
15-4
Money Balances
• Most of the money in the money supply is in
the form of bank balances
– Money Supply (M1): Currency held by the
public, plus balances in transactions accounts
– Money Supply (M2): M1 plus balances in most
savings accounts and money market mutual funds
15-5
The Demand for Money
• Demand for money: The quantities of money
people are willing and able to hold at
alternative interest rates, ceteris paribus
• Portfolio decision: The choice of how (where)
to hold idle funds
15-6
The Demand for Money
• Transactions demand for money: Money
held for making everyday market purchases
• Precautionary demand for money: Money
held for unexpected market transactions or for
emergencies
• Speculative demand for money: Money held
for speculative purposes, for later financial
opportunities
15-7
The Money Market
• The quantity of money that people are willing
and able to hold (demand) increases as interest
rates fall, ceteris paribus
• The money supply curve is assumed to be a
vertical line
– The Federal Reserve has the power to regulate the
money supply through its policy tools
15-8
Equilibrium
• Equilibrium rate of interest occurs at the
intersection of the money-demand and moneysupply curves
• Equilibrium rate of interest: The interest rate
at which the quantity of money demanded in a
given time period equals the quantity of money
supplied
15-9
Money Market Equilibrium
Interest Rate (%)
Money supply
9
E1
7
The amount of money
demanded (held) depends
on interest rates
Money
demand
0
g2
g1
Quantity Of Money
15-10
Changing Interest Rates
• The Federal Reserve can alter the money
supply through changes in reserve
requirements, the discount rate, or through
open market operations
• This changes the equilibrium rate of interest
15-11
Changing Interest Rates
Interest Rate (%)
Money supply
Money supply and
demand set
interest rates
7
6
0
E1
E3
g1
g3
Demand for
money
Quantity Of Money
15-12
Federal Funds Rate
• The federal funds rate is most directly affected
when the Fed injects or withdraws reserves
from the banking system
• The federal funds rate reflects the cost of funds
for banks
– Federal Funds Rate: The interest rate for
interbank reserve loans
15-13
Interest Rates and Spending
• When the cost of funds for banks changes,
they change the rates they charge on loans
• Changes in interest rates affect consumer,
investor, government, and net export spending
15-14
Monetary Stimulus
• The goal of monetary stimulus is to increase
aggregate demand
• Stimulating the economy is achieved through
– An increase in the money supply
– A reduction in interest rates
– An increase in aggregate demand
15-15
Monetary Stimulus
An increase in the
money supply lowers
the rate of interest
A reduction in the rate
of interest stimulates
investment
More investment increases
aggregate demand
(including multiplier effects)
6
Demand
for money
E2
Investment
demand
7
6
Price Level
7
E1
Interest Rate
Interest Rate
AS
AD1
0
g1 g2
Quantity Of Money
0
I1
AD2
I2
Rate Of Investment
Income (Output)
15-16
Monetary Restraint
• To lessen inflationary pressures, the Fed will
apply a policy of monetary restraint
• This is achieved through
– A decrease in the money supply
– An increase in interest rates
– A decrease in aggregate demand
15-17
Policy Constraints
• Several constraints can limit the Fed’s ability
to alter the money supply, interest rates, or
aggregate demand
– Short- vs. long-term
rates
– Reluctant lenders
– Liquidity trap
– Low expectations
– Time lags
15-18
Short- vs. Long-Term Rates
• Fed’s open market operations have the most
direct effect on short-term rates
• The success of Fed intervention depends in
part on how well changes in long-term interest
rates mirror changes in short-term interest rates
15-19
Reluctant Lenders
• Banks themselves must expand the money
supply by making new loans
• Banks may be unwilling to make new loans
even when the Fed is injecting excess reserves
into the banking system
15-20
Liquidity Trap & Low Expectations
• Liquidity trap: The portion of the money
demand curve that is horizontal; people are
willing to hold unlimited amounts of money at
some (low) interest rate
• Gloomy expectations deter borrowing
• Investment demand that is slow to respond to
lower interest rates is said to be inelastic
15-21
Constraints on Monetary Stimulus
Inelastic investment demand can
also impede monetary policy
Demand
for
money
7
E1 E2
The
liquidity
trap
g1 g2
Quantity Of Money
Interest Rate
Interest Rate
A liquidity trap can stop
interest rates from falling
6
Inelastic
demand
Investment
demand
0
Rate Of Investment
15-22
Time Lags
• There is always a time lag between interestrate changes and investment responses
• It may take 6–12 months before market
behavior responds to monetary policy
15-23
Limits on Monetary Restraint
• It is also harder for the Fed to restrain demand
– Expectations - Optimistic consumers and investors
may continue borrowing even though interest rates
are higher
– Global money - U.S. borrowers might tap global
sources of money or local non-bank lenders not
regulated by the Fed
15-24
How Effective?
• Keynes believed that monetary policy would
not be effective at ending a deep recession
• Combination of reluctant bankers, the liquidity
trap, and low expectations could render
monetary stimulus ineffective
• Limitations on monetary restraint are not
considered as serious
15-25
The Monetarist Perspective
• Keynesians believe that changes in the money
supply affect macro outcomes primarily
through changes in interest rates
• Monetarists believe monetary policy cannot
effectively fight the short-run business cycle
but is a powerful tool for managing inflation
15-26
The Equation of Exchange
• Monetarists use the equation of exchange to
express the potential of monetary policy
• Equation of exchange: Money supply (M)
times velocity of circulation (V) equals level of
aggregate spending (P  Q)
MV  PQ
15-27
The Equation of Exchange
• Income velocity of money (V): The number
of times per year, on average, a dollar is used
to purchase final goods and services
– How often a dollar changes hands
PQ
V
M
15-28
The Equation of Exchange
• The quantity of money in circulation and its
velocity in product markets will always equal
total spending and income (nominal GDP)
• The equation implies that if M increases, then
prices (P) or output (Q) must rise or V must
fall
M V  P  Q
15-29
Money-Supply Focus
• Monetarists assume velocity (V) is stable
• If so, changes in money supply must alter total
spending, regardless of interest rates
• Then the Fed should focus on the money
supply itself, not interest rates
15-30
“Natural” Unemployment
• Some monetarists assert that Q, as well as V, is
stable at the natural rate of unemployment
– Natural rate of unemployment: Long-term rate
of unemployment determined by structural forces
in labor and product markets
• The most extreme perspective concludes that
changes in the money supply only affect prices
15-31
The Monetarist View
PRICE LEVEL
Long-run Aggregate Supply
P2
P1
AD2
AD1
QN
REAL OUTPUT
Fluctuations in aggregate demand affect the price level but not real output.
15-32
Monetarist Policies
• Monetarists and Keynesians disagree on
how to stabilize the economy
– Keynesians concentrate on how the money
supply affects interest rates, which affects
spending, which affects output
– Monetarists use a simple equation (MV=PQ)
to produce straightforward monetary policy
15-33
Fighting Inflation
• Keynesian anti-inflation policy is to shrink the
money supply to drive up interest rates to slow
spending
• Monetarists argue that this policy will push
interest rates down rather than up
• Monetarists distinguish between nominal and
real interest rates
15-34
Real vs. Nominal Interest
Real
nominal
anticipated


interest rate interest rate
inflation rate
• Monetarists believe that real interest rates are
stable, so changes in the nominal interest rate
reflect changes in anticipated inflation
Nominal
real
anticipated


interest rate interest rate
inflation rate
15-35
Short- vs. Long-Term Rates (again)
• According to Monetarists, reducing money
supply growth may increase short term rates
• Long term rates won’t change unless people
expect inflation to worsen
• The best policy is steady and predictable
changes in money supply
15-36
Fighting Unemployment
• The Keynesian cure for unemployment is to
expand M and lower interest rates
• Using the equation of exchange, Monetarists
fear an increase in M will lead to higher P
– Rather than leading us out of recession,
expansionary monetary policies heap inflation on
top of our unemployment woes
15-37
The Concern for Content
• Monetary policy, like fiscal policy, can affect
the content of GDP as well as its level
• When interest rates change, not all spending
decisions will be affected equally
• Monetary policy also redistributes money
between lenders and borrowers
15-38
Which Lever to Pull?
• The success in managing the macro economy
depends on pulling the right policy levers at
the right time
• Keynesians and Monetarists argue about which
of the policy levers – M or V – is likely to be
effective in altering aggregate spending
15-39
The Policy Tools
• Monetarists point to money supply (M) as the
principal macroeconomic policy lever
• Keynesian fiscal policy must rely on changes
in velocity (V), as tax and expenditure policies
have no direct impact on money supply
15-40
Crowding Out
• If V is constant, changes in total spending can
come about only through changes in money
supply
• Increased G effectively “crowds out” some C
or I, leaving total spending unchanged
• If the government raises taxes, households will
have less money to spend
15-41
How Fiscal Policy Matters
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
(crowding out)
Maybe
(may alter demand for
money)
No
(determined by real
growth)
Yes
(real growth and
expectations may vary)
Aggregate demand?
Nominal interest rates?
Real interest rates?
15-42
How Money Matters
Do changes in M affect:
Monetarist View
Keynesian View
Yes
(V stable)
Maybe
(V may change)
Yes
(V and Q stable)
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
Maybe
(depends on real growth) (real growth may vary)
Aggregate demand?
Prices?
15-43
Is Velocity Stable?
• The critical question of monetary policy
appears to be whether V is stable or not
• The historical pattern justifies the Monetarist
assumption of a stable V over long periods of
time
• There is a pattern of short-run variations in
velocity
15-44
The Velocity of M2
Source: Federal Reserve
15-45
Money Supply Targets
• The differing views of Keynesians and
Monetarists lead to different conclusions about
which policy lever to pull
– Monetarists favor fixed money supply targets
– Keynesians advocate targeting interest rates, not
the money supply
15-46
Inflation Targeting
• The Fed has tried both Monetarist and
Keynesian strategies
• Price stability is current Fed’s primary goal
• Inflation targeting: The use of an inflation
ceiling (“target”) to signal the need for
monetary policy adjustments
15-47
Monetary Policy
End of Chapter 15
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.