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Chapter 14
Modern
Macroeconomics
– Monetary Policy
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. Impact of
Monetary Policy
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Impact of Monetary Policy

Evolution of Modern View:



The Keynesian View dominated during the
1950s and 1960s.
 Keynesians argued that the money supply did
not matter much.
Monetarists challenged the Keynesian view
during 1960s and 1970s.
 According to monetarists, changes in the
money supply caused of both inflation and
economic instability.
While minor disagreements remain, the modern
view emerged from this debate.
-- Modern Keynesians and monetarists agree
that monetary policy exerts an important
impact on the economy.
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The Demand and
Supply of Money:

The quantity of money
people want to hold
(the demand for
money) is inversely
related to the money
rate of interest, because
higher interest rates
make it more costly to
hold money instead of
interest-earnings assets
like bonds.
Money
Interest Rate
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Money
Demand
Quantity
of Money
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The Demand and
Supply of Money:

The supply of money is
vertical because it is
determined by the Fed.
Money
Interest Rate
Money
Supply
Determined
by the Fed
Quantity
of Money
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The Demand and
Supply of Money:

Equilibrium:
-- The money interest rate will gravitate toward the
rate where the quantity of money people want to
hold (the demand) is just equal to the stock of
money the Fed has supplied (the supply).
Money
Interest Rate
S
Excess Supply
Money
Supply
at i2
At ie , people are
willing to hold the
money supply set by Fed
i2
ie
i3
Excess Demand Money
at I3
Qs (Set by the Fed)
Demand
D
Quantity
of Money
Quantity of money
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Transmission of Monetary Policy



When the Fed shifts to a more expansionary monetary policy, it will
generally buy additional bonds thereby expanding the money supply.
This increase in the money supply (shifting S1 to S2 in the market
for money) will supply the banking system with additional reserves.
Both the Fed’s bond purchases and the bank’s use of the additional
reserves to extend new loans will increase the supply of loanable
funds (shifting S1 to S2 in the loanable funds market) . . . and put
downward pressure on the real rate of interest (reduction to r2).
Money
Interest Rate
S1
Real
Interest Rate
S2
S1
S2
i1
r1
i2
r2
D1
Qs
Qb
D
Quantity
of Money
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Q1
Q2
Quantity of
Loanable Funds
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Transmission of Monetary Policy




As the real rate of interest falls, aggregate demand increases (to AD2).
Since the effects of the monetary expansion were unanticipated, the
expansion in AD leads to a short-run increase in current output
(from Y1 to Y2) . . . and increase in prices (from P1 to P2) – inflation.
The path that monetary policy takes through the macroeconomic
system is called the Transmission of Monetary Policy.
The impact of a shift in monetary policy is generally transmitted
through interest rates, exchange rates, and asset prices.
Real
Interest Rate
Price
Level
S1
AS1
S2
P2
P1
r2
AD2
D
Q2
Quantity of
Loanable Funds
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AD1
Y1 Y2
Goods & Services
(Real GDP)
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A Shift to a More
Expansionary Monetary Policy


During expansionary monetary policy the Fed
may buy bonds, reduce the discount rate, or
reduce the reserve requirements for deposits.
The Fed generally buys bonds, which:




increases bond prices, and,
creates additional bank reserves, while it,
places downward pressure on real interest rates.
As a result, an unanticipated shift to a more
expansionary policy will stimulate aggregate
demand and thereby increase both output and
employment.
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The Effects of
Expansionary Monetary Policy
Price
level
LRAS
E2
P2
P1
e1
AD1
Y1 YF


SRAS1
AD2
Goods & Services
(real GDP)
If the impact of an increase in aggregate demand accompanying
expansionary monetary policy is felt when the economy is operating
below capacity, the policy will help direct the economy back to a
long-run full-employment output equilibrium (YF).
In this case, the increase in output from Y1 to YF will be long term.
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The Effects of
Expansionary Monetary Policy
Price
level
P3
LRAS
SRAS1
E2
P2
P1
SRAS2
e2
E1
AD1
YF Y2



AD2
Goods & Services
(real GDP)
In contrast, if the demand-stimulus effects are imposed on an
economy already at full-employment (YF), they will lead to excess
demand, higher product prices, and temporarily higher output (Y2).
In the long-run, the strong demand will push up resource prices,
shifting short run aggregate supply (from SRAS to SRAS2).
The price level rises to P3 (from P2) and output falls back to
full-employment output once again (YF from it temporary high,Y2).
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A Shift to a More
Restrictive Monetary Policy


During restrictive monetary policy the Fed
may sell bonds, increase the discount rate, or
increase the reserve requirements for deposits.
The Fed generally sells bonds, which:




depresses bond prices, and,
drains bank reserves from the banking system,
while it,
places upward pressure on real interest rates.
As a result, an unanticipated shift to a more
restrictive policy will reduce aggregate demand
and thereby decrease both output and
employment.
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Short-run Effects of a
More Restrictive Monetary Policy
When the Fed shifts to a more restrictive policy, it sells bonds,
reducing the reserves available to banks, decreasing the supply
of loanable funds and placing upward pressure on interest rates.
The higher interest rates will decrease aggregate demand
(shifting from AD1 to AD2).
When the reduction in aggregate demand is unanticipated,
real output will decline (to Y2) and downward pressure on
prices will result.



Real
Interest Rate
Price
Level
S2
AS1
S1
r2
P1
P2
r1
AD1
D
Q2
Q1
Quantity of
Loanable Funds
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AD2
Y2 Y1
Goods & Services
(Real GDP)
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The Effects of
Restrictive Monetary Policy
Price
LRAS
level
SRAS
P1
P2
e1
E2
AD1
AD2
YF



Y1
Goods & Services
(real GDP)
The stabilization effects of restrictive monetary policy depend on
the state of the economy when the policy exerts its primary impact.
Restrictive monetary policy will reduce aggregate demand.
If the demand restraint comes during a period of strong demand
and an overheated economy, then it will limit or even prevent the
occurrence of an inflationary boom.
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The Effects of
Expansionary Monetary Policy
LRAS
Price
level
SRAS
P1
P2
E1
e2
AD2
Y2

YF
AD1
Goods & Services
(real GDP)
In contrast, if the reduction in aggregate demand takes place
when the economy is at full-employment, then it will disrupt
long-run equilibrium, and result in a recession.
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Proper Timing

Proper Timing:


The proper timing of monetary policy
is not an easy task.
While the Fed can institute policy
changes rapidly, there may be a
substantial time lag before the change
will exert a significant impact on AD.
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Questions for Thought:
1. What are the determinants of the demand for
money? How is the supply of money determined?
2. If the Fed shifts to a more restrictive monetary
policy, it will generally sell bonds in the open
market. How will this action influence each of
the following?
(a) The reserves available to banks.
(b) Real interest rates.
(c) Household spending on consumer durables.
(d) The exchange rate value of the dollar.
(e) Net exports.
(f) The prices of stocks and real assets like
apartment or office buildings.
(g) Real GDP.
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2. Monetary Policy
in the Long Run
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Monetary Policy
in the Long Run

The Quantity Theory of Money:
M * V = P *Y
Money
Velocity

Price
Y = Income
If V and Y are constant, than an
increase in M would lead to a
proportional increase in P.
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Monetary Policy
in the Long Run

The Long-Run Implications of Modern
Analysis:



In the long run, the primary impact
will be on prices rather than on real output.
When expansionary monetary policy leads
to rising prices, decision makers eventually
anticipate the higher inflation rate and build
it into their choices.
As this happens, money interest rates,
wages, and incomes will reflect the
expectation of inflation, and so real interest
rates, wages, and output will return to their
long-run normal levels.
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The Long-run Effects of More Rapid
Expansion in the Money Supply




Here we illustrate the long-term impact of an increase in the
annual growth rate of the money supply from 3 to 8 percent.
Initially, prices are stable (P100) when the money supply is
expanding by 3% annually.
The acceleration in the growth rate of the money supply increases
aggregate demand (shifting to AD2).
At first, real output may expand beyond the economy’s potential
(YF), however low unemployment and strong demand create upward
pressure on wages and other resource prices, shifting AS to AS2.
Annual Growth Rate
Price Level
of the Money Supply
(ratio scale)
LRAS
AS 2
9.0
8% growth
AS 1
6.0
3.0
P100
3% growth
1
2
3
4
Time
Periods
(a) Growth rate of the money supply.
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e1
AD 2
AD 1
YF
Real
GDP
(b) Impact in the goods and services market.
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The Long-run Effects of More Rapid
Expansion in the Money Supply
Output returns to its long-run potential (YF), and the price level
increases to P105 (e2).

If more rapid monetary growth continues in subsequent periods,
AD and AS will continue to shift upward, leading to still higher
prices (e3 and points beyond).
The net result of this process is sustained inflation.


Annual Growth Rate
Price Level
of the Money Supply
(ratio scale)
LRAS
AS 3
9.0
P110
8% growth
AS 2
e3
AS 1
P105
6.0
e2
AD 3
3.0
P100
3% growth
1
2
3
4
Time
Periods
(a) Growth rate of the money supply.
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e1
AD 2
AD 1
YF
Real
GDP
(b) Impact in the goods and services market.
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The Long-run Effects of More Rapid
Expansion in the Money Supply
Interest
Rate
rate
S 2 (expected
of inflation = 5 %)
i.09
rate
S 1 (expected
of inflation = 0 %)
A higher expected rate
of inflation increases the
money interest rate.
rate
D2 (expected
of inflation = 5 %)
r.04
Q



rate
D1 (expected
of inflation = 0 %)
Loanable
Funds
When prices are stable, supply and demand in the loanable funds
market are in balance at a real and nominal interest rate of 4%.
If more rapid monetary expansion leads to a long-term 5%
inflation rate, borrowers and lenders will build the higher
inflation rate into their decision making.
As a result, the nominal interest rate ( i ) will rise to 9% -- the 4%
real rate plus the 5% inflationary premium.
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3. Monetary Policy
When Effects
Are Anticipated
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Monetary Policy
When Effects Are Anticipated


When the effects of policy are anticipated
prior to their occurrence, the short-run
impact of an increase in the money supply
is similar to its impact in the long run.
Nominal prices and interest rates rise,
but real output remains unchanged.
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The Short-run Effects of An
Anticipated Monetary Expansion
Price
SRAS2 SRAS
1
level
P2
E2
P1
E1
AD2
AD1
Y1



Goods & Services
(real GDP)
When decision makers fully anticipate the effects of a monetary
expansion, the expansion does not alter real output even in the short-run.
Suppliers, including resource suppliers, build the expected price rise into
their decisions. The anticipated inflation leads to a rise in nominal costs
(including wages) causing aggregate supply to decline (shifts to SRAS2).
While nominal wages, prices, and interests rates rise, their real counterparts are unchanged – and so, inflation without any change in output.
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4. Interest Rates
and Monetary Policy
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Interest Rates
and Monetary Policy


While the Fed can strongly influence
short-term interest rates, its impact on
long-term rates is much more limited.
Interest rates can be a misleading
indicator of monetary policy:


In the long run, expansionary monetary
policy leads to inflation and high interest
rates, rather than low interest rates.
Similarly, restrictive monetary policy,
when pursued over a lengthy time period,
leads to low inflation and low interest rates.
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5. The Effects of
Monetary Policy
– A Summary
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The Effects of
Monetary Policy: -- A Summary





An unanticipated shift to a more expansionary
(restrictive) monetary policy will temporarily
stimulate (retard) output and employment.
The stabilizing effects of a change in monetary
policy are dependent upon the state of the
economy when the effects of the policy change
are observed.
Persistent growth of the money supply at a
rapid rate will cause inflation.
Money interest rates and the inflation rate will
be directly related.
There will be only a loose year-to-year
relationship between shifts in monetary policy
and changes in output and prices.
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Monetary Policy and Real GDP
Annual % Change
in Money Supply
% Change
in Real GDP
(4-Quarter Moving Avg.)
(M2)
M2 Money supply
14
14
Note that the growth
rate of the money supply
12
has been slower and
more stable during
10 the
last decade.
12
10
8
6
8
6
4
4
2
2
0
0
-2
-2
Real GDP
-4
-6
-4
-6
1960
1965
1970
1975
1980
1985
1990
1995 1998
Source: Derived from computerized data supplied by FAME Economics.


Sharp declines in the growth rate of the money supply, such as those of
1968-1969, 1973-1974, 1977-1978, & 1988-1991, have generally
preceded reductions in real GDP and recessions (indicated by shading).
Conversely, periods of sharp acceleration in the growth rate of the money
supply, such as 1971-1972 & 1976, have often been followed by a rapid
growth of GDP.
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Effect of Changes in
Money Supply on Inflation
Annual Rate
of Inflation
Annual Growth Rate
of Money Supply
M2 Money supply
(Percent)
(Percent)
14
12
12
10
10
8
8
6
6
4
4
2
Inflation Rate
2
0
M2 1960
P 1963
0
(lagged 3 years)
-2
1965
1968
1970
1973
1975
1978
1980
1983
1985
1988
1990
1993
1995
1998
M2
P
Source: Derived from computerized data supplied by FAME Economics.



Here we illustrate the relationship between the rate of growth in the
money supply (M2) and the annual inflation rate 3 years later.
While the two are not perfectly correlated, the data do indicate that the
periods of monetary acceleration (for example: ’71-’72 & ’75-’76) tend
to be associated with an increase in the inflation rate about 3 years later.
Similarly, a slower growth rate of the money supply, like that of the
1990’s, is generally associated with a reduction in the rate of inflation.
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Inflation Rate and
the Money Interest Rate
Percent
16
Interest Rate
( 3 month Treasury bills )
12
8
4
Annual Rate
of Inflation
0
1960
1965
1970
1975
1980
1985
1990
1995 1998
Source: Derived from computerized data supplied by FAME Economics.


The expectation of inflation . . .
 reduces the supply, and,
 increases the demand for loanable funds,
— thereby causing interest rates to rise.
Note how the short-term money rate of interest has
tended to increase when the inflation rate accelerates
(and declines as the inflation rate falls).
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Money and Inflation
– An International Comparison 1980 - 1996
1,000
Rate of Inflation
Per Year
Brazil
(%, log scale)
Argentina
• The relationship between the
average annual growth rate
of the money supply and the
rate of inflation is show here
for the 1980-1996 period.
• Clearly, there is a close
relationship between the two.
• Higher rates of money
growth lead to higher rates
of inflation.
100
Uganda
Turkey
Israel
Zambia Poland
Mexico
Ecuador Ghana
Venezuela
Syria HungaryChile
Portugal
Kenya
Philippines
South Africa
India
Pakistan
Indonesia
Italy
10
Australia
France Thailand
United States
Belgium
Malaysia
Switzerland Canada
Germany
Japan
1
1
10
Rate of Money
Supply Growth
100
(%, log scale)
1,000
Sources: International Monetary Fund, International Financial Statistics
Yearbook, 1997 & International Financial Statistics (December 1998).
Note: The money supply data are the actual growth rate of
the money supply minus the growth rate of real GDP.
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Questions for Thought:
1. What impact will an unanticipated increase in
the money supply have on the real interest rate,
real output, and employment in the short run?
What will be the impact in the long run?
2. Political officials often call on the monetary
authorities to expand the money supply more
rapidly so that interest rates can be reduced.
Will expansionary monetary policy reduce
interest rates in the short run? Will it do so in
the long run? Explain.
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End
Chapter 14
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