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Chapter 18
The Federal Reserve and
Monetary Policy
Copyright © 2003 by Thomson Learning, Inc.
18.1 The Federal Reserve System

In most countries of the world, the job of
manipulating the supply of money
belongs to the central bank.
Copyright © 2003 by Thomson Learning, Inc.
18.1 The Federal Reserve System

A central bank has many functions.

First, a central bank is a "banker's bank."


It serves as a bank where commercial banks
maintain their own reserves.
Second, it performs service functions for
commercial banks

transferring funds and checks between various
commercial banks in the banking system
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18.1 The Federal Reserve System




Third, it typically serves as the major bank
for the central government.
Fourth, it buys and sells foreign currencies
and generally assists in the completion of
financial transactions with other countries.
Fifth, it serves as a "lender of last resort"
that helps banking institutions in financial
distress.
Sixth, it is concerned with the stability of
the banking system and the money supply.
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18.1 The Federal Reserve System


The central bank can and does impose
regulations on private commercial
banks; it thereby regulates the size of
the money supply and influences the
level of economic activity.
The central bank also implements
monetary policy, which along with fiscal
policy, forms the basis of efforts to direct
the economy to perform in accordance
with macroeconomic goals.
Copyright © 2003 by Thomson Learning, Inc.
18.1 The Federal Reserve System



In most countries, the central bank is a
single bank.
In the United States, however, the
central bank is 12 institutions, spread all
over the country, closely tied together
and collectively called the Federal
Reserve System.
Each of the 12 banks has branches in
key cities in its district.
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18.1 The Federal Reserve System


Each Federal Reserve bank has its own
board of directors and, to some limited
extent, can set its own policies.
Effectively, however, the 12 banks act
largely in unison on major policy issues,
with effective control of major policy
decisions resting with the Board of
Governors and the Federal Open
Market Committee of the Federal
Reserve System, headquartered in
Washington, D.C.
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18.1 The Federal Reserve System



The Chairman of the Federal Reserve
Board of Governors is generally
regarded as one of the most important
and powerful economic policy makers in
the country.
The Federal Reserve was created in
1913 because the U.S. banking system
had little stability and no central
direction.
Technically, the Fed is privately owned
by the banks that “belong” to it.
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Boundaries of Federal Reserve Districts and
Their Branch Territories
1
Minneapolis
Boston
2
9
New York
3
Cleveland
Philadelphia
Chicago
7
12
4
10
San Francisco
Washington
Richmond
St. Louis
Kansas City
5
8
Atlanta
Dallas
11
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6
18.1 The Federal Reserve System


All banks are not required to belong to
the Fed; but since new legislation was
passed in 1980, there is virtually no
difference in the requirements of
member and nonmember banks.
The private ownership of the Fed is
essentially meaningless because the
Board of Governors of the Federal
Reserve, which controls major policy
decisions, is appointed by the president
of the United States, not by the
stockholders.
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18.1 The Federal Reserve System


Historically, the Fed has had a
considerable amount of independence
from both the executive and legislative
branches of government.
The president appoints the seven
members of the Board of Governors,
subject to Senate approval, but the term
of appointment is 14 years.
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18.1 The Federal Reserve System

No member of the Federal Reserve
Board will face reappointment from the
president who initially made the
appointment because presidential
tenure is limited to two four-year terms.
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18.1 The Federal Reserve System


Moreover, the terms of board members
are staggered, so a new appointment is
made only every two years.
It is practically impossible for a single
president to appoint a majority of the
members of the board, and even if it
were possible, members have little fear
of losing their jobs as a result of
presidential wrath.
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18.1 The Federal Reserve System


The Chair of the Federal Reserve Board
is a member of the Board of Governors
who serves a four year term.
The Chair is truly the chief executive
officer of the system, and he effectively
runs it with considerable help from the
presidents of the 12 regional banks.
Copyright © 2003 by Thomson Learning, Inc.
18.1 The Federal Reserve System


Many of the key policy decisions of the
Federal Reserve are actually made by
its Federal Open Market Committee
(FOMC), which consists of the seven
members of the Board of Governors
The president of the New York Federal
Reserve Bank, and four other
presidents of Federal Reserve Banks,
who serve on the committee on a
rotating basis.
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18.1 The Federal Reserve System

The FOMC makes most of the key
decisions influencing the direction and
size of changes in the money stock, and
their regular, secret meetings are
accordingly considered very important
by the business community and
government.
Copyright © 2003 by Thomson Learning, Inc.
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18.2 The Equation of Exchange


Perhaps the most important function of
the Federal Reserve is its ability to
regulate the money supply.
In order to fully understand the
significant role that the Federal Reserve
plays in the economy, we will first
examine the role of money in the
national economy.
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18.2 The Equation of Exchange

In the early part of this century,
economists noted a useful relationship
that helps our understanding of the role
of money in the national economy.
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18.2 The Equation of Exchange

The relationship, called the equation of
exchange, can be presented as:
M  V = P  Q,
where
M is the money supply,
V is the income velocity of money,
P is the average prices of final goods and
services, and
Q is the physical quantity of final goods and
services produced in a given period
(usually one year).
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18.2 The Equation of Exchange


V, the velocity of money, refers to the
"turnover" rate, or the intensity with
which money is used.
V represents the average number of
times that a dollar is used in purchasing
final goods or services in a one-year
period.
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18.2 The Equation of Exchange


If individuals are hoarding their money,
velocity will be low.
If individuals are writing lots of checks
on their checking accounts and
spending currency as fast as they
receive it, velocity will tend to be high.
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18.2 The Equation of Exchange



The expression P  Q represents the
dollar value of all final goods and
services sold in a country in a given
year.
But that is the definition of nominal
gross domestic product (GDP).
Thus, the average level of prices (P)
times the physical quantity of final
goods and services (Q) equals nominal
GDP.
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18.2 The Equation of Exchange

The quantity equation of money could
also be expressed as: M  V = Nominal
GDP, or V = Nominal GDP/M. That, in
fact, is the definition of velocity

The total output of goods divided by the
amount of money is the same thing as the
average number of times a dollar is used in
final goods transactions in a year.
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18.2 The Equation of Exchange

The magnitude of V will depend on the
definition of money that is used. The
average dollar of money turns over a
few times in the course of a year, with
the precise number depending on the
definition of money.
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18.2 The Equation of Exchange


The equation of exchange is a useful
tool when we try to assess the impact in
a change in the money supply (M) on
the aggregate economy.
If M increases, then one of the following
must happen:



V must decline by the same magnitude, so
that M  V remains constant, leaving P  Q
unchanged;
P must rise
Y must rise
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18.2 The Equation of Exchange


Or P and Q must each rise some, so that
the product of P and Q remains equal to
M  V.
If the money supply increases and the
velocity of money does not change, there
will be either higher prices (inflation),
greater real output of goods and services,
or a combination of both.
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18.2 The Equation of Exchange

If one considers a macroeconomic
policy to be successful when real output
is increased but unsuccessful when the
only effect of the policy is inflation, an
increase in M is a good policy if Q
increases but a bad policy if P
increases.
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18.2 The Equation of Exchange


Dampening the rate of increase in M or
even causing it to decline will cause
nominal GDP to fall, unless the change
in M is counteracted by a rising velocity
of money.
Intentionally decreasing M can also
either be good or bad, depending on
whether the declining money GDP is
reflected mainly in falling prices (P) or in
falling real output (Q).
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18.2 The Equation of Exchange

Expanding the money supply, unless
counteracted by increased hoarding of
currency (leading to a decline in V), will
have the same type of impact on
aggregate demand as an expansionary
fiscal policy:



increasing government purchases,
reducing taxes, or
increases in transfer payments.
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18.2 The Equation of Exchange


Likewise, policies designed to reduce
the money supply will have a
contractionary impact (unless offset by
a rising velocity of money) on aggregate
demand.
This is similar to the impact obtained
from increasing taxes, decreasing
transfer payments, or decreasing
government purchases.
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18.2 The Equation of Exchange


What the quantity equation of exchange
relationship illustrates is that monetary
policy can be used to obtain the same
objectives as fiscal policy.
Some economists, often called
monetarists, believe that monetary
policy is the most powerful determinant
of macroeconomic results.
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18.2 The Equation of Exchange



Economists once considered the
velocity of money a given.
We now know that it is not constant, but
it often moves in a fairly predictable
pattern.
Thus, the connection between money
supply and GDP is still fairly predictable.
Copyright © 2003 by Thomson Learning, Inc.
18.2 The Equation of Exchange

Historically, the velocity of money has
been quite stable over a long period of
time, particularly using the M2 definition.
However, velocity is less stable when
measured using the M1 definition and
over shorter periods of time.
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18.2 The Equation of Exchange



For example, an increase in velocity can
occur with anticipated inflation.
When individuals expect inflation, they
will spend their money more quickly.
They don't want to be caught with
money that is going to be worth less in
the future.
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18.2 The Equation of Exchange


Also, an increase in the interest rates
will cause people to hold less money
because people want to hold less
money when the opportunity cost of
holding money increases.
This, in turn, means that the velocity of
money increases.
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18.2 The Equation of Exchange



There is international support for the
fact that the inflation rate tends to rise
more in periods of rapid monetary
expansion.
The relationship is particularly strong
with hyperinflation, as illustrated by the
hyperinflation in Germany in the 1920s.
The cause of hyperinflation is simply
excessive money growth.
Copyright © 2003 by Thomson Learning, Inc.
Inflation Rate
(percent per year)
Money Supply Growth and Inflation
Rates, 1980-1996
1000
900
800
700
600
500
400
300
200
100
Brazil
Turkey
Zambia
Uganda
Israel
Poland
Mexico
Ecuador
Ghana
Venezuela
SyriaHungary Chile
Portugal
Kenya
South Africa
Phillippines
India
Pakistan
Indonesia
Italy
Australia
Thailand
France
United States
Belgium
Malaysia
Canada
Switzerland Germany
Japan
0
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200 400 600 800 1000
Money Growth
(percent per year)
18.3 Implementing Monetary
Policy: Tools of the Fed


The Board of Governors of the Fed and
the Federal Open Market Committee
are the prime decision makers for
monetary policy in the United States.
They decide whether to change policies
to expand the supply of money and,
hopefully, the real level of economic
activity, or to contract the money supply,
hoping to cool inflationary pressures.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

The Fed controls the supply of money,
even though privately owned
commercial banks actually create and
destroy money by making loans.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

The Fed has three major methods to
control the supply of money





open market operations
change reserve requirements
change its discount rate.
Of these three tools, the Fed uses open
market operations the most.
It is by far the most important device
used by the Fed to influence the money
supply.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


Open market operations involve the
purchase and sale of government
securities by the Federal Reserve
System.
Decisions regarding whether to buy or
sell government bonds are made by the
Federal Open Market Committee at its
regular meetings.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


For several reasons, open market
operations are the most important
method the Fed uses to change the
supply of money.
To begin, it is a device that can be
implemented quickly and cheaply—the
Fed merely calls an agent who buys or
sells bonds.
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18.3 Implementing Monetary
Policy: Tools of the Fed


It can be done quietly, without a lot of
political debate or a public
announcement.
It is also a rather powerful tool, as any
given purchase or sale of securities
usually has an ultimate impact on the
money supply of several times the
amount of the initial transaction.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


When the Fed buys bonds, it pays the
seller of the bonds with a check written
from one of the 12 Federal Reserve
banks.
The person receiving the check will
likely deposit it in his or her bank
account, increasing the money supply in
the form of added transactions deposits.
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18.3 Implementing Monetary
Policy: Tools of the Fed

More importantly, the commercial bank,
in return for crediting the account of the
bond seller with a new deposit, gets
cash reserves or a higher balance in
their reserve account at the Federal
Reserve Bank in its district.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


Loans R Us National Bank has no
excess reserves and one of its
customers sells a bond for $10,000
through a broker to the Fed.
The customer deposits the check from
the Fed for $10,000 in an account, and
the Fed credits the Loans R Us Bank
with $10,000 in reserves.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


Suppose the reserve requirement is 10
percent.
The Loans R Us Bank only needs new
reserves of $1,000 ($10,000  .10) to
support its $10,000, meaning that it has
acquired $9,000 in new excess reserves
($10,000 new actual reserves minus
$1,000 in new required reserves).
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18.3 Implementing Monetary
Policy: Tools of the Fed


Loans R Us can, and probably will, lend
out its excess reserves of $9,000,
creating $9,000 in new deposits in the
process.
The recipients of the loans, in turn, will
likely spend the money, leading to still
more new deposits and excess reserves
in other banks.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

The Fed's $10,000 bond purchase
directly creates $10,000 in money in the
form of bank deposits, and indirectly
permits up to $90,000 in additional
money to be created through the
multiple expansion in bank deposits.

The money multiplier is the reciprocal of
the reserve requirement ,1/10, or 10. 10 
$9,000 = $90,000.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

If the reserve requirement is 10 percent,
a total of up to $100,000 in new money
is potentially created by the purchase of
one $10,000 bond by the Fed.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed



The process works in reverse when the
Fed sells a bond.
The individual purchasing the bond will
pay the Fed by check, lowering demand
deposits in the banking system.
Reserves of the bank where the bond
purchaser has a bank account will
likewise fall.
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18.3 Implementing Monetary
Policy: Tools of the Fed


If the bank had zero excess reserves at
the beginning of the process, it will now
have a reserve deficiency that must be
met by selling secondary reserves or by
reducing loan volume, either of which
will lead to further destruction of
deposits.
A multiple contraction of deposits will
begin.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

Generally, in a growing economy where
the real value of goods and services is
increasing over time, an increase in the
supply of money is needed even to
maintain stable prices.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

If the velocity of money (V) in the
equation of exchange is fairly constant
and real GDP (denoted by Q in the
equation of exchange) is rising between
3 and 4 percent a year (as it has over
the period since 1840), then a 3 or 4
percent increase in M is consistent with
stable prices.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary Policy:
Tools of the Fed

In periods of rising prices (meaning M 
V would be rising considerably), if V is
fairly constant, the growth of M likely will
exceed the 3 to 4 percent annual
growth, seemingly consistent with
long-term price stability.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

While open market operations are the
most important and widely utilized tool
that the Fed has to achieve its monetary
objectives, it is not its potentially most
powerful tool.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


The Fed possesses the power to
change the reserve requirements of
member banks by altering the reserve
ratio.
This can have an immediate impact on
the ability of member banks to create
money.
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18.3 Implementing Monetary
Policy: Tools of the Fed



Suppose the Fed lowers reserve
requirements.
That will create excess reserves in the
banking system.
The banking system as a whole can
then expand deposits and the money
stock by a multiple of this amount (equal
to 1/10 the required reserve ratio).
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


Relatively small reserve requirement
changes can have a big impact on the
potential supply of money by changing
the money multiplier.
The tool is so potent, in fact, that it is
seldom used.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed


The Fed changes reserve requirements
rather infrequently, and when it does
make changes, it is by very small
amounts.
Between 1970 and 1980, the Fed
changed the reserve requirement twice,
and less than 1 percent on each
occasion.
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18.3 Implementing Monetary
Policy: Tools of the Fed


Banks having trouble meeting their
reserve requirement can borrow funds
directly from the Fed.
The interest rate the Fed charges on
these borrowed reserves is called the
discount rate.
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18.3 Implementing Monetary
Policy: Tools of the Fed


If the Fed raises the discount rate, it
makes it more costly for banks to
borrow funds from it to meet their
reserve requirements.
The higher the interest rate banks have
to pay on the borrowed funds, the lower
the potential profits from any new loans
made from borrowed reserves, and
fewer new loans will be made and less
money created.
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18.3 Implementing Monetary
Policy: Tools of the Fed


If the Fed wants to contract the money
supply, it will raise the discount rate,
making it more costly for banks to
borrow reserves
If the Fed is promoting an expansion of
money and credit, it will lower the
discount rate, making it cheaper for
banks to borrow reserves.
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18.3 Implementing Monetary
Policy: Tools of the Fed


The discount rate changes fairly
frequently, often several times a year.
Sometimes the rate will be moved
several times in the same direction
within a single year, which has a
substantial cumulative effect.
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18.3 Implementing Monetary
Policy: Tools of the Fed

The discount rate is a relatively
unimportant tool, mainly because
member banks do not rely heavily on
the Fed for borrowed funds.

There seems to be some stigma among
bankers about borrowing from the Fed;
borrowing from the Fed is something most
bankers believe should be reserved for real
emergencies.
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18.3 Implementing Monetary
Policy: Tools of the Fed



When banks have short-term needs for
cash to meet reserve requirements,
they are more likely to take a very shortterm (often overnight) loan from other
banks in the federal funds market.
Many people pay a lot of attention to the
interest rate on federal funds.
The discount rate's main significance is
that changes in the rate signal the Fed's
intentions with respect to monetary
policy.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

The Fed can do three things if it wants
to reduce the money supply.



sell bonds
raise reserve requirements
raise the discount rate
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed



The Fed could also opt to use some
combination of these three tools in its
approach.
These moves would tend to decrease
aggregate demand reducing nominal GDP,
hopefully through a decrease in P rather than
Q.
These actions would be the monetary policy
equivalent of a fiscal policy of raising taxes,
lowering transfer payments, and/or lowering
government purchases.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

If the Fed is concerned about
underutilization of resources (e.g.,
unemployment), it would engage in
precisely the opposite policies



buy bonds
lower reserve requirements
lower the discount rate
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary Policy:
Tools of the Fed



The government could use some
combination of these three approaches.
These moves would tend to increase
aggregate demand raising nominal
GDP, hopefully through an increase in Q
(in the context of the equation of
exchange) rather than P.
Equivalent expansionary fiscal policy
actions would be to reduce taxes,
increase transfer payments, and/or
increase government purchases.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

The Fed's control of the money supply
is largely exercised through the three
methods outlined above, but it can
influence the level and direction of
economic activity in numerous less
important ways as well.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary
Policy: Tools of the Fed

The Fed can attempt to influence banks
through moral suasion.


If the Fed thinks the money supply is
growing too fast, it might urge bank
presidents to be more selective in making
loans and maintain some excess reserves.
During business contractions, the Fed may
urge bankers to lend more freely, hoping to
promote an increase in the supply of
money.
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary Policy:
Tools of the Fed

The Fed also has at its command some
selective regulatory authority over
specific types of economic activity.

Federal Reserve Board of Governors
establishes margin requirements for the
purchase of common stock.

The Fed specifies the proportion of the
purchase price of stock that a purchaser must
pay in cash.
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18.3 Implementing Monetary
Policy: Tools of the Fed

By allowing the Fed to control limits on
borrowing for stock purchases, Congress
believes that the Fed can limit speculative
market dealings in securities and reduce
instability in securities markets (although
whether the margin requirement rule has in
fact helped achieve such stability is open
to question).
Copyright © 2003 by Thomson Learning, Inc.
18.3 Implementing Monetary Policy:
Tools of the Fed

In the last few decades, the Federal
Reserve regulatory authority has been
extended into new areas.


Beginning in 1969, the Fed began
enforcing provisions of the Truth in Lending
Act, which requires lenders to state actual
interest rate charges when making loans.
In the mid-1970s, the Fed began enforcing
provisions of the Equal Lending
Opportunity Act, designed to eliminate
discrimination against loan applicants.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The Federal Reserve's policies with
respect to the supply of money has a
direct impact on short-run real interest
rates, and accordingly, on the
components of aggregate demand.
The money market is the market where
money demand and money supply
determine the equilibrium nominal
interest rate.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


When the Fed acts to change the
money supply by changing one of its
policy variables, it alters the money
market equilibrium.
People have three basic motives for
holding money instead of other assets:



transactions purposes,
precautionary reasons,
asset purposes.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The quantity of money demanded varies
inversely with the rate of interest.
When interest rates are higher, the
opportunity cost in terms of the interest
income on alternative assets forgone of
holding monetary assets is higher, and
persons will want to hold less money for
each of these reasons.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


At the same time, the demand for
money, particularly for transactions
purposes, is highly dependent on
income levels because the transactions
volume varies directly with income.
And lastly, the demand for money
depends on the price level.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


If the price level increases, buyers will
need more money to purchase their
goods and services.
Or if the price level falls, buyers will
need less money to purchase their
goods and services.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

At lower interest rates, the quantity of
money demanded, but not the demand
for money, is greater. An increase in
income will lead to an increase in the
demand for money, depicted by a
rightward shift in the money demand
curve.
Copyright © 2003 by Thomson Learning, Inc.
Nominal Interest Rates
Money Demand, Interest Rates, and Income
A  B = Increase in
the quantity of
money demanded
A
I0
C
B
I1
A  C = Increase in
the demand
for money
MD1
MD0
Q0
Q1 Q2
Quantity of Money
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

The supply of money is largely
governed by the regulatory policies of
the central bank.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

Whether interest rates are 4 percent or
14 percent, banks seeking to maximize
profits will increase lending as long as
they have reserves above their desired
level because even a 4 percent return
on loans provides more profit than
maintaining those assets in noninterestbearing cash or reserve accounts at the
Fed.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The supply of money is effectively
almost perfectly inelastic with respect to
interest rates over their plausible range,
controlled by Fed policies, which
determine the level of bank reserves
and the money multiplier.
Therefore, we draw the money supply
curve as vertical, other things equal,
with changes in Fed policies acting to
shift the money supply curve.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

Combining the money demand and
money supply curves, money market
equilibrium occurs at that nominal
interest rate where the quantity of
money demanded equals the quantity of
money supplied.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


Rising national income will increase the
amount of money that people want to
hold at any given interest rate; therefore
shifting the demand for money to the
right, leading to a new higher
equilibrium nominal interest rate.
An increase in the money supply lowers
the equilibrium nominal interest rate .
Copyright © 2003 by Thomson Learning, Inc.
Nominal Interest Rates
Changes in the Money Market Equilibrium
MS0
I1
B
C
I2
I0
MS1
A
MD1
MD0
Q0
Q1
Quantity of Money
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

Say the Fed wants to pursue an
expansionary monetary policy to
increase aggregate demand.


The Fed will buy bonds on the open
market, increasing the the demand for
bonds causing an increase in the price of
bonds.
Bond sellers will deposit their checks from
the Fed, increasing the money supply.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The immediate impact of expansionary
monetary policy is to decrease interest
rates.
The lower interest rate, or the fall in the
cost of borrowing money, then leads to
an increase in aggregate demand for
goods and services at each and every
price level.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The lower interest rate will increase
home sales, car sales, business
investments, and so on.
That is, an increase in the money
supply will lead to lower interest rates
and an increase in aggregate demand.
Copyright © 2003 by Thomson Learning, Inc.
P1
P0
D0
D1
Q0 Q1
Quantity of Bonds
Copyright © 2003 by Thomson Learning, Inc.
MS0 MS1
i0
i1
MD
Q0 Q1
Quantity of Money
Price Level
S
Nominal Interest Rate
Price of Bonds
The Fed Buys Bonds, Increases the Money
Supply
SRAS
PL1
AD1
PL0
AD0
RGDP0 RGDP1
RGDP
18.4 Money, Interest Rates, and
Aggregate Demand


Suppose the Fed wants to pursue a
contractionary monetary policy to
reduce aggregate demand.
It will sell bonds on the open market,
lowering the price of bonds.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The purchasers of bonds take the
money out of their checking account to
pay for the bond, and bank reserves are
reduced by the amount of the check.
This reduction in reserves leads to a
reduction in the supply of money, which
leads to an increase in the interest rate
in the money market.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The higher interest rate then leads to a
reduction in aggregate demand for
goods and services.
In sum, when the Fed sells bonds, it



lowers the price of bonds,
raises interest rates and
reduces aggregate demand, at least in the
short run.
Copyright © 2003 by Thomson Learning, Inc.
S1
P0
P1
D
MS1 MS0
i1
i0
MD
Q0 Q1
Q1 Q0
Quantity of Bonds
Quantity of Money
Copyright © 2003 by Thomson Learning, Inc.
Price of Bonds
S0
Price of Bonds
Price of Bonds
The Fed Sells Bonds,
Decreases the Money Supply
SRAS
PL0
AD0
PL1
AD1
RGDP1 RGDP0
RGDP
18.4 Money, Interest Rates, and
Aggregate Demand

There is an inverse correlation between
the interest rate and the price of bonds.


When the price of bonds falls, the interest
rate rises.
When the price of bonds rises, the interest
rate falls.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand



Some economists believe the Fed
should try to control the money supply
Others believe the Fed should try to
control the interest rate.
The Fed cannot do both: it must pick
one or the other.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

Suppose the demand for money
increases.


If the Fed doesn’t allow the money supply
to increase, interest rates will rise and
aggregate demand will fall.
If the Fed wants to keep the interest rate
stable, it will have to increase the money
supply.
Copyright © 2003 by Thomson Learning, Inc.
Nominal Interest Rate
Fed Targeting: Money Supply Versus the
Interest Rate
MS0
i1
i0
MS1
C
A
B
MD1
MD0
Q0
Q1
Quantity of Money
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The problem with targeting the money
supply is that the demand for money
fluctuates considerably in the short run.
Focusing on the growth in the money
supply when the demand for money is
changing unpredictably will lead to large
fluctuations in the interest rate, which
can seriously disrupt the investment
climate.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


Keeping interest rates in check would
also create problems.
When the economy grows, the demand
for money also grows, so the Fed would
have to increase the money supply to
keep interest rates from rising.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


If the economy was in a recession, the
Fed would have to contract the money
supply.
This would lead to the wrong policy
prescription.


Expanding the money supply during a
boom would eventually lead to inflation.
Contracting the money supply during a
recession would worsen the recession.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The federal funds rate is the interest
rate the Fed has targeted since about
1965.
At the close of the meetings of the
Federal Open Market Committee
(FOMC), the Fed will usually announce
whether the federal funds rate will be
increased, decreased, or left alone.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand



Monetary policy actions can be
conveyed through either the money
supply or the interest rate.
A contractionary policy can be thought
of as a decrease in the money supply or
an increase in the interest rate.
An expansionary policy can be thought
of as an increase in the money supply
or a decrease in the interest rate.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

Why is the interest rate used for
monetary policy?




Many economists believe the primary
effects of monetary policy are felt through
the interest rate
The money supply is difficult to accurately
measure.
Changes in the demand for money can
complicate money supply targets.
People are more familiar with changes in
interest rates than changes in the money
supply.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand



The real interest rate is determined by
investment demand and saving supply.
The nominal interest rate is determined
by the demand and supply of money.
Many economist believe that in the
short run, the Fed can control the
nominal interest rate and the real
interest rate.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand


The real interest rate is equal to the
nominal interest rate minus the
expected inflation rate.
So a change in the nominal interest rate
tends to change the real interest rate by
the same amount because the expected
inflation rate is slow to change in the
short run.
Copyright © 2003 by Thomson Learning, Inc.
18.4 Money, Interest Rates, and
Aggregate Demand

However, in the long run, after the
inflation rate has adjusted, the real
interest rate is determined by the
intersection of the saving supply and
investment demand curve.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

An increase in AD through monetary
policy can lead to an increase in real
GDP if the economy is initially operating
at less than full employment.
Copyright © 2003 by Thomson Learning, Inc.
Expansionary Monetary Policy at Less Than
Full Employment
LRAS
Price Level
SRAS
PL1
PL0
E0
E1
AD1
AD0
RGDP0 RGDPNR
RGDP
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

An increase in AD through monetary
policy can lead to only a temporary,
short-run increase in real GDP, if the
economy is initially operating at or
above full employment, with no long-run
effect on output or employment.
Copyright © 2003 by Thomson Learning, Inc.
Expansionary Monetary Policy at Full
Employment
Price Level
LRAS
SRAS1
SRAS0
PL2
E2
E1
PL1
PL0
E0
AD1
AD0
RGDPNR RGDP1
RGDP
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy


A contractionary monetary policy would
reduce aggregate demand.
When the economy is temporarily
beyond full employment, an appropriate
countercyclical monetary policy would
shift the aggregate demand curve
leftward, to combat a potential
inflationary boom.
Copyright © 2003 by Thomson Learning, Inc.
Contractionary Monetary Policy Beyond Full
Employment
Price Level
LRAS
SRAS
E0
PL0
PL1
E1
AD0
AD1
RGDPNR RGDP0
RGDP
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

If the Fed pursues a contractionary
monetary policy when the economy is at
full employment, the Fed could cause a
recession by shifting the aggregate
demand curve leftward, resulting in
higher unemployment and a lower price
level.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

At a lower than expected price level,
owners of inputs will then revise their
expectations downward, causing a
rightward shift in the SRAS curve,
leading to a new long-run equilibrium
back at full employment.
Copyright © 2003 by Thomson Learning, Inc.
Contractionary Monetary Policy at Full
Employment
Price Level
LRAS
SRAS0
SRAS1
E0
PL0
PL1
PL2
E1
E2
AD0
AD1
RGDP1 RGDPNR
RGDP
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy


For simplicity, we have assumed that
the global economy does not impact
domestic monetary policy.
This is incorrect.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy



Suppose the Fed buys bonds on the
open market, leading to an increase in
the money supply and a fall in interest
rates.
Some domestic investors will seek to
invest funds in foreign markets,
exchanging dollars for foreign currency,
leading to a depreciation of the dollar.
This increases exports and decreases
imports, and the increase in net exports
increases RGDP in the short run.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

Suppose the Fed sells bonds on the
open market.



This leads to a decrease in the money
supply and a rise in interest rates.
Some foreign investors will seek to invest
funds in the U.S. market, exchanging
foreign currency for dollars, leading to an
appreciation of the dollar.
This decreases exports and increases
imports, and the decrease in net exports
decreases RGDP in the short run.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

The shape of the aggregate supply
curve is a source of debate among
economists, and it has important policy
implications.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively inelastic, expansionary
monetary and fiscal policy are less
effective at increasing RGDP in the
short run, but have larger effects on the
price level in the short run.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively elastic, expansionary
monetary and fiscal policy are more
effective at increasing RGDP in the
short run, and have smaller effects on
the price level in the short run.
Copyright © 2003 by Thomson Learning, Inc.
Expansionary Policy
B
PL1
PL0
LRAS
SRAS
A
AD1
Price Level
Price Level
LRAS
SRAS
PL1
PL0
B
A
AD1
AD0
AD0
RGDP1
RGDPNR
RGDP
Copyright © 2003 by Thomson Learning, Inc.
RGDP0
RGDPNR
RGDP
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively inelastic, contractionary
monetary and fiscal policy are less
effective at changing RGDP in the short
run, but have larger effects on the price
level in the short run.
Copyright © 2003 by Thomson Learning, Inc.
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively elastic, contractionary
monetary and fiscal policy are more
effective at changing RGDP in the short
run, and have smaller effects on the
price level in the short run.
Copyright © 2003 by Thomson Learning, Inc.
Contractionary Policy
A
PL0
PL1
LRAS
SRAS
B
AD0
Price Level
Price Level
LRAS
SRAS
PL0
PL1
A
B
AD0
AD1
AD1
RGDP1
RGDPNR
RGDP
Copyright © 2003 by Thomson Learning, Inc.
RGDP1
RGDPNR
RGDP
18.6 Problems in Implementing
Monetary Policy


The lag problem inherent in adopting
fiscal policy changes are much less
acute for monetary policy, largely
because the decisions are not slowed
by the same budgetary process.
The FOMC of the Fed, for example, can
act quickly (in emergencies, almost
instantly, by conference call) and even
secretly to buy or sell government
bonds, the key day-to-day operating tool
of monetary policy.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

However the length and variability of the
impact lag before its effects on output
and employment are felt is still
significant and the time before the full
price level effects are felt is even longer
and more variable.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

According to the Federal Reserve Bank
of San Francisco, the major effects of a
change in policy


on growth in the overall production of
goods and services usually are felt within
three months to two years, and
the effects on inflation tend to involve even
longer lags, perhaps one to three years, or
more.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


One limitation of monetary policy is that
it ultimately must be carried out through
the commercial banking system.
The Central Bank (U.S. Federal
Reserve System) can change the
environment in which banks act, but the
banks themselves must take the steps
necessary to increase or decrease the
supply of money.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


Usually, when the Fed is trying to
constrain monetary expansion, there is
no difficulty in getting banks to make
appropriate responses.
Banks must meet their reserve
requirements, and if the Fed raises
bank reserve requirements, sells bonds,
and/or raises the discount rate, banks
must obtain the necessary cash or
reserve deposits at the Fed to meet
their reserve requirements.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

In response, they will call in loans that
are due for collection, sell secondary
reserves, and so on, to obtain the
necessary reserves, and in the process
of contracting loans, they lower the
supply of money.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

When the Federal Reserve wants to
induce monetary expansion, however, it
can provide banks with excess reserves
(e.g., by lowering reserve requirements
or buying government bonds), but it
cannot force the banks to make loans,
thereby creating new money.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


Ordinarily, of course, banks want to
convert their excess reserves to work
earning interest income by making
loans.
But in a deep recession or depression,
banks might be hesitant to make
enough loans to put all those reserves
to work, fearing that they will not be
repaid.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

Their pessimism might lead them to
perceive that the risks of making loans
to many normally creditworthy
borrowers outweigh any potential
interest earnings.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

Banks maintaining excess reserves
rather than loaning them out was, in
fact, one of the monetary policy
problems that arose in the Great
Depression.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

A second problem with monetary policy
relates to the fact that the Fed can
control deposit expansion at member
banks, but it has no control over global
and nonbank institutions that also issue
credit (loan money) but are not subject
to reserve requirement limitations, like
pension funds and insurance
companies.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


While the Fed may be able to predict
the impact of its monetary policies on
member bank loans, the actions of
global and nonbanking institutions can
serve to partially offset the impact of
monetary policies adopted by the Fed
on the money and loanable funds
markets.
There is a real question of how
precisely the Fed can control the shortrun real interest rates through its
monetary policy instruments.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

Another possible problem that arises
out of existing institutional policy making
arrangements is the coordination of
fiscal and monetary policy.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


Decision making with respect to fiscal
policy is made by Congress and the
president, while monetary policy
decision making is in the hands of the
Federal Reserve System.
A macroeconomic problem arises if the
federal government's fiscal decision
makers differ on policy objectives or
targets with the Fed's monetary
decision makers.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


In recognition of potential
macroeconomic policy coordination
problems, the Chairman of the Federal
Reserve Board has participated for
several years in meetings with top
economic advisers of the president.
An attempt is made in those meetings to
reach a consensus on the appropriate
policy responses, both monetary and
fiscal.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

There is often some disagreement, and
the Fed occasionally works to partly
offset or even neutralize the effects of
fiscal policies that it views as
inappropriate.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy


Some people believe that monetary
policy should be more directly controlled
by the president and Congress, so that
all macroeconomic policy will be
determined more directly by the political
process.
It is argued that such a move would
enhance coordination considerably.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

Others argue that it is dangerous to turn
over control of the nation's money stock
to politicians, rather than allowing
decisions to be made by technically
competent administrators who are
focused more on price stability and
more insulated from political pressures
from the public and from special interest
groups.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems in Implementing
Monetary Policy

Much of macroeconomic policy in this
country is driven by the idea that the
federal government can counteract
economic fluctuations

Stimulating the economy when it is weak.
increased government purchases
 tax cuts
 transfer payment increases
 easy money


Restraining it when it is overheating.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


But policy makers must adopt the right
policies in the right amounts at the right
time for such “stabilization” to do more
good than harm.
And for government policy makers to do
more good than harm, they need far
more accurate and timely information
than experts can give them.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy

First, economists must know not only
which way the economy is heading, but
also how rapidly. And no one knows
exactly what the economy will do, no
matter how sophisticated the
econometric models used.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy

Even if economists could provide
completely accurate economic forecasts
of what will happen if macroeconomic
policies are unchanged, they could not
be certain of how to best promote stable
economic growth.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy

If economists knew, for example, that
the economy was going to dip into
another recession in six months, they
would then need to know exactly how
much each possible policy would spur
activity in order to keep the economy
stable.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


But such precision is unattainable, given
the complex forecasting problems
faced.
Further, economists aren’t always sure
what effect a policy will have on the
economy.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy

It is widely assumed that an increase in
government purchases quicken
economic growth.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


Increasing government purchases
increases the budget deficit, which
could send a frightening signal to the
bond markets.
The result can be to drive up interest
rates and choke off economic activity.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy

Even when policy makers know which
direction to nudge the economy, they
can’t be sure which policy levers to pull,
or how hard to pull them, to fine tune
the economy to stable economic
growth.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy

A third crucial consideration is how long
it will take a policy before it has its effect
on the economy.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


Even when increased government
purchases or expansionary monetary
policy does give the economy a boost,
no one knows precisely how long it will
take to do so.
The boost may come very quickly, or
many months (or even years) in the
future, when it may add inflationary
pressures to an economy that is already
overheating, rather than helping the
economy recover from a recession.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


Macroeconomic policy making is like
driving down a twisting road in a car
with an unpredictable lag and degree of
response in the steering mechanism.
If you turn the wheel to the right, the car
will eventually veer to the right, but you
don’t know exactly when or how much.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


There are severe practical difficulties in
trying to fine-tune the economy.
Even the best forecasting models and
methods are far from perfect.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


Economists are not exactly sure where
the economy is or where or how fast it is
going, making it very difficult to
prescribe an effective policy.
Even if we do know where the economy
is headed, we can not be sure how
large a policy’s effect will be or when it
will take effect.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy



The Fed must take into account the
many different factors that can either
offset or reinforce monetary policy.
This isn’t easy because sometimes
these developments occur
unexpectedly, and because the size and
timing of their effects are difficult to
estimate.
The 1997-98 currency crisis in East Asia
is an example.
Copyright © 2003 by Thomson Learning, Inc.
18.6 Problems In Implementing
Monetary Policy


The “new” economy may increase
productivity, allowing for greater
economic growth without creating
inflationary pressures.
The Fed must estimate how much faster
productivity is increasing and whether
those increases are temporary or
permanent, which is not an easy task.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Is it possible that people can anticipate
the plans of policy makers and alter
their behavior quickly, to neutralize the
intended impact of government action?

For example, if workers see that the
government is allowing the money supply
to expand rapidly, they may quickly
demand higher money wages in order to
offset the anticipated inflation.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


In the extreme form, if people could
instantly recognize and respond to
government policy changes, it might be
impossible to alter real output or
unemployment levels through policy
actions unless they can surprise
consumers and businesses.
An increasing number of economists
believe that there is at least some truth
to this point of view.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

At a minimum, most economists accept
the notion that real output and the
unemployment rate cannot be altered
with the ease that was earlier believed;
some believe that the unemployment
rate can seldom be influenced by fiscal
and monetary policies.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

The relatively new extension of
economic theory that leads to this rather
pessimistic conclusion regarding
macroeconomic policy’s ability to
achieve our economic goals is called
the theory of rational expectations.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


The notion that expectations or
anticipations of future events are
relevant to economic theory is not new;
for decades economists have
incorporated expectations into models
analyzing many forms of economic
behavior.
Only in the recent past, however, has a
theory evolved that tries to incorporate
expectations as a central factor in the
analysis of the entire economy.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Rational expectation economists believe
that wages and prices are flexible, and
that workers and consumers incorporate
the likely consequences of government
policy changes quickly into their
expectations.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

In addition, rational expectation
economists believe that the economy is
inherently stable after macroeconomic
shocks, and that tinkering with fiscal
and monetary policy cannot have the
desired effect unless consumers and
workers are caught off-guard (and
catching them off-guard gets harder the
more you try to do it).
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


Rational expectations theory suggests
that government economic policies
designed to alter aggregate demand to
meet macroeconomic goals are of very
limited effectiveness.
When policy targets become public, it is
argued, people will alter their own
behavior from what it would otherwise
have been, and, in so doing, they
largely negate the intended impact of
policy changes.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

If government policy seems tilted
towards permitting more inflation in
order to try to reduce unemployment,
people start spending their money faster
than before, become more adamant in
their wage and other input price
demands, and so on.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

In the process of quickly altering their
behavior to reflect the likely
consequences of policy changes, they
make it more difficult (costly) for
government authorities to meet their
macroeconomic objectives.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


Rather than fooling people into
changing real wages, and therefore
unemployment, with inflation
“surprises,” changes in inflation are
quickly reflected into expectations with
little or no effect on unemployment or
real output even in the short run.
As a consequence, policies intended to
reduce unemployment through
stimulating aggregate demand will often
fail to have the intended effect.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Fiscal and monetary policy, according to
this view, will work only if the people are
caught off-guard or fooled by policies so
that they do not modify their behavior in
a way that reduces policy effectiveness.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


In the case of an expansionary
monetary policy, AD will shift to the
right.
As a result of anticipating the
predictable inflationary consequences of
that expansionary policy, the price level
will immediately adjust to a new higher
price level.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Consumers, producers, workers, and
lenders who have anticipated the effects
of the expansionary policy simply built
the higher inflation rates into their
product prices, wages, and interest
rates because they realize that
expansionary monetary policy can
cause inflation if the economy is
working close to capacity.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Consequently, in an effort to protect
themselves from the higher anticipated
inflation, workers ask for higher wages,
suppliers increase input prices, and
producers raise their product prices.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


Because wages, prices, and interest
rates are assumed to be flexible, the
adjustments take place immediately.
This increase in input costs for wages,
interest, and raw materials causes the
aggregate supply curve to also shift up
or leftward.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

So the desired policy effect of greater
real output and reduced unemployment
from a shift in the aggregate demand
curve is offset by an upward or leftward
shift in the aggregate supply curve
caused by an increase in input costs.
Copyright © 2003 by Thomson Learning, Inc.
Rational Expectations and the AD/AS Model
LRAS
AS1
AS0
PL1
AD1
PL0
AD0
0
Copyright © 2003 by Thomson Learning, Inc.
RGDPNR
RGDP
18.7 Rational Expectations



An unanticipated increase in AD as a
result of an expansionary monetary
policy stimulates output and
employment in the short run.
The output is beyond the full
employment level, and so is not
sustainable in the long run.
The price level ends up higher than
workers and other input owners
expected.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

However, when they eventually realize
that the price level has changed, they
will require higher input prices, shifting
SRAS left to a new long-run equilibrium
at full employment and a higher price
level.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

In the short run, the policy expands
output and employment, but only
increases the price level inflation in the
long run.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


A correctly anticipated increase in AD
from expansionary monetary or fiscal
policy will not change real output or
unemployment even in the short run.
The only effect is an immediate change
in the price level.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

The only way that monetary or fiscal
policy can change output in the rational
expectations model is with a surprise—
an unanticipated change.
Copyright © 2003 by Thomson Learning, Inc.
An Expansionary Policy That Is
Unanticipated
Price Level
LRAS
SRAS1
SRAS0
PL2
C
B
PL1
PL0
A
AD1
(Unanticipated)
AD0
RGDPNR RGDP1
RGDP
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


In the rational expectations model,
when people expect a larger increase in
AD than actually results from a policy
change (say, from a smaller increase in
the money supply than expected), it
leads to a higher price level and a lower
level of RGDP—a recession.
A policy designed to increase output
may actually reduce output if prices and
wages are flexible and the expansionary
effect is less than people anticipated.
Copyright © 2003 by Thomson Learning, Inc.
An Actual Expansionary Policy That Is Less
Than the Anticipated Policy
Price Level
LRAS
SRAS1
SRAS0
C
PL2
PL1
B
A
PL0
AD2 (Anticipated)
AD1 (Actual)
AD0
RGDP1 RGDPNR
RGDP
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Rational expectations theory does have
its critics.

Critics want to know if consumers and
producers are completely informed about
the impact that say, an increase in money
supply will have on the economy.

In general, not all citizens will be completely
informed, but key players like corporations,
financial institutions, and labor organizations
may well be informed about the impact of these
policy changes.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations

Are wages and other input prices really
that flexible?

Even if decision makers could anticipate the
eventual effect of policy changes on prices,
prices may still be slow to adapt (e.g., what if
you had just signed a three-year labor or supply
contract when the new policy is implemented?).
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


Many economists reject the extreme
rational expectations model of complete
wage and price flexibility.
Most still believe there is a short-run
trade-off between inflation and
unemployment.
Copyright © 2003 by Thomson Learning, Inc.
18.7 Rational Expectations


The reason is that some input prices are
slow to adjust to changes in the price
level.
In the long run, the expected inflation
rate adjusts to changes in the actual
inflation rate at the natural rate of
unemployment.
Copyright © 2003 by Thomson Learning, Inc.