Download The Tools of Monetary Policy

Monetary Policy and Inflation:
Quantity Theory of Money
• The Equation of Exchange
– The formula indicating that the number of
monetary units times the number of times
each unit is spent on final goods and
services is identical to the price level
times output (or nominal national
income)
MV  PY
1
Money, Real GDP, and
the Price Level
The equation of exchange states
that the quantity of money (M)
multiplied by the velocity of
circulation (V) equals GDP, or
MV=PY
2
Money, Real GDP, and
the Price Level
GDP equals the price level
(P) times real GDP (Y), or:
GDP = PY
3
Monetary Policy and Inflation :
Quantity Theory of Money
• The equation of exchange
and the quantity theory: MV = PY
M = actual money balances held
by non-banking public
V = income velocity of money; the
number of times, on average, cash
monetary units are spent on final
goods and services
4
Monetary Policy and Inflation :
Quantity Theory of Money
• The equation of exchange
and the quantity theory: MV =
PY
P = price level
Y = real national output (real
GDP)
5
Monetary Policy and Inflation :
Quantity Theory of Money
• The equation of exchange as an identity
MV  PY
PY = nominal national income
MV = nominal national spending
6
Money, Real GDP, and
the Price Level
We can convert the equation of
exchange into the quantity theory of
money by making two assumptions:
1) The velocity of circulation is not
influenced by the quantity of money.
2) Potential income is not influenced by
the quantity of money.
7
Money, Real GDP, and
the Price Level
The Quantity Theory of Money
– The quantity theory of money is the
proposition that in the long run, an
increase in the quantity of money brings
an equal percentage increase in the price
level.
– This theory is based upon the velocity of
circulation and the equation of exchange.
8
Money, Real GDP, and
the Price Level
The Quantity Theory of
Money
The velocity of circulation is
the average number of times a
dollar of money is used
annually to buy goods and
services that make up GDP.
9
Money, Real GDP, and
the Price Level
Make the quantity of money
M, and the velocity of
circulation V is determined
by:
V = PY/M
10
The Velocity of Circulation in the
United States: 1930–1999
11
Money, Real GDP, and
the Price Level
This can be shown by using
the equation of exchange to
solve for the price level.
P = (V/Y)M
12
Money, Real GDP, and
the Price Level
In the long run, real GDP equals
potential GDP, so the relationship
between the change in the price level
and the quantity of money is:
P  (V / Y )M
13
Money, Real GDP, and
the Price Level
Dividing this equation
by an earlier one,
P = (V/Y)M, gives us
P / P  M / M
14
Money, Real GDP, and
the Price Level
This equation shows that the proportionate
change in the price level equals the
proportionate change in the quantity of
money.
This gives us the quantity theory of money:
In the long run, the percentage increase in the
price level equals the percentage increase in
the quantity of money.
15
Monetary Policy and Inflation :
Quantity Theory of Money
• The crude quantity theory
of money and prices
–Assume: V is constant
Y is stable
MV = PY
16
Monetary Policy and Inflation :
Quantity Theory of Money
• The crude quantity theory of
money and prices
–Increases in M must be
matched by equal increases in
the price level
MV = PY
17
Figure 17-5
18
Money Growth and
Inflation in the United States
19
Money Growth and
Inflation in the United States
20
Money Growth and
Inflation in the World Economy
21
Money Growth and
Inflation in the World Economy
22
Money, Real GDP, and
the Price Level
Historical Evidence on the
Quantity Theory of Money
–The data are broadly consistent with
the quantity theory of money, but the
relationship is not precise.
–The relationship is stronger in the
long run than in the short run.
23
Money, Real GDP, and
the Price Level
Correlation, Causation, and
Other Influences
The evidence shows that
money growth and inflation
are correlated.
24
Money, Real GDP, and
the Price Level
Correlation, Causation, and Other
Influences
This does not represent causation.
• Does money growth cause
inflation, or does inflation cause
money growth?
• Does some other factor cause
inflation (deficit spending)?
25
Monetary Policy
• The ultimate goal of all macro policy
is to stabilize the economy at its fullemployment capacity.
• A government has three basic tools of
monetary policy:
–Reserve requirements
–Open-market operations
–Discount rates
27
The Tools of Monetary Policy
• Changes in the reserve requirements
– An increase in the required reserve ratio
• Makes it more expensive for banks
to meet reserve requirements
• Reduces bank lending
– A decrease in the required reserve ratio
• Makes it more expensive for banks
to meet reserve requirements
• Increases bank lending
28
Reserve Requirements
• A lower reserve requirement
increases the size of the money
multiplier.
– The money multiplier is the number of
deposit (loan) dollars that the banking
system can create from $1 of excess
reserves.
29
A Decrease in Required Reserves
• A change in the reserve
requirement causes:
–A change in excess reserves.
–A change in the money multiplier.
30
The Impact of Reduced Reserve
Requirement
1. Total deposits
2. Total reserves
3. Required reserves
4. Excess reserves
5. Money multiplier
6. Unused lending capacity
Required Reserve Ratio
25 percent 20 percent
$100 billion $100 billion
30 billion
30 billion
25 billion
20 billion
5 billion
10 billion
4
5
$20 billion $50 billion
31
The Monetary Base
• The government can control the
monetary base which equals
–currency in public
circulation plus bank
reserves.
32
The Monetary Base
• However, HKMA cannot
control the amount of the
monetary base that flows
outside the country.
33
The Tools of Monetary Policy
• Open market operations
–The HKMA changes
reserves by buying and
selling bonds.
34
Open Market Activity
• The HKMA purchases and sells
government bonds to alter bank
reserves.
–By buying bonds — HKMA
increases bank reserves.
–By selling bonds — HKMA
reduces bank reserves.
35
Determining the Price of Bonds
S1
Price of Bonds
P1
Contractionary Policy
• Fed sells bonds
• Supply of bonds
increases
• Bond prices fall
D
Quantity of Bonds
per Unit Time Period
36
Determining the Price of Bonds
S1
Price of Bonds
P1
P2
S1
Contractionary Policy
• Fed sells bonds
• Supply of bonds
increases
• Bond prices fall
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (a)
37
Determining the Price of Bonds
Price of Bonds
S1
P1
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
D
Quantity of Bonds
per Unit Time Period
38
Determining the Price of Bonds
S3
Price of Bonds
P3
P1
S1
Expansionary Policy
• Fed buys bonds
• Supply of bonds
falls
• Bond prices rise
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (b)
39
The Tools of Monetary Policy
• Relationship between the price
of existing bonds and the rate
of interest
–What happens to the interest on a
bond when the price of a bond
increases?
40
The Tools of Monetary Policy
• Example
– You pay $1,000 for a bond that pays
$50/year in interest
$50
Rate of interest =
= 5%
$1000
41
The Tools of Monetary Policy
• Example
– Now suppose you pay $500
for the same bond
$50
Rate of interest =
= 10%
$500
42
The Tools of Monetary Policy
• The market price of existing
bonds (and all fixed-income
assets) is inversely related to
the rate of interest prevailing
in the economy.
43
The Tools of Monetary Policy
• Changes in the discount rate
Increasing the discount rate increases
the cost of borrowed funds for
depository institutions that borrow
reserves
Decreasing the discount rate
decreases the cost of borrowed funds
for depository institutions that
borrow reserves
44
Effects of an Increase
in the Money Supply
• When the money supply
increases people have too
much money
–How can this be?
–Have you ever had too much
money?
45
Effects of an Increase
in the Money Supply
• If you have a savings
account
the answer is “yes.”
• We must distinguish
between
income and money
46
Tools of Monetary Policy
• Expansionary monetary policy:
effects on aggregate demand,
the price level, and real GDP
• Monetary policy can be used to
move the economy to its fullemployment potential.
47
Monetary Policy During
Periods of Underutilized Resources
• Monetary policy can
generate increases in the
equilibrium level of real
GDP.
48
Expansionary Policy
• The HKMA can increase AD/AE
by increasing the money supply by:
–Lowering reserve requirements.
–Dropping the discount rate.
–Buying more bonds: it increases
bank lending capacity.
49
Expansionary Monetary Policy
with Underutilized Resources
Price Level
LRAS
SRAS
E1
120
Recessionary gap
AD1
0
9.5
The contractionary
gap is caused by
insufficient AD
• To increase AD,
use
expansionary
monetary policy
• AD increases and
real GDP increases
to full employment
•
10.0
Real GDP per Year
($ trillions)
50
Expansionary Monetary Policy
with Underutilized Resources
LRAS
SRAS
Price Level
125
E2
E1
120
AD2
Recessionary gap
AD1
0
Figure 17-3
• The
9.5
contractionary
gap is caused by
insufficient AD
• To increase AD,
use
expansionary
monetary policy
• AD increases
and real GDP
increases to full
employment
10.0
Real GDP per Year
($ trillions)
51
Exhibit 4: Expansionary Monetary Policy
to Correct a Contractionary Gap
Potential
output
Price level
SRAS 130
b
130
125
a
AD'
AD
0
7.8
8.0
Contractionary gap
Real GDP
(trillions of dollars)
52
Open Economy Transmission
of Monetary Policy
• The net export effect
– Impact of expansionary monetary policy
• increase the money supply
• interest rates fall
• value of the local currency falls
• net exports increase
• the net export effect complements the
effectiveness of monetary policy by making
greater income growth
53
Open Economy Transmission
of Monetary Policy
• The net export effect
– Impact of expansionary fiscal
policy revisited
•
•
•
•
•
•
larger deficit
higher interest rates
attracts foreign capital
value of the local currency appreciates
net exports fall
net export effect reduces the effectiveness
of fiscal policy by making smaller income growth 54
Adding Monetary Policy
to the Keynesian Model
Interest Rate
MS
M’S
r1
Md
Quantity of Money
55
Adding Monetary Policy
to the Keynesian Model
Interest Rate
MS
M’S
r1
At lower rates,
a larger
quantity of
money will be
demanded
Interest
rate falls
r2
Md
Quantity of Money
Figure 17-7, Panel (a)
56
Interest Rate
Adding Monetary Policy
to the Keynesian Model
r1
I
I1
Planned Investment
57
Interest Rate
Adding Monetary Policy
to the Keynesian Model
r1
The decrease
in interest
stimulates
investment
r2
I
I1
I2
Planned Investment
Figure 17-7, Panel (b)
58
Adding Monetary Policy
to the Keynesian Model
LRAS
Price Level
SRAS
E1
AD1
0
7.0 10.0
Real GDP per Year
($ trillions)
59
Adding Monetary Policy
to the Keynesian Model
LRAS
Price Level
SRAS
E2
E1
AD2
AD1
0
Figure 17-7, Panel (c)
The
increase in
investment
shifts the
AD curve to
the right
9.5 10.0
Real GDP per Year
($ trillions)
60
Contractionary Monetary Policy
via Open Market Operations
Figure 17-4
61
Monetary Policy in Action:
The Transmission Mechanism
• The monetarist’s views of money
supply changes
– They are those Macroeconomists
who believe that inflation is always
caused by excessive monetary
growth and that changes in the
money supply affect AD both
directly and indirectly
62
Monetary Policy in Action:
The Transmission Mechanism
• The monetarist’s views of money
supply changes
– Increase in the money supply
increases aggregate demand directly
– Based on the equation of exchange,
prices always rise when the money
supply is increased
63
Monetary Policy in Action:
The Transmission Mechanism
• Monetarists’ criticism of
monetary policy
–Time lags are too long to use
monetary policy effectively
–Monetary policy is seen as a
destabilizing force
64
Monetary Policy in Action:
The Transmission Mechanism
• Monetary Rule
– A monetary policy that incorporates a
rule specifying the annual rate of growth
of some monetary aggregate
– Example
• Increase in the money supply smoothly at a
rate consistent with the economy’s long-run
average growth rate measured in terms of NI
% change
65
Monetary Policy in Action:
The Transmission Mechanism
• What do you think?
–What would happen to the
effectiveness of the
monetary rule if V is not
stable?
66
Price vs. Output Effects
• The success of monetary
policy depends on the
conditions of aggregate
demand and aggregate
supply.
67
Aggregate Supply
• The shape of the AS curve
determines the
effectiveness of
expansionary monetary
policy in raising output.
68
Aggregate Supply
• Horizontal AS — output increases without
any inflation/price change.
• Vertical AS — inflation occurs without
changing output.
• Upward sloping AS — both prices and
output are affected by monetary policy.
69
Aggregate Supply
• With an upward-sloping AS
curve, expansionary policy
causes some inflation and
restrictive policy causes
some unemployment.
70
Contrasting Views of AS
PRICE LEVEL
(average price per unit of output)
(a) The Keynesian view
Aggregate supply
P3
P1
AD3
AD2
AD1
0
Q1
QF
RATE OF OUTPUT
(real GDP per time period)
71
Contrasting Views of AS
PRICE LEVEL
(average price per unit of output)
(b) The Monetarist view
Aggregate supply
P5
P4
AD5
AD4
0
QN
RATE OF OUTPUT
(real GDP per time period)
72
Figure 28-10
Two Views on the Strength of Monetary Changes
73
Contrasting Views of AS
PRICE LEVEL
(average price per unit of output)
(c) A popular view
Aggregate
supply
P7
P6
AD7
AD6
0
Q6
Q7
RATE OF OUTPUT
(real GDP per time period)
74
Policy Perspectives
• The shape of the
aggregate supply curve
spotlights a central policy
debate.
75
Fixed Rules or Discretion?
• Should the government
try to fine-tune the
economy with constant
adjustments of the money
supply?
76
Fixed Rules or Discretion?
• Or should the government
instead simply keep the
money supply growing at
a steady pace?
77
Discretionary Policy
• The economy is constantly
beset by expansionary and
recessionary forces.
• There is a need for continual
adjustments to money supply.
78
Fixed Rules
• Critics of discretionary
monetary policy raise
objections linked to the shape
of the AS curve.
• AS curve could be vertical or at
least upward sloping.
79
Fixed Rules
• With an upward-sloping
AS curve, too much
expansionary monetary
policy leads to inflation.
80
Fixed Rules
• Fixed rules for moneysupply management are
less prone to error than
discretionary policy.
81
Fixed Rules
• The money supply should
increase by a constant
(fixed) rate each year
equal to that of potential
Y growth.
82