Download Chapter 11 Money and the Economy

Chapter 15
Monetary Policy
© West Publishing Company 1996
EQUATION OF EXCHANGE
MV=P Q
 M is the money supply
 V is the velocity of money
 P is the price level
 Q is the real GDP

INFLATION
Inflation refers to an increase in the general
price level.
 One-shot inflation is a one-time increase in
the price level.
 Continued inflation is continuous increases
in the price level (CPI rises each year)

CONTINUED INFLATION
YEAR
1992 1993 1994 1995 1996
CPI
100
108
120
133
150
CONTINUED INFLATION
Continued inflation results from continued
increases in AD.
 What causes these continued increases in
AD?
 Usually continued increases in the Money
Supply

COSTS OF INFLATION
Inflation is a “tax” on peoples
moneyholdings.
 Inflation lowers the real return on your
savings.
 Inflation redistributes purchasing power
from lenders to borrowers.

COSTS OF INFLATION
Inflation can lead to social tension
 Inflation creates greater uncertainty
 Inflation leads people to divert money away
from productive activities.

INTEREST RATES
REAL RATE - the rate of return banks
must have to cover costs and provide a
return to investors
 NOMINAL RATE - real rate plus the
expected rate of inflation

DEMAND FOR MONEY
The inverse relationship between the
quantity of money balances and the interest
rate
 the interest rate is the opportunity cost of
holding money

Demand for, and Supply of
Money
Exhibit 1 Interest Rate
Interest Rate
Supply of Money
i2
i1
Demand for Money
0
M2
M1
Quantity of Money
(a)
0
Quantity of Money
(b)
Equilibrium in the Money
Interest Rate Market
S1
i2
Excess Supply
of Money
Equilibrium in the
money market
i1
i3
D1
Excess Demand
for Money
0
M1
Quantity of Money
BONDS AND INTEREST
RATES
bonds have a face value
 bonds pay a fixed interest payment each
year (coupon pmt)
 bond prices are determined by the
relationship between current interest rates
and the bond’s rate

BONDS AND INTEREST
RATES
Bond Prices are inversely related to the
current interest rate.
 If current interest rates are higher than the
bond’s rate then the bond will sell below
face value
 If interest rates fall, bond prices rise

APPROPRIATE POLICIES

What are the appropriate monetary policies
to close a recessionary gap?
– buy bonds
– decrease discount rate
– decrease reserve requirement
APPROPRIATE POLICIES

What are appropriate monetary policies to
close an inflationary gap?
– sell bonds
– increase the discount rate
– increase reserve requirements