Download M x V = P x Q

© 2010 Jane Himarios, Ph.D.
1
Lecture 12
Chapter 12: Monetary Policy
I. Easy versus Tight Monetary Policy
Easy Money Policy:
Goal: increase excess reserves and the money supply to stimulate the economy
(expand output and employment)
Actions: buy government securities, lower the discount rate, lower the reserve
requirement
Tight Money Policy:
Goal: decrease excess reserves and the money supply to fight inflation
Actions: sell government securities, raise the discount rate, raise the reserve
requirement
II. Our Goal
Our goal is to learn how a change in the money supply will help us achieve our
three macroeconomic goals of low unemployment, stable prices, and high and
sustained economic growth.
To achieve this goal we have to understand how a change in the money supply
affects the AD curve. Once we understand why a change in the money supply
shifts the AD curve, it’s simple to use the AD-SRAS model to see the effects of a
change in the money supply on the price level, real GDP, and the unemployment
rate.
III. Monetary Theories
We will study three theories.
© 2010 Jane Himarios, Ph.D.
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A. A Long Run Theory: The Quantity Theory of Money (Classical)
Classical economists believe that all prices are flexible in the long run, allowing
the economy to stay at full employment.
The Equation of Exchange
Economists use the equation of exchange to explore the relationship between
the size of the money supply and the price level.
In any economy, Total Expenditures = Total Sales.
Therefore, since Total Expenditures = MV and since Total Sales = PQ,
MV = PQ
where: M is the money supply
V is velocity = average number of times a dollar is spent to buy final
goods and services in a year
P is the price level
Q is real GDP
Classical assumptions underlying the quantity theory:
1.
V is fixed
2.
Q (real GDP) is fixed at full employment
The Quantity Theory of Money: changes in M translate directly into
proportional changes in P:
M x V
For example:
M
X
$500
X
$1000
X
$1500
X
$1200
X
=
P x Q
V
4
4
4
4
=
=
=
=
=
P
$2
$
$6
4.8
X
X
X
X
X
Q
1000
1000
1000
1000
Notice, for example, that when the money supply increased by 100%, the price
level increased by 100%.
Prediction of the simple quantity theory: “When the money supply changes by
x%, then the price level will also change by x%, but real GDP and the
unemployment rate don’t change.”
See Figure 1 on page 282 for real world evidence.
© 2010 Jane Himarios, Ph.D.
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Classical Money Transmission Mechanism
Assumption: People hold money to make transactions.
Since people hold just the amount of money they need for their accustomed
transactions, whenever the Fed practices easy money by using its tools to
increase the money supply, people just spend this extra money to buy
consumption goods. This shifts the AD curve rightward and changes the price
level, but not real GDP or the unemployment rate.
Easy Money: MS↑ → C↑ → AD↑ → P↑
Price Level
LRAS
P2
P1
AD2
AD1
Qf
Real GDP
Similarly, since people hold just the amount of money they need for their
accustomed transactions, whenever the Fed practices tight money by using its
tools to decrease the money supply, people just cut back on their spending for
consumption goods. This shifts the AD curve leftward and changes the price
level, but not real GDP or the unemployment rate.
Tight Money: MS↓ → C↓ → AD↓ → P↓
Price Level
LRAS
P1
P2
AD1
AD2
Qf
Real GDP
© 2010 Jane Himarios, Ph.D.
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Since, in the real world, velocity and real GDP are not always constant,
economists just use the quantity theory of money as a starting point to their
discussions about the effects of changes in the money supply.
B. Short Run Theory: Interest Rate Channels
Keynesian Monetary Analysis
Keynes believed people had three motives for holding money rather than
interest-paying assets:
1. Transactions motive: hold money to make transactions
2. Precautionary motive: hold money to accommodate unforeseen circumstances
3. Speculative motive: hold money for speculation against changes in interest
rates or the price level (if interest rates are low you expect that they will rise
again, causing bond prices to fall and causing you to suffer capital losses, so you
will want to hold money instead of bonds) (if you think the price level will fall then
you expect the purchasing power of your money to rise so you will want to hold
money instead of bonds)
Economists have observed that, given their individual wealth levels, people want
to hold a certain amount of their wealth as money and the rest of their wealth as
interest-paying assets. Therefore, economists theorize that the demand for
money is related to the interest rate. As the interest rate rises, people will choose
to hold more of their wealth as interest-paying assets and less of their wealth as
M1 money.
M1 money
Interest-paying
Components
Assets
Asset Shelf
While the demand for money is a function of the interest rate, the supply of
money is not related to the interest rate. The Fed largely determines the supply
of money.
When the Fed uses its tools to increase the money supply, people end up
holding more of their wealth as money than they want to hold. To remedy this,
lots of people try to spend their “excess” money to buy interest-paying
assets, such as bonds. This drives up bond prices, and drives down interest
rates.
The important point here is that when the Fed increases the money supply,
interest rates will fall, and vice versa.
© 2010 Jane Himarios, Ph.D.
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Finally, remember that interest rate changes affect consumption and investment
spending. We can put all of this information together to show the effects of easy
money policy and tight money policy.
Easy money:
MS↑ → Demand for bonds↑ → Bond prices↑ → interest rates↓ → investment↑ AD↑ →
Price level↑, Real GDP↑, and Unemployment↓
Price Level
LRAS
SRAS
ADnew
AD
Real GDPactual Real GDPpotential Real GDP
= Real GDPactualnew
Tight money:
MS↓ → Demand for bonds↓ → Bond prices↓ → interest rates↑ → investment↓ → AD↓ →
Price level↓, Real GDP↓, and Unemployment↑
Price Level
LRAS
SRAS
AD
ADnew
Real GDPpotential Real GDPactual Real GDP
= Real GDPactualnew
It appears from these two graphs that easy money policy can cure recessionary
gaps and tight money policy can cure inflationary gaps. However, as discussed
below, the Keynesians looked at the world and saw that there are a couple of
potential problems with using monetary policy. Because of these potential
problems, Keynesians think that we cannot rely on monetary policy.
© 2010 Jane Himarios, Ph.D.
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Potential Problem #1: Investment Spending may be Interest-RateInsensitive
Principle of economics: Monetary policy won’t work if investment spending is
unresponsive to interest rate changes.
When the Fed takes steps to make interest rates change, it expects investment
spending to change in response. Most of the time this happens. Sometimes,
though, the Fed takes steps to change interest rates but then investment
spending doesn’t change much in response. We can show this as a breakdown
in the chain of events described in our Keynesian theory.
Easy money policy:
MS↑ → Demand for bonds↑ → Bond prices↑ → interest rates↓ X
→ investment↑ → AD↓ →
Price level↑, Real GDP↑, and Unemployment↓
X
The X shows where the breakdown occurs.
If investment doesn’t change, then the AD curve doesn’t shift, and so monetary
policy doesn’t have an effect on the price level, real GDP, or the unemployment
rate.
Example: “Banks are urging Masato Uno, president of car-door supplier Hirotec Corp., to
borrow fresh money, though he considers it foolhardy to invest in Japan. But he is taking
advantage of the cheap credit -- by investing it overseas, to start metal-stamping ventures in
Thailand and Mexico.” Phred Dvorak, “Can’t Give It Away,” The Wall Street Journal, 10/25/2001.
(Notice that he didn’t start a metal-stamping venture in Japan.)
Potential Problem #2: A Liquidity Trap May Occur
Principle of economics: Monetary policy won’t work if people don’t respond to
changes in the money supply by buying bonds.
When the Fed takes steps to increase the money supply it expects people to use
the extra money to buy more bonds. Most of the time this happens.
Sometimes, though, the Fed increases the money supply but then people do not
buy more bonds. This is most likely to occur when interest rates are very low
(and, by association, when bond prices are very high). This situation is called a
liquidity trap.
Liquidity traps occur when high bond prices make bond purchases unattractive.
People decide to continue to hold money, rather than buy bonds, because they
feel that bond prices have nowhere to go but down. In other words, at very low
interest rates, people are “trapped” holding money. (Hence the name “liquidity
trap”: people are trapped holding a liquid asset (money) rather than an interestpaying asset.) They want to reallocate their wealth away from money towards
© 2010 Jane Himarios, Ph.D.
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interest-paying assets, but feel that it is unwise to do so. We can show this as a
breakdown in the chain of events described in our Keynesian theory.
Easy money policy:
X Demand for bonds↑ → Bond prices↑ → interest rates↓ → investment↑ → AD↓ →
MS↑ →
PriceXlevel↑, Real GDP↑, and Unemployment↓
The X shows where the breakdown occurs.
If the demand for bonds doesn’t change, then the price of bonds doesn’t change,
interest rates don’t change, investment doesn’t change, the AD curve doesn’t
shift, and so monetary policy doesn’t have an effect on the price level, real GDP,
or the unemployment rate.
Another way to think of this is that in a liquidity trap people hoard money. As M ↑,
V↓. Looking at MV = PQ, MV doesn’t change and, therefore, PQ can’t change.
Conclusion:
Keynesians claim that monetary policy might not be effective at changing real
GDP and/or the price level. They claim that we cannot rely on monetary policy.
Example: “As treasury chief at Setouchi, Hidenori Nuibe is in charge of investing 130 billion
yen of the bank's money but has run out of safely lucrative places to put it. So in June, Mr. Nuibe
took a desperate step: He stuck the yen equivalent of $33 million into a plain-vanilla savings
account at rival Hiroshima Bank Ltd., earning him interest of $17 a day. Hiroshima Bank, which
won't comment, howled in protest, and Mr. Nuibe says he withdrew the money the next month.”
Phred Dvorak, “Can’t Give It Away,” The Wall Street Journal, 10/25/2001. (Notice that he didn’t
buy bonds.)
Keynesians say monetary policy is unreliable.
C. The Monetarist Model—this deals with short run and long run
implications of monetary policy
Milton Friedman believed that consumption is not only based on income, but also
on wealth (holdings of money, bonds, equities, real assets, and human capital).
Consumption is based on permanent income, which is the present value of an
individual’s future stream of labor income.
He believed that the demand for real money balances rises if wealth or
permanent income rises or if the rate of return on other assets or expected
inflation falls.
© 2010 Jane Himarios, Ph.D.
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Easy Money Policy in the Short Run:
MS↑ → Demand for bonds↑ → Bond prices↑ → interest rates↓ → investment↑ → AD↓ →
Price level↑, and/or Real GDP↑ and Unemployment↓
Easy Money Policy in the Long Run:
Monetarists believe that the economy is self-regulating: it always returns to
full employment.
1.
Start in equilibrium (this is a point of long run equilibrium) at point 1, where
the economy is at full employment.
SRAS’
2.
Increase the money supply while holding velocity constant.
3.
This causes the AD curve to shift to the right.
4.
Find the new short run equilibrium at point 2.
AD’
5.
Compare equilibrium points:
a.
real GDP* rises
b.
the price level rises
c.
the unemployment rate falls
AD
6.
Now that there is an inflationary gap, wages will be bid up.
7.
This causes the SRAS curve to shift to the left.
8.
Find the new short run equilibrium at point 3.
9.
Compare equilibrium points:
a.
real GDP* fell back to Real GDPpotential
b.
the price level is higher than before
c.
the unemployment rate has returned to its natural level.
LRAS
The movement from point 1 to point 2 was a short run movement. The movement
from point 1 to point 3 was a long run movement.
IV. Monetary Policy Lags
Information Lags
Recognition Lags
Decision Lags
Implementation Lags
SRAS
© 2010 Jane Himarios, Ph.D.
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V. Implementing Monetary Policy
Long run: price stability is the best policy for long-run economic growth
Short run: “the direction of monetary policy and its extent depends on whether it
targets the price level or income and output, and whether the shock to the
economy comes from the demand or supply side”
A. Demand Shock:
LRAS
Price level
AS1
AD1 = AD3
AD2
The demand shock
reduces output and the
price level. Easy
money policy takes the
economy back to its
initial equilibrium,
regardless of whether
the Fed targets prices
or output.
Real GDP
B. Supply Shock (three options)
1. Supply Shock with an output target:
Using easy money policy to target output makes inflation worse:
LRAS AS2
Price level
AS1
AD1
Notice that inflation
worsens
AD2
Real GDP
© 2010 Jane Himarios, Ph.D.
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2. Supply shock with an inflation target:
Using tight money policy to target prices makes unemployment worse:
LRAS AS2
Price level
Notice that
unemployment worsens
and the Fed might
actually turn a recession
into a depression
AS1
AD1
AD2
Real GDP
3. Supply shock and the Fed’s best option:
In reality, the Fed’s best option is to practice easy money but only enough to
partially offset the supply shock:
LRAS AS2
Price level
AS1
AD1 AD2
Notice that the price
level rises somewhat but
not as much as in the
first scenario and that
output is still below Qf,
but not as far below Qf
as in the second scenario
Real GDP
Rules or Discretion?
Some economists call for rules to guide the Fed. Others say that the economy is
too complex to rely on rules.
© 2010 Jane Himarios, Ph.D.
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Examples of Rules
1. Monetary Targeting: keeps the growth of money on a steady path
Milton Friedman argued that variations in money growth rates were destabilizing.
He advocated increasing the money supply by the amount consistent with longterm price stability and economic growth.
LRAS AS2
Price level
AS1
When faced with a
demand shock, money
targeting means that it
will take longer for the
economy to return to
full employment
(notice here that the
Fed doesn’t offset the
demand shock)
AD1
AD2
Real GDP
On the other hand, when faced with a negative supply-shock, money targeting
means that the Fed won’t practice tight money policy, so we won’t see the
economy enter a larger recession or depression.
2. Inflation Targeting: keeps the inflation rate constant (usually around 2%
per year)
If there is a demand shock, inflation targeting calls for increasing the money
supply:
LRAS
Price level
AS1
AD1 = AD3
AD2
Real GDP
© 2010 Jane Himarios, Ph.D.
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If there is a supply shock, inflation targeting calls for reducing the money supply
(which will make the recession worse):
LRAS AS2
The Fed probably would abandon
inflation targeting rather than suffer
this result.
Price level
AS1
AD1
AD2
Real GDP
Transparency and the Fed
Read about this in your text.
See Figures 3 and 4 (on pages 34 and 35) for transparency comparisons by
country at http://www.nber.org/papers/w13003.pdf.
Also see The Fed Is Already Transparent
Anil K. Kashyap, Frederic S. Mishkin. Wall Street Journal 11/10/2009
The Real Threat to Fed Independence
Henry Kaufman. Wall Street Journal 11/11/2009
1. What is transparency in the context of monetary policy? Why is it important?
2. What is meant by central bank independence? Is the Fed independent?
3. What are the advantages and disadvantages of central bank independence?
4. According to the authors of this op-ed piece, how and why would the legislation introduced by Congressman Ron Paul
affect the Fed's ability to maintain low inflation?
5. Why is it important that the Federal Reserve maintain credibility?