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Transcript
© 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. 2 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. 3 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. 4 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. 5 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. 6 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. 7 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. 8 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. 9 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. 10 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. 11 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. 12 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?