3.4 Supply and Demand - Monetary Policy Estelle Schmermer HL Economics Mr. Bollom

Definitions Monetary Policy: changing the AD to increase GDP or lower inflation by changing the money supply and interest rates Expansionary Monetary Policy: Expanding the supply of money and lowering the interest rate to increase AD and ultimately increase GDP Contractionary Monetary Policy: Contracting the supply of money and increasing the interest rate to decrease AD and ultimately decrease inflation

Role of Central Bank Regulates money supply Supply currency Hold reserves of depository institutions reserves Acts as government’s fiscal agent Lender of last resort Supervises member banks Regulates money supply Goal: Economic growth with stable prices, so greater output (GDP) and low, steady rate of inflation.

Situation: Economical Downturn AD is below where it should be Central bank uses power to change AD Assumptions When have more money in pockets, people will spend more Interest rates affect consumption and investment

Why hold money? Transaction demand Precautionary demand spend it on goods and services Precautionary demand keep it for emergencies/sudden transactions Speculative demand To deal with uncertainty of value of other assets, scared of declined value so hold money as safety Don’t need to know this

What can the Central Bank do? Can affect money and supply and interest rates by Reserve requirements Discount rate Open market operations Quantitative easing Don’t need to know these in specific Don’t need to know these in specific, just know that the central bank controls and uses money supply

Step 1: Change Interest Rate How? By Central Bank increasing Money supply Central bank increases money supply  interest rates fall

Step 2: Investment Spending Increases Lower Interest Rates  Increase Investment Spending

Step 3: Increased Investment brings AD up Y1 Y

Situation: Inflation Y1 Y

Decreasing AD Lower Money Supply  Higher Interest Rates  Decrease Investment Spending

Decreasing AD Y Y1

Evaluation: Strengths Almost no time lag effect No “crowding out” Less politics since almost all central banks are independent Works very well for fighting inflation Smaller action time lag Act fast as meet almost every month

Also … Good Net Export Effect Expansionary monetary policy FED buys bonds Interest rates go down, foreigners take $ out of US Lower demand makes dollar worth less Increases exports That increases AD Net export reinforces monetary policy

Evaluation: Weaknesses (Traditional Keynesian Counterattack) Monetary policy still has recognition time lag Increasing money supply and low interest don’t always make people spend more  panicked/unemployed people During deflation, nominal interest rates cannot fall below zero Inflation rate -2%, interest rate 0% = real interest rate 2%, why would you want to borrow if it causes real debt to increase over time?

Also … Bad Net Export Effect When expand, government borrows money Increases interest rates Attracts foreign capital Increased D for $ so prices increase US good get more expensive Reduces exports Harms AD!  Net export effect can counteract fiscal policy …

Monetarism ≠ Monetary Policy! Monetarism argues that business cycle results from discretionary and monetary policies Believe activist policies make business cycle worse and expansionary policy only leads to inflation

Monetarism – What to do? LRAS curve is vertical Focus on supply-side microeconomic adjustments Non-interventionists Change money supply according to GDP growth, nothing else! Guided by Fisher Rule M V = P Q