Chapter 17: Dimensions of Monetary Policy ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

2 Learning Objectives Identify the key factors that influence the quantity of money that people desire to hold Describe how the Federal Reserve’s tools of monetary policy affect the level of real GDP and the price level Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run

3 Learning Objectives Understand the equation of exchange and its importance in the crude quantity theory of money and prices Distinguish between the Keynesian and monetarist views on the transmission mechanism of monetary policy Explain why the Federal Reserve cannot stabilize both the money supply and the interest rate simultaneously

4 Money is the product of a “social contract” in which we all agree to:  Express all prices in terms of a common unit of account, which in the United States we call the dollar  Use a specific medium of exchange for market transactions What’s So Special About Money?

5 Anything that affects the amount of money in existence is going to affect all markets. Holding money  To use money, one must hold money. If people desire to hold money, there is a demand for money. What’s So Special About Money?

6 The demand for money: the amount of money people wish to hold  Transactions demand  Precautionary demand  Asset demand What’s So Special About Money?

7 Transactions Demand  Holding money as a medium of exchange to make payments  The level varies directly with nominal national income What’s So Special About Money?

8 Precautionary Demand  Holding money to meet unplanned expenditures and emergencies  The level varies with the interest rate What’s So Special About Money?

9 Asset Demand  Holding money as a store of value instead of other assets  The level varies with the interest rate What’s So Special About Money?

10 The demand for money curve  The amount of money demanded for transactions purposes is fixed given the level of income  Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate) What’s So Special About Money?

11 The Demand for Money Curve Quantity of Money Interest Rate MdMd Figure 17-1

12 The Demand for Money Curve Quantity of Money Interest Rate MdMd When the interest rate rises the opportunity cost of holding money increases and the quantity of money demanded falls The location of M d is determined by the level of income Q1Q1 B r2r2 A r1r1 Q2Q2

13 Open market operations  The Fed changes reserves by buying and selling government bonds issued by the U.S. Treasury. The Tools of Monetary Policy

14 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall D S1S1 P1P1 Figure 17-2, Panel (a)

15 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds D Figure 17-2, Panel (a) Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall S1S1 S2S2 P1P1 P2P2

16 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise D S1S1 P1P1 Figure 17-2, Panel (b)

17 Determining the Price of Bonds Quantity of Bonds per Unit Time Period Price of Bonds Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise Figure 17-2, Panel (b) S1S1 S3S3 P1P1 P3P3 D

18 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 (decreases)? The Tools of Monetary Policy

19 Example  You pay $1,000 for a bond that pays $50/year in interest The Tools of Monetary Policy Rate of interest = $50 $1000 = 5%

20 Example  Now suppose you pay $500 for the same bond The Tools of Monetary Policy Rate of interest = $50 $500 = 10%

21 The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy. The Tools of Monetary Policy

22 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

23 The Tools of Monetary Policy Changing the discount rate relative to the federal funds rate  The Fed has been keeping the discount rate one percentage point above the federal funds rate.  This discourages borrowing from the Fed.

24 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 less expensive for banks to meet reserve requirements Increases bank lending The Tools of Monetary Policy

25 When the money supply increases, people have too much money.  How can this be?  Have you ever had too much money?  If you have a savings account, then at some point you had too much money.  Money is not the same thing as income. Effects of an Increase in the Money Supply

26 Monetary policy can generate increases in the equilibrium level of real GDP. Monetary Policy During Periods of Underutilized Resources

27 Real GDP per Year ($ trillions) Price Level 0 AD LRAS SRAS The contractionary gap is caused by insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment Expansionary Monetary Policy with Underutilized Resources Recessionary gap E1E1 Figure 17-3

28 Real GDP per Year ($ trillions) Price Level 0 AD 1 SRAS E1E1 Recessionary gap The contractionary gap is caused by insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment Expansionary Monetary Policy with Underutilized Resources Figure LRAS AD E2E2

29 Figure 17-4 Contractionary Monetary Policy via Open Market Operations

30 The net export effect  Impact of expansionary monetary policy increase the money supply interest rates fall value of the dollar falls net exports increase the net export effect complements the effectiveness of monetary policy Open Economy Transmission of Monetary Policy

31 The net export effect  Impact of expansionary fiscal policy revisited larger deficit higher interest rates attracts foreign capital value of the dollar appreciates net exports fall net export effect reduces the effectiveness of fiscal policy Open Economy Transmission of Monetary Policy

32 Globalization of international money markets  How will global money markets impact the Fed's ability to control the rate of growth in the money supply? Open Economy Transmission of Monetary Policy

33 Short-run inflation  Temporarily shocks the SRAS and AD Long-run inflation  The supply of money expands relative to the demand for money  Takes more units of money to purchase given quantities of goods and services (i.e., the price level has risen) Monetary Policy and Inflation

34 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) M s V = PY Monetary Policy and Inflation

35 The equation of exchange and the quantity theory: M S V = PY  M S = 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 Monetary Policy and Inflation

36 The equation of exchange and the quantity theory: M S V = PY  P = price level  Y = real national output per year Monetary Policy and Inflation

37 The equation of exchange as an identity M s V = PY PY = nominal national income M s V = nominal national spending Monetary Policy and Inflation

38 The crude quantity theory of money and prices  Assume: V is constant and Y is stable M s V = PY Monetary Policy and Inflation

39 The crude quantity theory of money and prices  Increases in M s must be matched by equal increases in the price level Monetary Policy and Inflation M s V = PY

40 Adding Monetary Policy to the Keynesian Model Quantity of Money Interest Rate MdMd MSMS r1r1 M’ S Figure 17-7, Panel (a)

41 Adding Monetary Policy to the Keynesian Model Quantity of Money Interest Rate MdMd r2r2 M’ S At lower rates, a larger quantity of money will be demanded Interest rate falls Figure 17-7, Panel (a) MSMS r1r1

42 Adding Monetary Policy to the Keynesian Model Planned Investment Interest Rate I I1I1 r1r1 Figure 17-7, Panel (b)

43 Adding Monetary Policy to the Keynesian Model Planned Investment Interest Rate The decrease in the interest rate stimulates investment Figure 17-7, Panel (b) r1r1 r2r2 I1I1 I2I2 I

44 Real GDP per Year ($ trillions) Price Level 0 AD 1 SRAS Adding Monetary Policy to the Keynesian Model 12.0 LRAS 11.5 E1E1 Figure 17-7, Panel (c)

45 Real GDP per Year ($ trillions) Price Level 0 AD 1 SRAS 12.0 LRAS The increase in investment shifts the AD curve to the right Adding Monetary Policy to the Keynesian Model AD 2 Figure 17-7, Panel (c) E2E E1E1

46 The monetarist’s views of money supply changes  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 Monetary Policy in Action: The Transmission Mechanism

47 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 Monetary Policy in Action: The Transmission Mechanism

48 Monetarists’ criticism of monetary policy  Time lags are too long to use monetary policy effectively  Monetary policy is seen as a destabilizing force Monetary Policy in Action: The Transmission Mechanism

49 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 Monetary Policy in Action: The Transmission Mechanism

50 What do you think?  What would happen to the effectiveness of the monetary rule if the velocity of money is not stable? Monetary Policy in Action: The Transmission Mechanism

51 It is not possible to stabilize the money supply and interest rate simultaneously. Fed Target Choice: Interest Rates or Money Supply?

52 Choosing a Monetary Policy Target Quantity of Money Interest Rate MdMd MSMS M’ S Figure 17-8

53 MdMd Choosing a Monetary Policy Target Quantity of Money Interest Rate MSMS M’ S rere AD If the Fed selects r e, it must accept M s If the Fed selects M’ s, it must allow the interest rate to fall Figure 17-8 r1r1 CB

54 Target interest rates  The money supply will be unstable Target the money supply  The interest rate will be unstable Fed Target Choice: Interest Rates or Money Supply?

55 Choosing a target  Interest rates When the demand for money is unstable  Money supply When variations in private spending occur Fed Target Choice: Interest Rates or Money Supply?

56 The Way Fed Policy is Currently Announced No matter what the Fed is actually targeting, it only announces an interest rate target. The current strategy is outlined in the FOMC directive. This strategy is implemented through open market operations conducted by the Trading Desk of the New York Federal Reserve.

57 Issues and Applications: Maintaining Federal Reserve Targets The Trading Desk of the New York Federal Reserve Bank implements the Federal Open Market Committee directives. If a lowering of interest rates is called for, then the Fed will purchase bonds, pumping reserves into the banking system.

58 Issues and Applications: Maintaining Federal Reserve Targets The Fed sells bonds, drawing reserves from the banking system, when a contractionary measure in needed. The Fed does not set the federal funds rate explicitly, but it changes the level of reserves in depository institutions, and this influences the money supply.

59 Summary Discussion of Learning Objectives Key factors that influence the quantity of money that people desire to hold:  To make transactions  To hold for precautionary reasons  To hold as an asset (store of value)

60 Summary Discussion of Learning Objectives How the Federal Reserve’s monetary policy tools influence market interest rates  Open market purchases, reducing the discount rate, or reducing the required reserve ratio increases the money supply and lowers the interest rate.  Open market sales, raising the discount rate, or increasing the required reserve ratio decreases the money supply and raises the interest rate.

61 Summary Discussion of Learning Objectives How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run  Expansionary monetary policy Increase real GDP Decrease the price level  Contractionary monetary policy Decrease real GDP Decrease the price level

62 Summary Discussion of Learning Objectives The equation of exchange and the crude quantity theory of money and prices  Equation of exchange MV = PY  Crude quantity theory of money and prices V is constant and Y is Stable Increases in M cause proportionate increases in P

63 Summary Discussion of Learning Objectives Keynesian versus monetarist views on the transmission mechanism of monetary policy  Keynesian transmission mechanism Changes in interest rates cause changes in investment which change equilibrium real GDP  Monetarist transmission mechanism Changes in the money supply change desired spending

64 Summary Discussion of Learning Objectives Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously  To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes  To target the money supply the Fed must permit the interest rate to vary when the demand for money changes

Chapter 17: Dimensions of Monetary Policy ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.