Modern Macroeconomics and Monetary Policy Chapter 14

The Demand for Money Money Demand Money interest rate Money Demand Quantity of money The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly (recall OPPORTUNITY COST) to hold money.

The Supply of Money Money interest rate Money Supply Quantity of money The supply of money is vertical because it is established by the Fed. It’s EXOGENOUS in the model.

Three Tools of Monetary Policy Open Market Operations Discount rate Reserve requirements

Transmission of Monetary Policy When the Fed shifts to a more expansionary monetary policy, it usually buys additional bonds, expanding the money supply. This increase in the money supply (shift from S1 to S2 in the market for money) provides banks with additional reserves. Money interest rate Real interest rate S1 S1 S2 S2 i1 r1 i2 r2 D1 D Qty of loanable funds Quantity of money Qs Qb Q1 Q2

Transmission of Monetary Policy Real interest rate S1 Price Level AD2 AS1 S2 r1 P2 P1 r2 D AD1 Qty of loanable funds Goods & Services (real GDP) Q1 Q2 Y1 Y2

Transmission of Monetary Policy Unanticipated Expansionary Monetary Policy Increases in investment & consumption This increases money supply and bank reserves Real interest rates fall Fed buys bonds Increase in aggregate demand Depreciation of the dollar Net exports rise Increase in asset prices Increases in investment & consumption Transmission of Monetary Policy

Proper Timing If a change in monetary policy is timed poorly, it can be a source of economic instability. Proper timing of monetary policy is not easy: While the Fed can institute policy changes rapidly, there may be a time lag before the change exerts much impact on output & prices. This time lag may be 6 to 18 months in the case of output, and even longer, perhaps as much as 36 months, before there is a significant impact on the price level.

What’s a “rate cut”? Fed's Hints Of a Rate Cut Cheer Markets By SUDEEP REDDY November 29, 2007; Page A1 The Federal Reserve, faced with mounting signs of a slowing economy, opened the door to an interest-rate cut next month, cheering the nation's stock market, which staged its biggest two-day rally in five years. The latest signal from the central bank came in remarks by Donald Kohn, its vice chairman, which represented a Fed acknowledgment that the financial-market turmoil that started this summer remains a threat to the economy.

= M V P Y The Quantity Theory of Money x Money Y = Income Velocity Price Y = Income If V and Y are constant, then an increase in M will lead to a proportional increase in P.

Monetary Policy and Real GDP 16 % change in M2 money supply a 14 12 10 8 6 4 2 -2 % change in real GDP b 1960 1965 1970 1975 1980 1985 1990 1995 2000 2003 a Annual percent change in M2 b 4-quarter percent change in real GDP Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org. Monetary Policy and Real GDP

Inflation & the Money Interest Rate 16 Inflation rate, % a Interest rate (3-mos. T-bill) a 12 8 4 1960 1965 1970 1975 1980 1985 1990 1995 2000 2003 a annual rate of inflation calculated using the CPI Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org. The expectation of inflation . . . reduces the supply of, and, increases the demand for loanable funds, Note how the short-term money rate of interest has tended to increase when the inflation rate accelerates (and decline as the inflation rate falls).

Inflation & Money – An International Comparison 1980 - 2002 The relationship between the avg. annual growth rate of the money supply and the rate of inflation is shown here for the 1980-2002 period. 1000 Brazil 100 Argentina The relationship between the two is clear: higher rates of money growth lead to higher rates of inflation. Turkey Israel Rate of inflation (%, log scale) Zambia Uganda Ghana Poland Venezuela Ecuador Mexico Chile Italy Hungary Portugal South Africa Kenya Philippines Indonesia 10 Syria Pakistan India Sources: World Bank, World Development Indicators, 2004. Switzerland Belgium France Note: The money supply data are the actual growth rate of the money supply minus the growth rate of real GDP. Germany Japan U.S. Australia Canada Malaysia Thailand 1 1 10 100 1,000 Rate of money supply growth (%, log scale)