Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 17 Domestic and International Dimensions of Monetary Policy

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Effects of an Increase in The Money Supply What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter? People pick up the money and put it in their pockets, but how do they dispose of the new money?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Direct effect –Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Indirect effect –Not everybody will necessarily spend the newfound money on goods and services. –Some of the money gets deposited, so banks have higher reserves (and they lend the excess out).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Indirect effect –Banks lower rates to induce borrowing. Businesses engage in investment. Individuals consume durable goods (like housing and autos). –Increased loans generate an increase in aggregate demand. More people are involved in more spending (even those who didn’t get money from the helicopter!).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Graphing the Effects of an Expansionary Monetary Policy Assume the economy is operating at less than full employment –Expansionary monetary policy can close the recessionary gap. –Direct and indirect effects cause the aggregate demand curve to shift outward.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 17-1 Expansionary Monetary Policy with Underutilized Resources The recessionary gap is due to insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Effects of an Increase in The Money Supply (cont'd) Graphing the Effects of Contractionary Monetary Policy Assume there is an inflationary gap –Contractionary monetary policy can eliminate this inflationary gap. –Direct and indirect effects cause the aggregate demand curve to shift inward.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The inflationary gap is shown To decrease AD, use contractionary monetary policy AD decreases and real GDP decreases Figure 17-2 Contractionary Monetary Policy with Overutilized Resources

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Open Economy Transmission of Monetary Policy So far we have discussed monetary policy in a closed economy. When we move to an open economy, monetary policy becomes more complex.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Open Economy Transmission of Monetary Policy (cont'd) The net export effect of contractionary monetary policy Boosts the market interest rate Higher rates attract foreign investment International price of dollar rises Appreciation of dollar reduces net exports Negative net export effect

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Open Economy Transmission of Monetary Policy (cont'd) The net export effect of expansionary monetary policy Lower interest rates Financial capital flows out of the United States Demand for dollars will decrease International price of dollar goes down Foreign goods look more expensive in United States Net exports increase (imports fall)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Monetary Policy in Action: The Transmission Mechanism Recall we talked about the direct and indirect effects of monetary policy –Direct effect: implies increase in money supply causes people to have excess money balances. –Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 17-4 The Interest-Rate-Based Money Transmission Mechanism

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a and b) At lower rates, a larger quantity of money will be demanded The decrease in the interest rate stimulates investment

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c) The increase in investment shifts the AD curve to the right