Chapter 15 Monetary Policy © West Publishing Company 1996

EQUATION OF EXCHANGE l M V = P Q l M is the money supply l V is the velocity of money l P is the price level l Q is the real GDP

INFLATION l Inflation refers to an increase in the general price level. l One-shot inflation is a one-time increase in the price level. l Continued inflation is continuous increases in the price level (CPI rises each year)

CONTINUED INFLATION

l Continued inflation results from continued increases in AD. l What causes these continued increases in AD? l Usually continued increases in the Money Supply

COSTS OF INFLATION l Inflation is a “tax” on peoples moneyholdings. l Inflation lowers the real return on your savings. l Inflation redistributes purchasing power from lenders to borrowers.

COSTS OF INFLATION l Inflation can lead to social tension l Inflation creates greater uncertainty l Inflation leads people to divert money away from productive activities.

INTEREST RATES l REAL RATE - the rate of return banks must have to cover costs and provide a return to investors l NOMINAL RATE - real rate plus the expected rate of inflation

DEMAND FOR MONEY l The inverse relationship between the quantity of money balances and the interest rate l the interest rate is the opportunity cost of holding money

Demand for, and Supply of Money Exhibit 1 Interest Rate Quantity of Money M 2 0 Interest Rate Quantity of Money 0M 1 i 2 i 1 Demand for Money Supply of Money (a)(b)

Equilibrium in the Money Market Interest Rate Quantity of Money D 1 0 M 1 i 2 i 1 Excess Demand for Money S 1 Excess Supply of Money i 3 Equilibrium in the money market

BONDS AND INTEREST RATES l bonds have a face value l bonds pay a fixed interest payment each year (coupon pmt) l bond prices are determined by the relationship between current interest rates and the bond’s rate

BONDS AND INTEREST RATES l Bond Prices are inversely related to the current interest rate. l If current interest rates are higher than the bond’s rate then the bond will sell below face value l If interest rates fall, bond prices rise

APPROPRIATE POLICIES l What are the appropriate monetary policies to close a recessionary gap? –buy bonds –decrease discount rate –decrease reserve requirement

APPROPRIATE POLICIES l What are appropriate monetary policies to close an inflationary gap? –sell bonds –increase the discount rate –increase reserve requirements