{ Monetary Policy Explored Tools, application, inflation & unemployment

 Chapter 29 (previously completed)  Chapter 34 (focus on pages )  Chapter 30 (primarily pages )  Chapter 35 (primarily pages ) Overview

 Origins and Make-Up  1913  Board of Governors  System (DC + 12 Regional Banks)  Jobs  Regulate the banking industry (“easy”)  Control the money supply (“difficult”)  Tools  Open Market Operations  Reserve Requirements  Discount Rate  Federal Funds Rate (target, not control)  Impact of the Money Multiplier Fed Review

 Review:  Aggregate-demand curve slopes downward: 1. The wealth effect 2. The interest-rate effect 3. The exchange-rate effect  What changes interest rates? The Theory of Liquidity Preference  Interest rates adjust to balance the supply and demand for money. Monetary Policy Influences of AD Equilibrium in the Money Market Money supply- Controlled by the Federal Reserve (vertical) Money demand- Determined by the amount of money people wish to hold as a liquid asset

A monetary injection 5 Interest rate In panel (a), an increase in the money supply from MS 1 to MS 2 reduces the equilibrium interest rate from r 1 to r 2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level from Y 1 to Y 2. Thus, in panel (b), the aggregate-demand curve shifts to the right from AD 1 to AD 2. Quantity of money 0 (a) The Money Market Price level Quantity of output 0 (b) The Aggregate-Demand Curve Aggregate demand, AD 1 Money demand at price level P Money supply, MS 1 r1r1 Y1Y1 P 1. When the Fed increases the money supply... MS 2 r2r2 AD 2 Y2Y the equilibrium interest rate falls which increases the quantity of goods and services demanded at a given price level.

Quantity Theory of Money (M x V = P X Y) 1. Velocity of money is relatively stable over time 2. Changes in quantity of money (M) result in a proportionate changes in nominal value of output (P × Y) 3. Economy’s output of goods and services (Y)  Primarily determined by factor supplies and available production technology  Because money is neutral (doesn’t change real variables), money does not affect output 4. Change in money supply (M) induces proportional changes in the nominal value of output (P × Y) and these changes are reflected in the price level (P) 5. If the central bank - increases the money supply rapidly, the result is high inflation Chapter 30: Classical Theory of Inflation “Inflation is always and everywhere a monetary phenomenon.” Milton Friedman

An increase in the money supply 7 Quantity of Money 0 (high) (low) Value of Money, 1/P 1 ¾ ½ ¼ Price Level, P (high) (low) Money Demand M1M1 MS 1 A When the Fed increases the supply of money, the money supply curve shifts from MS 1 to MS 2. The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply and demand back into balance. The equilibrium moves from point A to point B. Thus, when an increase in the money supply makes dollars more plentiful, the price level increases, making each dollar less valuable. M2M2 MS 2 B 1. An increase in the money supply decreases the value of money and increases the price level.

Real interest rate = Nominal interest rate – Inflation rate Nominal interest rate = Real interest rate + Inflation rate  When the Fed increases the rate of money growth  Long-run result  Higher inflation rate  Higher nominal interest rate The Fisher Effect One-for-one adjustment of nominal interest rate to inflation rate

The nominal interest rate and the inflation rate 9 This figure uses annual data since 1960 to show the nominal interest rate on 3-month Treasury bills and the inflation rate as measured by the consumer price index. The close association between these two variables is evidence for the Fisher effect: When the inflation rate rises, so does the nominal interest rate

1. Shoe leather costs 2. Menu costs 3. Misallocation of resources 4. Tax distortions 5. Confusion/inconvenience 6. Arbitrary redistribution of wealth The Costs of Inflation

1. Quantity 2. Cost-Push 3. Demand-Pull Theories of Inflation

12 DEMAND-PULL INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 P3P3 AD 2 AS 2 c Occurs when AD shifts to the right

13 Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 AS 2 Occurs when short-run AS shifts left

14 Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 P3P3 AD 2 AS 2 Government response with increased AD c Even higher price levels

15 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 AS 2 If government allows a recession to occur Q2Q2

16 Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 AS 2 If government allows a recession to occur Nominal wages fall & AS returns to its original location

 The Phillips curve  Shows the short-run trade-off between inflation and unemployment  1958, economist A. W. Phillips  “The relationship between unemployment and the rate of change of money wages in the United Kingdom, 1861–1957”  Negative correlation between the rate of unemployment and the rate of inflation  1960, economists Paul Samuelson & Robert Solow  “Analytics of anti-inflation policy”  Negative correlation between the rate of unemployment and the rate of inflation  Policymakers: Monetary and fiscal policy  To influence aggregate demand  Choose any point on Phillips curve  Trade-off: High unemployment and low inflation or low unemployment and high inflation Chapter 35: Unemployment and Inflation

How the Phillips curve is related to the model of aggregate demand and aggregate supply 18 Price level This figure assumes price level of 100 for year 2020 and charts possible outcomes for the year Panel (a) shows the model of aggregate demand & aggregate supply. If AD is low, the economy is at point A; output is low (15,000), and the price level is low (102). If AD is high, the economy is at point B; output is high (16,000), and the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises when aggregate demand is low, has high unemployment (7%) and low inflation (2%). Point B, which arises when aggregate demand is high, has low unemployment (4%) and high inflation (6%). Quantity of output 0 (a) The Model of AD and AS Inflation Rate (percent per year) Unemployment Rate (percent) 0 (b) The Phillips Curve Phillips curve 6% Low aggregate demand Short-run aggregate supply High aggregate demand 2 15,000 unemployment =7% 102 A 106 B 16,000 unemployment =4% 7% output =15,000 A 4% output =16,000 B

Shifts in Phillips Curve: Role of Expectations  The long-run Phillips curve  Is vertical  Unemployment - does not depend on money growth and inflation in the long run  Expression of the classical idea of monetary neutrality  Increase in money supply  Aggregate-demand curve – shifts right  Price level – increases  Output – natural rate  Inflation rate – increases  Unemployment – natural rate 19

The long-run Phillips curve 20 Inflation Rate Unemployment Rate According to Friedman and Phelps, there is no trade-off between inflation and unemployment in the long run. Growth in the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical. Long-run Phillips curve Natural rate of unemployment High inflation B Low inflation A 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases but unemployment remains at its natural rate in the long run.

How the long-run Phillips curve is related to the model of aggregate demand and aggregate supply 21 Price level Panel (a) shows the model of AD and AS with a vertical aggregate-supply curve. When expansionary monetary policy shifts the AD curve to the right from AD 1 to AD 2, the equilibrium moves from point A to point B. The price level rises from P 1 to P 2, while output remains the same. Panel (b) shows the long-run Phillips curve, which is vertical at the natural rate of unemployment. In the long run, expansionary monetary policy moves the economy from lower inflation (point A) to higher inflation (point B) without changing the rate of unemployment Quantity of output 0 (a) The Model of AD and AS Inflation Rate Unemployment Rate 0 (b) The Phillips Curve Aggregate demand, AD 1 AD 2 Long-run aggregate supply Natural rate of output P1P1 A P2P2 B Long-run Phillips curve Natural rate of output B A 1. An increase in the money supply increases aggregate demand raises the price level and increases the inflation rate but leaves output and unemployment at their natural rates.