1. 3.4 Supply and Demand - Monetary Policy
Estelle Schmermer
HL Economics
Mr. Bollom

2. Definitions
Monetary Policy: changing the AD to increase GDP or lower inflation by changing the money supply and interest rates
Expansionary Monetary Policy: Expanding the supply of money and lowering the interest rate to increase AD and ultimately increase GDP
Contractionary Monetary Policy: Contracting the supply of money and increasing the interest rate to decrease AD and ultimately decrease inflation

3. Role of Central Bank Regulates money supply
Supply currency
Hold reserves of depository institutions reserves
Acts as government’s fiscal agent
Lender of last resort
Supervises member banks
Regulates money supply
Goal: Economic growth with stable prices, so greater output (GDP) and low, steady rate of inflation.

4. Situation: Economical Downturn
AD is below where it should be
Central bank uses power to change AD
Assumptions
When have more money in pockets, people will spend more
Interest rates affect consumption and investment

5. Why hold money? Transaction demand Precautionary demand
spend it on goods and services
Precautionary demand
keep it for emergencies/sudden transactions
Speculative demand
To deal with uncertainty of value of other assets, scared of declined value so hold money as safety
Don’t need to know this

6. What can the Central Bank do?
Can affect money and supply and interest rates by
Reserve requirements
Discount rate
Open market operations
Quantitative easing
Don’t need to know these in specific
Don’t need to know these in specific, just know that the central bank controls and uses money supply

7. Step 1: Change Interest Rate
How? By Central Bank increasing Money supply
Central bank increases money supply  interest rates fall

8. Step 2: Investment Spending Increases
Lower Interest Rates  Increase Investment Spending

9. Step 3:
Increased Investment brings AD up Y1 Y

10. Situation: Inflation Y1 Y

11. Decreasing AD
Lower Money Supply  Higher Interest Rates  Decrease Investment Spending

12. Decreasing AD Y Y1

13. Evaluation: Strengths
Almost no time lag effect
No “crowding out”
Less politics since almost all central banks are independent
Works very well for fighting inflation
Smaller action time lag
Act fast as meet almost every month

14. Also … Good Net Export Effect
Expansionary monetary policy
FED buys bonds
Interest rates go down, foreigners take $ out of US
Lower demand makes dollar worth less
Increases exports
That increases AD
Net export reinforces monetary policy

15. Evaluation: Weaknesses (Traditional Keynesian Counterattack)
Monetary policy still has recognition time lag
Increasing money supply and low interest don’t always make people spend more  panicked/unemployed people
During deflation, nominal interest rates cannot fall below zero
Inflation rate -2%, interest rate 0% = real interest rate 2%, why would you want to borrow if it causes real debt to increase over time?

16. Also … Bad Net Export Effect
When expand, government borrows money
Increases interest rates
Attracts foreign capital
Increased D for $ so prices increase
US good get more expensive
Reduces exports
Harms AD!
 Net export effect can counteract fiscal policy …

17. Monetarism ≠ Monetary Policy!
Monetarism argues that business cycle results from discretionary and monetary policies
Believe activist policies make business cycle worse and expansionary policy only leads to inflation

18. Monetarism – What to do? LRAS curve is vertical Focus on supply-side
microeconomic adjustments
Non-interventionists
Change money supply according to GDP growth, nothing else!
Guided by Fisher Rule M V = P Q