1. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Chapter Fourteen Modern Macroeconomics and Monetary Policy

2. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Impact of Monetary Policy: A Brief Historical Background

3. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson What is Money? A brief historical background: The Keynesian view dominated during the 1950s and 1960s. Keynesians argued that money supply did not matter much. Monetarists challenged the Keynesian view during the 1960s and 1970s. Monetarists argued that changes in the money supply caused both inflation and economic instability. While minor disagreements remain, the modern view emerged from this debate. Modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy. The following slides present this modern view.

4. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Demand and Supply of money

5. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Demand for 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 to hold money instead of interest- earning assets like bonds. Money interest rate Money Demand Quantity of money

6. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Supply of Money The supply of money is vertical because it is established by the Fed and, hence, determined independently of the interest rate. Money interest rate Quantity of money Money Supply

7. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Demand and Supply of Money Equilibrium: The money interest rate gravitates toward the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the Fed has supplied. Money interest rate Quantity of money Money Supply Money Demand i3i3 ieie i2i2 Excess supply at i 2 Excess demand at i 3 At i e, people are willing to hold the money supply set by the Fed.

8. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson How Does Monetary Policy Affect the Economy?

9. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson 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 S 1 to S 2 in the market for money) provides banks with additional reserves. The Fed’s bond purchases and the bank’s use of new reserves to extend new loans increases the supply of loanable funds (shifting S 1 to S 2 in the loanable funds market) … D1D1 Money interest rate S1S1 i1i1 QsQs i2i2 QbQb S2S2 Quantity of money D S1S1 r1r1 Q1Q1 r2r2 Q2Q2 S2S2 Real interest rate Qty of loanable funds and puts downward pressure on real interest rates (a reduction to r 2 ). Money Balances Loanable Funds

10. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Transmission of Monetary Policy As the real interest rate falls, AD increases (to AD 2 ). As the monetary expansion was unanticipated, the expansion in AD leads to a short-run increase in output (from Y 1 to Y 2 ) and an increase in the price level (from P 1 to P 2 ) – inflation. The impact of a shift in monetary policy is transmitted through interest rates, exchange rates, and asset prices. D S1S1 r1r1 Q1Q1 r2r2 Q2Q2 S2S2 Real interest rate Qty of loanable funds Loanable Funds Price Level Goods & Services (real GDP) P1P1 Y1Y1 Y2Y2 AS 1 AD 1 P2P2 AD 2

11. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Here, a shift to an expansionary monetary policy is shown. The Fed buys bonds (expanding the money supply) … which increases bank reserves … Transmission of Monetary Policy pushing real interest rates down … leading to increased investment and consumption … a depreciation of the dollar … (increased net exports) and … an increase in the general level of asset prices … (and with the increased personal wealth) increased investment & consumption. So, an unanticipated shift to a more expansionary monetary policy will stimulate AD and, thereby, increase both output and employment. Fed buys bonds Real interest rates fall Increases in investment & consumption Depreciation of the dollar Increase in asset prices Increases in investment & consumption Net exports rise Increase in aggregate demand This increases money supply and bank reserves

12. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Expansionary Monetary Policy If expansionary monetary policy leads to an in increase in AD when the economy is below capacity, the policy will help direct the economy toward LR full-employment output (Y F ). Here, the increase in output from Y 1 to Y F will be long term. AD 1 Price Level LRAS Y F Y1Y1 AD 2 Goods & Services (real GDP) P2P2 SRAS 1 P1P1 E2E2 e1e1

13. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson AD Increase Disrupts Equilibrium Alternatively, if demand-stimulus effects occur when economy is already at full-employment Y F, they will lead to excess demand, higher product prices, and temporarily higher output (Y 2 ). Price Level Goods & Services (real GDP) AD 1 LRAS YFYF P2P2 P1P1 SRAS 1 E1E1 Y2Y2 AD 2 e2e2

14. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson AD Increase: Long Run In the long-run, strong demand pushes up resource prices, shifting short run aggregate supply (from SRAS 1 to SRAS 2 ). The price level rises (from P 2 to P 3 ) and output recedes to full-employment output again (Y F from its temp high,Y 2 ). Price Level Goods & Services (real GDP) AD 1 LRAS YFYF P2P2 P1P1 SRAS 1 Y2Y2 AD 2 e2e2 Y F P3P3 SRAS 2 E3E3 E1E1

15. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson A Shift to More Restrictive Monetary Policy Suppose the Fed shifts to a more restrictive monetary policy. Typically it will do so by selling bonds which will: depress bond prices and drain reserves from the banking system, which places upward pressure on real interest rates. As a result, an unanticipated shift to a more restrictive monetary policy reduces aggregate demand and thereby decreases both output and employment.

16. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Short-run Effects of More Restrictive Monetary Policy A shift to a more restrictive monetary policy, will increase real interest rates. Higher interest rates decrease aggregate demand (to AD 2 ). When the change in AD is unanticipated, real output will decline (to Y 2 ) and downward pressure on prices will result. D r2r2 Q2Q2 r1r1 Q1Q1 S1S1 S2S2 Real interest rate Qty of loanable funds Price Level Goods & Services (real GDP) P2P2 Y2Y2 Y1Y1 AS 1 P1P1 AD 1 AD 2

17. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Restrictive Monetary Policy The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its impact. Restrictive monetary policy will reduce aggregate demand. If the demand restraint occurs during a period of strong demand and an overheated economy, then it may limit or prevent an inflationary boom. Price Level Goods & Services (real GDP) LRAS Y F P1P1 P2P2 SRAS 1 AD 1 e1e1 Y1Y1 AD 2 E2E2

18. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson AD Decrease Disrupts Equilibrium In contrast, if the reduction in aggregate demand takes place when the economy is at full- employment, then it will disrupt long-run equilibrium, and result in a recession. Price Level Goods & Services (real GDP) AD 1 LRAS YFYF Y2Y2 AD 2 P1P1 SRAS 1 P2P2 E1E1 e2e2

19. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Shifts in monetary policy and economic stability If a change in monetary policy is timed poorly, it can be a source of instability. It can cause either recession or inflation. Proper timing of monetary policy: If expansionary effects occur during a recession and restrictive effects during an inflationary boom, the impact would be stabilizing. However, if expansionary effects occur when an economy is already at or beyond full employment and restrictive effects occur when an economy is in a recession, the impact would be destabilizing.

20. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Monetary Policy in the Long Run

21. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson GDP = The Quantity Theory of Money The AD-AS model illustrates that nominal GDP is the product of the price (P) and output (Y) of each final-product good purchased during the period. GDP can also be visualized as the money stock (M) times the number of times it is used to buy those final goods & services (V). If V and Y are constant, then an increase in M will lead to a proportional increase in P. MVPY M oney V elocity P rice Y = Income xx =

22. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Long-run Impact of Monetary Policy -- The modern View Long-run implications of expansionary policy: When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and real output will return to long-run normal levels. Thus, in the long run, money supply growth will lead primarily to higher prices (inflation) just as the quantity theory of money implies.

23. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Long-run Effects of a Rapid Expansion in Money Supply Here we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3% to 8%. Initially, prices are stable (P 100 ) when the money supply is expanding by 3% annually. The acceleration in the growth rate of the money supply increases aggregate demand (shift to AD 2 ). Time periods Money supply growth rate (%) 3 1 6 9 23 4 (a) Growth rate of the money supply. 3% growth 8% growth Price level (ratio scale) Real GDP AD 1 LRAS YFYF SRAS 1 (b) Impact in the goods & services market. AD 2 P 100 E1 E1

24. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Long-run Effects of a Rapid Expansion in Money Supply At first, real output may expand beyond the economy’s potential Y F … Time periods Money supply growth rate (%) 3 1 6 9 23 4 (a) Growth rate of the money supply. 3% growth 8% growth Price level (ratio scale) Real GDP AD 1 LRAS YFYF SRAS 1 (b) Impact in the goods & services market. AD 2 P 100 E1 E1 SRAS 2 E2 E2 P 105 however low unemployment and strong demand create upward pressure on wages and other resource prices, shifting SRAS 1 to SRAS 2. Output returns to its long-run potential Y F, & price level increases to P 105 (E 2 ). Y1Y1

25. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Long-run Effects of a Rapid Expansion in Money Supply If the more rapid monetary growth continues, then AD and SRAS will continue to shift upward, leading to still higher prices (E 3 and points beyond). Time periods Money supply growth rate (%) 3 1 6 9 23 4 (a) Growth rate of the money supply. 3% growth 8% growth Price level (ratio scale) Real GDP AD 1 LRAS YFYF SRAS 1 (b) Impact in the goods & services market. AD 2 P 100 E1 E1 SRAS 2 E2 E2 P 105 The net result of this process is sustained inflation. AD 3 P 110 SRAS 3 E3 E3

26. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Expansionary Monetary Policy With stable prices, supply and demand in the loanable funds market are in balance at a real & nominal interest rate of 4%. If rapid monetary expansion leads to a long-term 5% inflation rate, borrowers and lenders will build the higher inflation rate into their decision making. As a result, the nominal interest rate i will rise to 9%. Quantity of loanable funds Q S1S1 Loanable Funds Market Interest rate r.04 D 1 S2S2 (expected rate of inflation = 5 %) (expected rate of inflation = 0 %) D 2 (expected rate of inflation = 5 %) (expected rate of inflation = 0 %) i.09 Recall: the nominal interest rate is the real rate plus the inflationary premium.

27. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Money and Inflation The impact of monetary policy differs between the short-run and the long-run. In the short run, shifts in monetary policy will affect real output and employment. A shift toward monetary expansion will temporarily increase output, while a shift toward monetary restriction will reduce output. But in the long-run, monetary expansion will only lead to inflation. The long-run impact of monetary policy is consistent with the quantity theory of money.

28. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Money and Inflation – An International Comparison 1985 - 2005 The relationship between the avg. annual growth rate of the money supply and the rate of inflation is shown here for the 1985-2005 period. The relationship between the two is clear: higher rates of money growth lead to higher rates of inflation. Note: The money supply data are the actual growth rate of the money supply minus the growth rate of real GDP. Rate of money supply growth (%, log scale) Rate of inflation (%, log scale) 1001,000110 1 100 1000 Brazil Nicaragua Congo, DR Ghana Sierra Leone Venezuela Mexico Nigeria Chile Indonesia Hungary Columbia Paraguay India Switzerland Japan Central Africa Republic South Korea Belgium United States

29. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Time Lags, Monetary Shifts, and Economic Stability While the Fed can institute policy changes rapidly, there will be a time lag before the change exerts much impact on output and prices. This time lag is estimated to be 6 to 18 months in the case of output. In the case of the price level, the lag is estimated to be 12 to 30 months.

30. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Potential & Limitations of Monetary Policy

31. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Two important points about monetary policy Expansionary monetary policy cannot loosen the bonds of scarcity and therefore it cannot promote long-term economic growth. Rapid growth of the money supply will lead to inflation. Shifts in monetary policy will influence the general level of prices and real output only after time lags that are long and variable.

32. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Why Proper Timing of Monetary Policy Changes is Difficult The long and variable time lags between a monetary policy shift and their impact on the economy will make it difficult for policy-makers to institute changes in a manner that will promote economic stability. Given our limited forecasting ability, policy errors are likely. If monetary policy makers are constantly shifting back and forth, policy errors will occur. Thus, constant policy shifts are likely to generate instability rather than stability. Historically this has been the case.

33. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Key to Prosperity: Price Stability Monetary policy that provides approximate price stability (persistently low rates of inflation) is the key to sound stabilization policy. Modern living standards are the result of gains from trade, specialization, division of labor, and mass production processes. Price stability will facilitate the smooth operation of the pricing system and the realization of these gains. In contrast, high and variable rates of inflation create uncertainty, distort relative prices, and reduce the efficiency of markets.

34. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson What Causes the Ups and Downs of the Business Cycle: the Austrian View

35. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Austrian View of the Business Cycle The Austrian view provides a plausible explanation of the recent boom and bust in the housing market and accompanying recession. Austrian view of the business cycle: Expansionary monetary policy pushes the interest rate to an artificial low. The low interest rates will induce entrepreneurs to undertake long-term investments like houses, shopping malls, and office buildings. This will generate an economic boom. (continued on next slide)

36. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Austrian View of the Business Cycle Austrian view of the business cycle: (continued from previous page) But, the low interest rates reflect monetary policy rather than an increase in savings. Thus, the boom will be unsustainable because savings are too low to provide a future income that is large enough for the purchase of the newly created assets at prices that will cover their cost. The boom turns to bust and a large share of the newly constructed assets end up unoccupied. Austrian economists refer to this as malinvestment.

37. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson What Causes the Ups and Downs of the Business Cycle: Austrian View In many respects, the Austrian view appears to be descriptive of the recent business cycle. Low interest rate policies contributed to a housing boom, but future demand was inadequate to purchase the larger quantity of houses at profitable prices. As a result, an excess supply of housing led to price declines, unsold housing inventories, empty office buildings, rising default rates, and a prolonged recession.

38. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Recent Monetary Policy of the United States

39. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Three Key Indicators of monetary policy Monetary Policy indicators: short-term interest rates, the growth rate of the money supply, growth rate of the monetary base

40. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson U.S. Inflation Rate 1990-2011 The U.S. inflation rate from 1990 to 2004 ranged between 2% and 4%, but it moved above this range beginning in 2005. -8% -6% -4% -2% 0% 2% 4% 6% 8% 1990 19921994 1996 1998 20002002 2004 20062008 2010 2011 Inflation Rate

41. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson U.S. Monetary Base 1990-2011 The U.S. monetary base grew steadily between 1990 - 2007 but soared beginning in 2008. By 2011, the monetary base was three times its 2007 level. 0 500 1,000 2,000 2,500 3,000 1990 19921994 1996 1998 20002002 2004 20062008 2010 2011 The Monetary Base (billions of $)

42. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson The Fed Funds Rate: 1990-2011 Between 2002 and 2004 the fed pushed short-term interest rates to historic lows (less than 2%). As the inflation rate accelerated, the fed switched to more restrictive policy in 2005-2006, pushing short-term interest rates above 5%. As the economy slipped into a recession in 2008, the Fed again shifted to expansion, pushing interest rates to nearly 0%. 0% 2% 4% 6% 8% 10% 1990 19921994 1996 1998 20002002 2004 20062008 2010 2011 Federal Funds Interest Rate

43. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Annual Growth Rate of M2 : 1990-2011 The annual growth rate of the M2 money supply spiked above 10% in 2002-2003 and declined to less than 4% in 2005-2006. These shifts contributed to the housing boom and bust. In response to the recession of 2008-2009, M2 growth spiked up (again) to nearly 10%. 0% 2% 4% 6% 8% 10% 1990 19921994 1996 1998 20002002 2004 20062008 2010 2011 Annual Growth Rate of M2 12% Average Growth Rate

44. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Monetary policy, 1990-2011 In the 1990s: Monetary policy was relatively stable and kept inflation rate low. Between 2002-2004: Monetary policy pushed interest rates to historic lows and M2 grew rapidly. This expansionary monetary policy contributed to the 87% increase in housing prices between 2002 and mid-year 2006. Between 2005-2007: As the inflation rate rose in 2005, Fed shifted to a more restrictive monetary policy. M2 growth slowed and interest rates rose. This shift contributed to the housing price bust and the recession that followed.

45. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Monetary policy, 1990-2011 There were other causal factors of the 2008 crisis including: government regulations that eroded lending standards and promoted the purchase of housing with little or no down payment (that began in the latter half of the 1990s) heavily leveraged borrowing for the financing of mortgage- backed securities the rising world price of oil during 2007 a sharp decline in stock prices during 2008. But, monetary policy was a contributing factor.

46. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Fed Policy During and Following the 2008 Financial Crisis Fed response to 2008 financial crisis: Purchased assets and extended loans tripling the monetary base between 2008 and 2011. Short-term interest rates were pushed to near zero. Unfortunately, demand for investment was weak and therefore… expansion in credit was small, and, banks held huge excess reserves. As a result, M2 expanded much less than the monetary base.

47. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 14 th edition Gwartney-Stroup Sobel-Macpherson Impact of Stop-Go Monetary Policy Monetary policy has been on a stop-go path throughout most of the past decade. As both theory and past experience indicate, continuation of this policy is likely to increase economic instability in the years ahead. Given the long and variable lags, it is hard for monetary policy- makers to institute stop-go policy in a stabilizing manner.

48. Copyright ©2013 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page End of Chapter 14