1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 13 Monetary Policy in the Short Run

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Monetary Policy in the Short Run In the short run, when prices don’t have enough time to change, the Federal Reserve can influence the level of interest rates in the economy.In the short run, when prices don’t have enough time to change, the Federal Reserve can influence the level of interest rates in the economy. In the short run, interest rates are determined by the supply and demand for money. The Fed can change the interest rate level because it controls the supply of money.In the short run, interest rates are determined by the supply and demand for money. The Fed can change the interest rate level because it controls the supply of money.

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Monetary Policy in the Short Run To change the money supply, the Fed uses open market operations—buying and selling bonds in the open market.To change the money supply, the Fed uses open market operations—buying and selling bonds in the open market. Actions by the Fed to influence the level of GDP are known as monetary policy.Actions by the Fed to influence the level of GDP are known as monetary policy.

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Open market purchase Monetary Policy in the Short Run When the Fed lowers interest rates, investment spending and GDP increase.When the Fed lowers interest rates, investment spending and GDP increase. GDP increases Money supply increases Interest rates fall Investment spending increases However, there are limits to the extent to which the Fed can control the economy. In the long run, changes in the money supply affect only prices, not the level of output.However, there are limits to the extent to which the Fed can control the economy. In the long run, changes in the money supply affect only prices, not the level of output.

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Model of the Money Market The model of the money market combines the supply of money, determined by the Fed, with the demand for money, determined by the public, to see how interest rates are determined in the short run.The model of the money market combines the supply of money, determined by the Fed, with the demand for money, determined by the public, to see how interest rates are determined in the short run.

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand for Money Money is simply a part of your wealth. You can hold assets such as stocks or bonds, or you can hold wealth in the form of money.Money is simply a part of your wealth. You can hold assets such as stocks or bonds, or you can hold wealth in the form of money. Holding wealth in currency or checking deposits means that you sacrifice the potential income from interest and dividends earned on stocks and bonds.Holding wealth in currency or checking deposits means that you sacrifice the potential income from interest and dividends earned on stocks and bonds. So why hold money? Because it makes it easier to conduct transactions.So why hold money? Because it makes it easier to conduct transactions.

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand for Money The transactions demand for money is based on the desire to facilitate transactions.The transactions demand for money is based on the desire to facilitate transactions. The opportunity cost of holding money is the return that you could have earned by holding your wealth in other assets.The opportunity cost of holding money is the return that you could have earned by holding your wealth in other assets. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand for Money The market rate of interest is a measure of the opportunity cost of holding money.The market rate of interest is a measure of the opportunity cost of holding money. As interest rates increase, the opportunity cost of holding money increases, and the public will demand less money.As interest rates increase, the opportunity cost of holding money increases, and the public will demand less money.

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand for Money The liquidity demand for money is the demand for money that represents the needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs.The liquidity demand for money is the demand for money that represents the needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs. The speculative demand for money is the demand for money that reflects that holding money over short periods is less risky than holding stocks or bonds.The speculative demand for money is the demand for money that reflects that holding money over short periods is less risky than holding stocks or bonds. In practice, the demand for money is the sum of transactions, liquidity, and speculative demands.In practice, the demand for money is the sum of transactions, liquidity, and speculative demands.

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand for Money A decrease in real GDP An increase in real GDP A decrease in the price level An increase in the price level Factors That Decrease the Demand for Money Factors That Increase the Demand for Money

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand for Money

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rate Determination The supply of money is determined by the Fed, so we assume that it is independent of the interest rate.The supply of money is determined by the Fed, so we assume that it is independent of the interest rate. Combining the supply of money with the demand for money yields the equilibrium interest rate.Combining the supply of money with the demand for money yields the equilibrium interest rate.

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Money Market Equilibrium At the equilibrium interest rate, r 0, the quantity of money supplied equals the quantity demanded.At the equilibrium interest rate, r 0, the quantity of money supplied equals the quantity demanded. A higher interest rate yields an excess supply of money. The interest rate will tend to fall.A higher interest rate yields an excess supply of money. The interest rate will tend to fall. A lower interest rate causes an excess demand for money. The interest rate will tend to rise.A lower interest rate causes an excess demand for money. The interest rate will tend to rise.

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Federal Reserve and Interest Rates A decrease in the money supply leads to a higher interest rate.A decrease in the money supply leads to a higher interest rate. An increase in the money supply leads to a lower interest rate.An increase in the money supply leads to a lower interest rate.

15. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Bond Prices and Interest Rates Bonds are promises to pay money in the future. The price of a bond one year from now is the promised payment divided by 1 plus the interest rate.Bonds are promises to pay money in the future. The price of a bond one year from now is the promised payment divided by 1 plus the interest rate. For example, a bond that promises to pay $106 a year, with an interest rate is 6% per year, would cost today:For example, a bond that promises to pay $106 a year, with an interest rate is 6% per year, would cost today: In other words, if you can invest at 6% per year, you would be willing to pay $100 today for a $106 promised payment next year.In other words, if you can invest at 6% per year, you would be willing to pay $100 today for a $106 promised payment next year.

16. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates and Bond Prices Bond prices change in the opposite direction from changes in interest rates:Bond prices change in the opposite direction from changes in interest rates: When the interest rate falls from 6% to 4%, you have to pay $101.92 today to have $106 next year. And if the interest rate rose to 8%, for example, you would pay only $98.15.When the interest rate falls from 6% to 4%, you have to pay $101.92 today to have $106 next year. And if the interest rate rose to 8%, for example, you would pay only $98.15. Interest Rate Promised Payment $1066% Interest Rate Promised Payment $1064%

17. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates and Bond Prices When interest rates rise, investors need less money to obtain the same promised payments in the future, so the price of bonds falls.When interest rates rise, investors need less money to obtain the same promised payments in the future, so the price of bonds falls. An alternative explanation of the relationship between bond prices and interest rates deals with the supply and demand for bonds.An alternative explanation of the relationship between bond prices and interest rates deals with the supply and demand for bonds. When the Fed buys bonds, in order to lower interest rates, it is increasing the demand for bonds, thus the price of bonds tends to rise. When the Fed buys bonds, in order to lower interest rates, it is increasing the demand for bonds, thus the price of bonds tends to rise. An open market sale increases the supply of bonds, causing bond prices to fall and interest rates to rise.An open market sale increases the supply of bonds, causing bond prices to fall and interest rates to rise.

18. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Why Is Good News for the Economy Bad News for the Bond Market? An increase in real GDP causes the demand for money to rise, putting upward pressure on interest rates. Consequently, bond prices will fall.An increase in real GDP causes the demand for money to rise, putting upward pressure on interest rates. Consequently, bond prices will fall. Also, higher GDP growth leads to higher expectations of inflation which tend to push up nominal interest rates, leading to lower bond prices.Also, higher GDP growth leads to higher expectations of inflation which tend to push up nominal interest rates, leading to lower bond prices. Stock prices can also fall despite good economic news. As bond prices fall, bonds become more attractive than stocks, resulting in lower demand for stocks, and lower stock prices.Stock prices can also fall despite good economic news. As bond prices fall, bonds become more attractive than stocks, resulting in lower demand for stocks, and lower stock prices.

19. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates, Investment, and Output The supply and demand for money determine the interest rate, which is consistent with particular levels of investment and output in the economy.The supply and demand for money determine the interest rate, which is consistent with particular levels of investment and output in the economy.

20. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates, Investment, and Output GDP increases Open market purchase Money supply increases Interest rates fall Investment spending rises

21. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Monetary Policy Monetary policy is the range of actions taken by the Federal Reserve to influence the level of GDP or the rate of inflation.Monetary policy is the range of actions taken by the Federal Reserve to influence the level of GDP or the rate of inflation.

22. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Exchange Rate International trade and movements of financial funds across countries are affected by interest rates and exchange rates.International trade and movements of financial funds across countries are affected by interest rates and exchange rates. The exchange rate is the rate at which one currency trades for another in the market.The exchange rate is the rate at which one currency trades for another in the market. Supply and demand for a currency determine the exchange rate.Supply and demand for a currency determine the exchange rate.

23. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Exchange Rate A decrease in the value of a currency is called depreciation, while an increase in the exchange rate is called appreciation.A decrease in the value of a currency is called depreciation, while an increase in the exchange rate is called appreciation.

24. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates and Exchange Rates There is a direct relationship between a country’s interest rates and its exchange rate.There is a direct relationship between a country’s interest rates and its exchange rate. Higher interest rates in the United States cause an increase in the demand for dollars. A higher demand for dollars leads to a higher exchange rate of the dollar against foreign currencies. The dollar appreciates. Higher interest rates in the United States cause an increase in the demand for dollars. A higher demand for dollars leads to a higher exchange rate of the dollar against foreign currencies. The dollar appreciates.

25. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Interest Rates and Exchange Rates There is a direct relationship between a country’s interest rates and its exchange rate:There is a direct relationship between a country’s interest rates and its exchange rate: Lower U.S. interest rates induce investors to sell their dollars and buy the foreign currency of a more attractive country in which to invest. A higher supply of dollars leads to dollar depreciation. Lower U.S. interest rates induce investors to sell their dollars and buy the foreign currency of a more attractive country in which to invest. A higher supply of dollars leads to dollar depreciation.

26. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Exchange Rates and Net Exports There is an inverse relationship between a country’s net exports and its exchange rate:There is an inverse relationship between a country’s net exports and its exchange rate: As the dollar appreciates, U.S. goods become more expensive on world markets. U.S. exports decline. A higher value of the dollar also makes it cheaper for U.S. residents to buy foreign goods. U.S. imports rise. Lower exports combined with higher imports result in a decrease in net exports. As the dollar appreciates, U.S. goods become more expensive on world markets. U.S. exports decline. A higher value of the dollar also makes it cheaper for U.S. residents to buy foreign goods. U.S. imports rise. Lower exports combined with higher imports result in a decrease in net exports.

27. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Exchange Rates and Net Exports There is an inverse relationship between a country’s net exports and its exchange rate:There is an inverse relationship between a country’s net exports and its exchange rate: Dollar depreciation leads to an increase in net exports. If the economy were in a recession, dollar depreciation could help increase GDP through higher net exports. Dollar depreciation leads to an increase in net exports. If the economy were in a recession, dollar depreciation could help increase GDP through higher net exports.

28. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Monetary Policy in an Open Economy Monetary policy is even more powerful in an open economy than in a closed economy. Take the case of a decision by the Fed to adopt expansionary monetary policy:Monetary policy is even more powerful in an open economy than in a closed economy. Take the case of a decision by the Fed to adopt expansionary monetary policy: Net exports increase Open market purchase Money supply increases Interest rates fall Exchange rate falls GDP increases

29. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Stabilization Policy and Its Limitations The government has two different types of tools to change the level of GDP in the short run:The government has two different types of tools to change the level of GDP in the short run: Fiscal policy: the use of government spending and taxation to influence the level of GDP. Fiscal policy: the use of government spending and taxation to influence the level of GDP. Monetary policy: changes in the money supply which lead to changes in interest rates and the level of GDP. Monetary policy: changes in the money supply which lead to changes in interest rates and the level of GDP.

30. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Stabilization Policy and Its Limitations Fiscal and monetary policies that are used to change the level of GDP can be:Fiscal and monetary policies that are used to change the level of GDP can be: Expansionary policies: policies such as tax cuts, increased government spending, or increased money supply that aim to increase the level of GDP. Expansionary policies: policies such as tax cuts, increased government spending, or increased money supply that aim to increase the level of GDP. Contractionary policies: policies that aim to decrease the level of GDP back to full employment, or potential output. Contractionary policies: policies that aim to decrease the level of GDP back to full employment, or potential output.

31. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Stabilization Policy and Its Limitations Stabilization policies are intended to move the economy closer to full employment or potential output. In practice, however, it is very difficult to accomplish this goal for two reasons:Stabilization policies are intended to move the economy closer to full employment or potential output. In practice, however, it is very difficult to accomplish this goal for two reasons: Lags: delays in stabilization policy caused by failure to recognize a problem and respond in a timely manner to changes in the economy. Lags: delays in stabilization policy caused by failure to recognize a problem and respond in a timely manner to changes in the economy. Insufficient knowledge: economists do not know enough about the economy to be accurate in all their forecasts. Insufficient knowledge: economists do not know enough about the economy to be accurate in all their forecasts.

32. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Problems Caused by Lags Successful stabilization policies can reduce the magnitude of economic fluctuations.Successful stabilization policies can reduce the magnitude of economic fluctuations. Ill-timed policies, on the other hand, can magnify economic fluctuations.Ill-timed policies, on the other hand, can magnify economic fluctuations.

33. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Inside Lags Inside lags are lags in implementing policy which occur for two reasons:Inside lags are lags in implementing policy which occur for two reasons: 1.It takes time to identify and recognize a problem. 2.It still takes time before any actions can be taken. This problem is most severe for fiscal policy in the United States because it is difficult to obtain a consensus for tax and spending changes in a timely manner.

34. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Outside Lags Outside lags refer to the time it takes for policy to work.Outside lags refer to the time it takes for policy to work. Econometric models are mathematical computer- based models that economists build to capture the actual dynamics of the economy.Econometric models are mathematical computer- based models that economists build to capture the actual dynamics of the economy. Econometric models have been used to estimate outside lags in monetary policy, which are longer than outside lags for fiscal policy (although fiscal policy has a much longer inside lag).Econometric models have been used to estimate outside lags in monetary policy, which are longer than outside lags for fiscal policy (although fiscal policy has a much longer inside lag).

35. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Forecasting Uncertainties Economists are not very accurate in forecasting what will happen in the economy.Economists are not very accurate in forecasting what will happen in the economy. For example, knowing whether a slowdown is temporary or permanent is a classical problem policymakers face when the economy appears to be slowing down.For example, knowing whether a slowdown is temporary or permanent is a classical problem policymakers face when the economy appears to be slowing down. Today, most policymakers understand these limitations and are cautious in using activist policies to smooth out economic fluctuations.Today, most policymakers understand these limitations and are cautious in using activist policies to smooth out economic fluctuations.