1. Domestic and International Dimensions of Monetary Policy
Chapter 17
Domestic and International Dimensions of Monetary Policy

2. Introduction
It is up to the Federal Reserve Board of Governors to determine whether the pace of money supply growth will be aimed at maintaining a steady rate of inflation. If so, then the interest rate will fluctuate. Why are these two variables related?

3. Learning Objectives
Identify the key factors that influence the quantity of money that people desire to hold
Describe how the Federal Reserve’s tools of monetary policy affect the level of real GDP and the price level
Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run

4. Learning Objectives
Understand the equation of exchange and its importance in the crude quantity theory of money and prices
Distinguish between the Keynesian and monetarist views on the transmission mechanism of monetary policy
Explain why the Federal Reserve cannot stabilize both the money supply and the interest rate simultaneously

5. Chapter Outline What’s So Special About Money?
The Tools of Monetary Policy
Effects of an Increase in the Money Supply
Open Economy Transmission of Monetary Policy

6. Chapter Outline Monetary Policy and Inflation
Monetary Policy in Action: The Transmission Mechanism
Fed Target Choice: Interest Rates or Money Supply?
The Way Fed Policy is Currently Announced

7. Did You Know That…
The European Central Bank oversees the EMU money supply, including transaction account balances held within the member nations?
The level of the money supply in an economy will affect the position of the aggregate demand curve?

8. What’s So Special About Money?
Money is the product of a “social contract” in which we all agree to:
Express all prices in terms of a common unit of account, which in the United States we call the dollar
Use a specific medium of exchange for market transactions

9. What’s So Special About Money?
Anything that affects the amount of money in existence is going to affect all markets.
Holding money
To use money, one must hold money.
If people desire to hold money, there is a demand for money.

10. What’s So Special About Money?
The demand for money: the amount of money people wish to hold
Transactions demand
Precautionary demand
Asset demand

11. What’s So Special About Money?
Transactions Demand
Holding money as a medium of exchange to make payments
The level varies directly with nominal national income

12. What’s So Special About Money?
Precautionary Demand
Holding money to meet unplanned expenditures and emergencies
The level varies with the interest rate

13. What’s So Special About Money?
Asset Demand
Holding money as a store of value instead of other assets
The level varies with the interest rate

14. What’s So Special About Money?
The demand for money curve
The amount of money demanded for transactions purposes is fixed given the level of income
Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate)

15. The Demand for Money CurveMd
Interest Rate
Quantity of Money
Figure 17-1

16. The Demand for Money Curve
• When the interest rate rises the opportunity cost of holding money increases and the quantity of money demanded falls
• The location of Md is determined by the level of income Md B r2 Q1
Interest Rate A r1 Q2
Quantity of Money

17. The Tools of Monetary Policy
Open market operations
The Fed changes reserves by buying and selling government bonds issued by the U.S. Treasury.

18. Determining the Price of Bonds
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall P1
Price of Bonds
Quantity of Bonds per Unit Time Period
Figure 17-2, Panel (a)

19. Determining the Price of Bonds
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall P1 P2
Price of Bonds
Quantity of Bonds per Unit Time Period
Figure 17-2, Panel (a)

20. Determining the Price of Bonds
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
Price of Bonds P1
Quantity of Bonds per Unit Time Period
Figure 17-2, Panel (b)

21. Determining the Price of Bonds
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise P3
Price of Bonds P1
Quantity of Bonds per Unit Time Period
Figure 17-2, Panel (b)

22. The Tools of Monetary Policy
Relationship between the price of existing bonds and the rate of interest
What happens to the interest on a bond when the price of a bond increases (decreases)?

23. The Tools of Monetary Policy
Example
You pay $1,000 for a bond that pays $50/year in interest
Rate of interest =
$50
$1000
= 5%

24. The Tools of Monetary Policy
Example
Now suppose you pay $500 for the same bond
Rate of interest =
$50
$500
= 10%

25. The Tools of Monetary Policy
The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.

26. The Tools of Monetary Policy
Changes in the discount rate
Increasing the discount rate increases the cost of borrowed funds for depository institutions that borrow reserves
Decreasing the discount rate decreases the cost of borrowed funds for depository institutions that borrow reserves

27. The Tools of Monetary Policy
Changes in the discount rate
Why is the discount rate a less important monetary tool today that in the 1920s?
Since 2002, the Fed has kept the discount rate 1 percentage point above the market-determined federal funds rate.

28. The Tools of Monetary Policy
Changing the discount rate relative to the federal funds rate
The Fed has been keeping the discount rate one percentage point above the federal funds rate.
This discourages borrowing from the Fed.

29. The Tools of Monetary Policy
Changes in the reserve requirements
An increase in the required reserve ratio
Makes it more expensive for banks to meet reserve requirements
Reduces bank lending
A decrease in the required reserve ratio
Makes it less expensive for banks to meet reserve requirements
Increases bank lending

30. Effects of an Increase in the Money Supply
When the money supply increases, people have too much money.
How can this be?
Have you ever had too much money?
If you have a savings account, then at some point you had too much money.
Money is not the same thing as income.

31. International Example: Controlling Growth of the Money Supply
In Zimbabwe, government officials tried to stem an inflationary growth of the money supply by no longer printing the highest denomination currency note.
But this did not reduce the demand for money, as citizens simply chose to hold more lower denomination notes.

32. Monetary Policy During Periods of Underutilized Resources
Monetary policy can generate increases in the equilibrium level of real GDP.

33. Expansionary Monetary Policy with Underutilized Resources
12.0
LRAS
SRAS
• The contractionary gap is
caused by insufficient AD
• To increase AD, use expansionary monetary policy
• AD increases and real GDP increases to full employment
AD1
Price Level
11.5
120 E1
Recessionary gap
Real GDP per Year ($ trillions)
Figure 17-3

34. Expansionary Monetary Policy with Underutilized Resources
12.0
LRAS
SRAS
AD2
• The contractionary gap is
caused by insufficient AD
• To increase AD, use expansionary monetary policy
• AD increases and real GDP increases to full employment
125 E2
AD1
Price Level
11.5
120 E1
Recessionary gap
Real GDP per Year ($ trillions)
Figure 17-3

35. Tools of Monetary Policy
Contractionary monetary policy: effects on aggregate demand, the price level, and real GDP
Question
What will happen?

36. Contractionary Monetary Policy via Open Market Operations
Figure 17-4

37. Open Economy Transmission of Monetary Policy
The net export effect
Impact of expansionary monetary policy
increase the money supply
interest rates fall
value of the dollar falls
net exports increase
the net export effect complements the effectiveness of monetary policy

38. Open Economy Transmission of Monetary Policy
The net export effect
Impact of expansionary fiscal policy revisited
larger deficit
higher interest rates
attracts foreign capital
value of the dollar appreciates
net exports fall
net export effect reduces the effectiveness of fiscal policy

39. International Policy Example: The Effect of the Exchange Rate on Net Exports
In 2003, nominal interest rates in Switzerland were close to zero, as an expansionary monetary policy had been employed to combat a recession.
The expansionary policy served also to depreciate the Swiss franc, which stimulated net exports.
It was this open economy effect that accounted for the eventual increase in aggregate demand, ending the recession.

40. Open Economy Transmission of Monetary Policy
Globalization of international money markets
How will global money markets impact the Fed's ability to control the rate of growth in the money supply?

41. Monetary Policy and Inflation
Short-run inflation
Temporarily shocks the SRAS and AD
Long-run inflation
The supply of money expands relative to the demand for money
Takes more units of money to purchase given quantities of goods and services (i.e., the price level has risen)

42. Monetary Policy and Inflation
The Equation of Exchange
The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times output (or nominal national income)
MsV = PY

43. Monetary Policy and Inflation
The equation of exchange and the quantity theory: MSV = PY
MS = actual money balances held by non-banking public
V = income velocity of money; the number of times, on average, cash monetary units are spent on final goods and services

44. Monetary Policy and Inflation
The equation of exchange and the quantity theory: MSV = PY
P = price level
Y = real national output per year

45. Monetary Policy and Inflation
The equation of exchange as an identity
MsV = PY
PY = nominal national income
MsV = nominal national spending

46. Monetary Policy and Inflation
The crude quantity theory of money and prices
Assume: V is constant
Q is stable
MsV = PY

47. Monetary Policy and Inflation
The crude quantity theory of money and prices
Increases in Ms must be matched by equal increases in the price level
MsV = PY

48. Adding Monetary Policy to the Keynesian ModelMS
M’S Md r1
Interest Rate
Quantity of Money
Figure 17-7, Panel (a)

49. Adding Monetary Policy to the Keynesian ModelMS
M’S
At lower rates, a larger quantity of money will be demanded Md r1
Interest Rate
Interest rate falls r2
Quantity of Money
Figure 17-7, Panel (a)

50. Adding Monetary Policy to the Keynesian Model
Interest Rate
Planned Investment
Figure 17-7, Panel (b)

51. Adding Monetary Policy to the Keynesian Model
The decrease in the interest rate stimulates investment I1
Interest Rate r2 I2
Planned Investment
Figure 17-7, Panel (b)

52. Adding Monetary Policy to the Keynesian Model
12.0
LRAS
SRAS
AD1
Price Level
11.5 E1
Real GDP per Year ($ trillions)
Figure 17-7, Panel (c)

53. Adding Monetary Policy to the Keynesian Model
12.0
LRAS
SRAS
AD2
AD1 E2
Price Level
11.5 E1
The increase in investment shifts the AD curve to the right
Real GDP per Year ($ trillions)
Figure 17-7, Panel (c)

54. Monetary Policy in Action: The Transmission Mechanism
The monetarist’s views of money supply changes
Macroeconomists who believe that inflation is always caused by excessive monetary growth and that changes in the money supply affect AD both directly and indirectly

55. Monetary Policy in Action: The Transmission Mechanism
The monetarist’s views of money supply changes
Increase in the money supply increases aggregate demand directly
Based on the equation of exchange, prices always rise when the money supply is increased

56. Monetary Policy in Action: The Transmission Mechanism
Monetarists’ criticism of monetary policy
Time lags are too long to use monetary policy effectively
Monetary policy is seen as a destabilizing force

57. Monetary Policy in Action: The Transmission Mechanism
Monetary Rule
A monetary policy that incorporates a rule specifying the annual rate of growth of some monetary aggregate
Example
Increase in the money supply smoothly at a rate consistent with the economy’s long-run average growth rate

58. Monetary Policy in Action: The Transmission Mechanism
What do you think?
What would happen to the effectiveness of the monetary rule if the velocity of money is not stable?

59. Fed Target Choice: Interest Rates or Money Supply?
It is not possible to stabilize the money supply and interest rate simultaneously.

60. Choosing a Monetary Policy TargetMS
M’S Md
Interest Rate
Quantity of Money
Figure 17-8

61. Choosing a Monetary Policy TargetMS
M’S Md
If the Fed selects re, it must accept Ms re A D
If the Fed selects M’s, it must allow the interest rate to fall
Interest Rate r1 C B
Quantity of Money
Figure 17-8

62. Fed Target Choice: Interest Rates or Money Supply?
Target interest rates
The money supply will be unstable
Target the money supply
The interest rate will be unstable

63. Fed Target Choice: Interest Rates or Money Supply?
Choosing a target
Interest rates
When the demand for money is unstable
Money supply
When variations in private spending occur

64. The Way Fed Policy is Currently Announced
No matter what the Fed is actually targeting, it only announces an interest rate target.
The current strategy is outlined in the FOMC directive.
This strategy is implemented through open market operations conducted by the Trading Desk of the New York Federal Reserve.

65. Issues and Applications: Maintaining Federal Reserve Targets
The Trading Desk of the New York Federal Reserve Bank implements the Federal Open Market Committee directives.
If a lowering of interest rates is called for, then the Fed will purchase bonds, pumping reserves into the banking system.

66. Issues and Applications: Maintaining Federal Reserve Targets
The Fed sells bonds, drawing reserves from the banking system, when a contractionary measure in needed.
The Fed does not set the federal funds rate explicitly, but it changes the level of reserves in depository institutions, and this influences the money supply.

67. Summary Discussion of Learning Objectives
Key factors that influence the quantity of money that people desire to hold:
To make transactions
To hold for precautionary reasons
To hold as an asset (store of value)

68. Summary Discussion of Learning Objectives
How the Federal Reserve’s monetary policy tools influence market interest rates
Open market purchases, reducing the discount rate, or reducing the required reserve ratio increases the money supply and lowers the interest rate.
Open market sales, raising the discount rate, or increasing the required reserve ratio decreases the money supply and raises the interest rate.

69. Summary Discussion of Learning Objectives
How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run
Expansionary monetary policy
Increase real GDP
Decrease the price level
Contractionary monetary policy
Decrease real GDP

70. Summary Discussion of Learning Objectives
The equation of exchange and the crude quantity theory of money and prices
Equation of exchange
MV = PY
Crude quantity theory of money and prices
V is constant and Y is Stable
Increases in M cause proportionate increases in P

71. Summary Discussion of Learning Objectives
Keynesian versus monetarist views on the transmission mechanism of monetary policy
Keynesian transmission mechanism
Changes in interest rates cause changes in investment which change equilibrium real GDP
Monetarist transmission mechanism
Changes in the money supply change desired spending

72. Summary Discussion of Learning Objectives
Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously
To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes
To target the money supply the Fed must permit the interest rate to vary when the demand for money changes

73. Domestic and International Dimensions of Monetary Policy
End of Chapter 17
Domestic and International Dimensions of Monetary Policy