1. Monetary Policy Ch. 15 What’s the relationship between money supply, interest rates, and aggregate demand? How can the Fed use its control of the money supply or interest rates to alter macro outcomes? How effective is monetary policy compared to fiscal policy?

2. The Money Market Money is a commodity that is traded in a marketplace, the money market. The money supply is controlled by the Fed and society has a money demand. The market determines the “price” of money, the interest rate. At high interest rates, money is expensive to acquire. At low interest rates, money is cheap to acquire. Money supply (M1): currency held by the public, plus balances in transactions accounts. *Money supply (M2): M1 plus balances in savings accounts and money market mutual funds. Money demand: quantities of money the public wants to hold at alternative interest rates.

3. The Demand for Money Why would people want to hold money – that is, have a demand for money? Transactions demand: for the purpose of making everyday market purchases. Precautionary demand: for unexpected market transactions or for emergencies. *Speculative demand: to be able to take advantage of an investment opportunity in the near future.

4. Money demand: the quantity of money people are willing and able to hold (demand) increases as interest rates fall, and vice versa. Money supply: since the Fed controls the money supply, it is represented by a vertical line. The intersection of money demand and money supply (E 1 ) establishes the equilibrium rate of interest. If interest rates are higher than equilibrium, there is a money surplus. People must hold more money as M1 than they want to. They will move money out of M1 into M2 or other assets (such as bonds). The interest rate will then fall to E 1. If interest rates are lower than equilibrium, there is a money shortage. People must hold less money as M1 than they want to. They will move money into M1 from M2 or other assets (such as bonds). The interest rate will then rise to E 1. Money Market Equilibrium

5. Policy Constraints Short- vs. long-term rates. *The Fed has greater influence on short-term rates (that is, the Fed funds rate) than long-term rates (mortgages and installment loans). Monetary stimulus will be most effective if long-term interest rate changes mirror short-term rate changes. If not, the AD increase will be less than hoped for. *Reluctant lenders. Banks must be willing to increase lending activity. Banks may pile up excess reserves instead of making loans. They worry about their financial well-being. They worry about not being paid back by weak borrowers. They worry about how new bank regulations may affect profitability.

6. Policy Constraints *Liquidity trap. Lowering interest rates too far eliminates the opportunity cost of holding M1. The public simply hold the money instead of investing. This is the liquidity trap: People are willing to hold unlimited amounts of money at some low interest rate. Low expectations: In a recession, firms have little incentive to expand production capability. There would be little expectation of future profit, or return on investment (ROI), from new investment. Consumers may be reluctant to take on added debt when future income prospects are uncertain. Time lags: It takes time to develop and implement new investments in response to lower interest rates. Consumers also may take time to decide to increase their borrowing. It may take 6 to 12 months before market behavior responds to monetary policy.

7. The Monetarist Perspective (Challenged Keynesian Econ.) Milton Friedman’s political philosophy (conservative) celebrated the virtues of a free market economic system with minimal intervention. (advisor to Pres. Ronald Reagan and PM Margaret Thatcher)free market Keynesians (liberals) say that changes in the money supply changes in interest rates, which shift AD. Monetarists say that real output levels are not affected by monetary policy. Only the price level is affected by Fed policy … and then only by changes in the money supply. So they say monetary policy is not effective for fighting recession, but is a powerful tool for managing inflation.

8. The Equation of Exchange The equation of exchange is: In this equation, total spending is price (P) times quantity (Q). This spending is financed by the money supply (M) times the velocity of its circulation (V). Velocity (V): the number of times per year, on average, that a dollar is used to purchase final goods and services. PQ is the same as nominal GDP. The quantity of money (M) in circulation and the velocity (V) with which it exchanges hands will always be equal to the value of nominal GDP. Monetarist view: If M increases, P and/or Q must rise, or V must fall. *MV = PQ

9. The Equation of Exchange Monetarists assume V is stable – that is, does not change. V is a function of how people handle their money and the institutions they use to do so. Neither should change much in the short run. Thus, total spending (PQ) must rise if money supply (M) grows and velocity (V) is stable, regardless of interest rates. *MV = PQ

10. Money Supply Focus If spending increases when the money supply grows, then the Fed should focus on the money supply, not interest rates. Fed policy should not be to manipulate interest rates. Fed policy should focus on the size and growth of the money supply.

11. “Natural” Unemployment Monetarists also say that, in the short run: Q is stable; a function of productive capacity, labor efficiency, and other “structural” forces. This leads to a “natural” rate of unemployment that is fairly immune to short-run policy intervention. Natural rate of unemployment: the long-term rate of unemployment determined by structural forces. (Friedman’s theorized) If both V and Q are stable, any increase in M in the long-run only increases P. If prices rise, costs of production will rise also, so there is no profit incentive to increase Q. Any increase in AD directly increases the price level. MV = PQ

12. Monetarist Policy: Fighting Inflation With an inflationary gap, interest rates are likely to be high. A decrease in the money supply will lower nominal interest rates, not raise them. Nominal interest rate: the interest rate we actually see and pay. *Real interest rate: the nominal rate minus the anticipated inflation rate. As the money supply shrinks, the price level falls and anticipated inflation decreases, so nominal interest rates fall, not rise. To close an inflationary GDP gap using monetary policy, reduce the money supply and shift AD left. Monetarists advise steady and predictable changes in the money supply, to reduce uncertainty and thus stabilize both long-term interest rates and GDP growth.