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Ch. 15: Monetary Policy Pt. II

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Impact of Monetary Policy u According to monetarists, changes in the money supply affects both inflation and economic output.

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n 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-earnings assets like bonds. M oney D emand M oney I nterest R ate Q uantity of M oney The Demand of Money:

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Determined by the Fed M oney I nterest R ate Q uantity of M oney M oney S upply n The supply of money is vertical because it is determined by the Fed. The Supply of Money:

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D S M oney S upply M oney I nterest R ate Q uantity of M oney M oney D emand i 3 i e i 2 Q s (Set by the Fed) Quantity of money E xcess S upply at i2i2 E xcess D emand at I3I3 At, people are willing to hold the money supply set by Fed i e The Demand and Supply of Money: Equilibrium: -- the point where the quantity of money people want to hold (the demand) is just equal to the stock of money the Fed has supplied (the supply).

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D1D1 M oney I nterest R ate Q uantity of M oney S1S1 D R eal I nterest R ate Q uantity of L oanable F unds S1S1 i 1 QsQs r 1 Q1Q1 n Expansionary monetary policy = FED buys bonds increasing the money supply. Monetary Policy of the Fed i 2 QbQb S2S2 r 2 Q2Q2 S2S2 n This increase in the money supply (shifting S 1 to S 2 in the market for money) will supply the banking system with additional reserves. n Both the Feds bond purchases and the banks use of the additional reserves to extend new loans will increase the supply of loanable funds (shifting S 1 to S 2 in the loanable funds market).

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n As the real rate of interest falls, investment increases, causing aggregate demand to increase (to AD 2 ). D R eal I nterest R ate Q uantity of L oanable F unds r 2 Q2Q2 S1S1 S2S2 P rice L evel G oods & S ervices (Real GDP) P 1 Y1Y1 Y2Y2 AS 1 AD 1 P 2 AD 2

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Expansionary Monetary Policy n During expansionary monetary policy the Fed may 1. buy bonds 2. reduce the discount rate 3. reduce the reserve requirements n The Fed generally buys bonds, which: n increases bond prices n creates additional bank reserves n places downward pressure on real interest rates

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Restrictive Monetary Policy n During restrictive monetary policy the Fed may 1. sell bonds 2. increase the discount rate 3. increase the reserve requirements n The Fed generally sells bonds, which: n depresses bond prices n drains bank reserves from the banking system n places upward pressure on real interest rates.

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D R eal I nterest R ate Q uantity of L oanable F unds r 1 Q1Q1 S1S1 P rice L evel G oods & S ervices (Real GDP) Y1Y1 AS 1 P 1 AD 1 n Restrictive policy = selling of bonds = reducing the reserves available to banks = decreases the supply of loanable funds = raises interest rates = lower investment = lowers AD = lowers GDP Short-run Effects of a Restrictive Monetary Policy P 2 Y2Y2 AD 2 r 2 S2S2 Q2Q2

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Proper Timing: n While the Fed can institute policy changes rapidly, there may be a substantial time lag before the change will exert a significant impact on AD.

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= * * Monetary Policy in the Long Run n The Quantity Theory of Money: nvelocity refers to how many times the average dollar is spent in a year n If V and Y are constant, than an increase in M would lead to a proportional increase in P. M V P Y M oney supply V elocity P rice Y = Income

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The Effects of Monetary Policy: n Persistent growth of the money supply at a rapid rate will cause inflation. n Interest rates can be a misleading indicator of monetary policy: u In the long run, expansionary monetary policy leads to inflation and high interest rates, rather than low interest rates. u Similarly, restrictive monetary policy, when pursued over a lengthy time period, leads to low inflation and low interest rates.

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Note that the growth rate of the money supply has been slower and more stable during the last decade. M2 Money supply Real GDP n Sharp declines in the growth rate of the money supply have generally preceded reductions in real GDP and recessions (indicated by shading). n Conversely, periods of sharp acceleration in the growth rate of the money supply have often been followed by a rapid growth of GDP. Monetary Policy and Real GDP

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A nnual R ate of I nflation (Percent) A nnual G rowth R ate of M oney S upply (Percent) 1960 1963 1965 1968 1970 1973 1975 1978 1980 1983 1985 1988 1990 1993 1995 1998 M2 P P 14 12 10 8 6 4 2 0 12 10 8 6 4 2 0 - 2 Source: Derived from computerized data supplied by FAME Economics. n The relationship between the rate of growth in the money supply and the annual inflation rate 3 years later. Effect of Changes in Money Supply on Inflation Money supply Inflation Rate (lagged 3 years)

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16 12 8 4 0 196019651970197519801985199019951998 P ercent Source: Derived from computerized data supplied by FAME Economics. Annual Rate of Inflation Interest Rate ( 3 month Treasury bills ) Inflation Rate and the Money Interest Rate

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