Presentation is loading. Please wait.

Presentation is loading. Please wait.

Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard.

Similar presentations


Presentation on theme: "Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard."— Presentation transcript:

1 Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard Stroup, and Russell Sobel Modern Macroeconomics – Monetary Policy Chapter 14

2 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Impact of Monetary Policy

3 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. u The Keynesian View dominated during the 1950s and 1960s. u Keynesians argued that the money supply did not matter much. u Monetarists challenged the Keynesian view during 1960s and 1970s. u According to monetarists, changes in the money supply caused of both inflation and economic instability. u 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. Impact of Monetary Policy n Evolution of Modern View:

4 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 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 and Supply of Money:

5 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 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 Demand and Supply of Money:

6 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 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: n Equilibrium: -- The money interest rate will gravitate toward the rate 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).

7 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 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 When the Fed shifts to a more expansionary monetary policy, it will generally buy additional bonds thereby expanding the money supply. Transmission of Monetary Policy 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)... and put downward pressure on the real rate of interest (reduction to r 2 ).

8 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n As the real rate of interest falls, aggregate demand increases (to AD 2 ). Transmission of Monetary Policy n Since the effects of the monetary expansion were unanticipated, the expansion in AD leads to a short-run increase in current output (from Y 1 to Y 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 and increase in prices (from P 1 to P 2 ) – inflation. n The path that monetary policy takes through the macroeconomic system is called the Transmission of Monetary Policy. n The impact of a shift in monetary policy is generally transmitted through interest rates, exchange rates, and asset prices.

9 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. A Shift to a More Expansionary Monetary Policy n During expansionary monetary policy the Fed may buy bonds, reduce the discount rate, or reduce the reserve requirements for deposits. n The Fed generally buys bonds, which: n increases bond prices, and, n creates additional bank reserves, while it, n places downward pressure on real interest rates. n As a result, an unanticipated shift to a more expansionary policy will stimulate aggregate demand and thereby increase both output and employment.

10 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. LRAS G oods & S ervices (real GDP) P rice level SRAS 1 P 1 Y 1 AD 1 e1e1 Y F P 2 Y F The Effects of Expansionary Monetary Policy n If the impact of an increase in aggregate demand accompanying expansionary monetary policy is felt when the economy is operating below capacity, the policy will help direct the economy back to a long-run full-employment output equilibrium (Y F ). AD 2 n In this case, the increase in output from Y 1 to Y F will be long term. E2E2

11 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS AD 1 P 1 Y F SRAS 1 Y F E1E1 The Effects of Expansionary Monetary Policy n In contrast, if the demand-stimulus effects are imposed on an economy already at full-employment (Y F ), they will lead to excess demand, higher product prices, and temporarily higher output (Y 2 ). n In the long-run, the strong demand will push up resource prices, shifting short run aggregate supply (from SRAS to SRAS 2 ). P 2 Y 2 P 3 n The price level rises to P 3 (from P 2 ) and output falls back to full-employment output once again (Y F from it temporary high,Y 2 ). AD 2 e2e2 SRAS 2 E2E2 Y F

12 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. A Shift to a More Restrictive Monetary Policy n During restrictive monetary policy the Fed may sell bonds, increase the discount rate, or increase the reserve requirements for deposits. n The Fed generally sells bonds, which: n depresses bond prices, and, n drains bank reserves from the banking system, while it, n places upward pressure on real interest rates. n As a result, an unanticipated shift to a more restrictive policy will reduce aggregate demand and thereby decrease both output and employment.

13 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 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 When the Fed shifts to a more restrictive policy, it sells bonds, reducing the reserves available to banks, decreasing the supply of loanable funds and placing upward pressure on interest rates. Short-run Effects of a More Restrictive Monetary Policy P 2 Y2Y2 AD 2 n The higher interest rates will decrease aggregate demand (shifting from AD 1 to AD 2 ). n When the reduction in aggregate demand is unanticipated, real output will decline (to Y 2 ) and downward pressure on prices will result. r 2 S2S2 Q2Q2

14 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS Y F SRAS P 1 AD 1 e1e1 Y 1 The Effects of Restrictive Monetary Policy n The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its primary impact. P 2 Y F n Restrictive monetary policy will reduce aggregate demand. n If the demand restraint comes during a period of strong demand and an overheated economy, then it will limit or even prevent the occurrence of an inflationary boom. AD 2 E2E2

15 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS Y F SRAS Y F P 1 AD 1 E1E1 The Effects of Expansionary Monetary Policy n 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. P 2 Y 2 AD 2 e2e2

16 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Proper Timing n Proper Timing: n The proper timing of monetary policy is not an easy task. 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.

17 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. What are the determinants of the demand for money? How is the supply of money determined? Questions for Thought: 2. If the Fed shifts to a more restrictive monetary policy, it will generally sell bonds in the open market. How will this action influence each of the following? (a) The reserves available to banks. (b) Real interest rates. (c) Household spending on consumer durables. (d) The exchange rate value of the dollar. (e) Net exports. (f) The prices of stocks and real assets like apartment or office buildings. (g) Real GDP.

18 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. Monetary Policy in the Long Run

19 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. = * * Monetary Policy in the Long Run n The Quantity Theory of Money: 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 V elocity P rice Y = Income

20 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Monetary Policy in the Long Run n The Long-Run Implications of Modern Analysis: u In the long run, the primary impact will be on prices rather than on real output. u When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. u As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.

21 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. P rice L evel (ratio scale) T ime P eriods A nnual G rowth R ate of the M oney S upply R eal GDP AD 1 LRAS Y F AS 1 e 1 P 100 (a) Growth rate of the money supply. (b) Impact in the goods and services market. n Here we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3 to 8 percent. The Long-run Effects of More Rapid Expansion in the Money Supply n Initially, prices are stable (P 100 ) when the money supply is expanding by 3% annually. n The acceleration in the growth rate of the money supply increases aggregate demand (shifting to AD 2 ). 3% growth AD 2 AS 2 n At first, real output may expand beyond the economys potential (Y F ), however low unemployment and strong demand create upward pressure on wages and other resource prices, shifting AS to AS 2. 8% growth

22 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. P rice L evel (ratio scale) P 100 T ime P eriods A nnual G rowth R ate of the M oney S upply R eal GDP AD 1 LRAS Y F AS 1 e 1 (a) Growth rate of the money supply. (b) Impact in the goods and services market. n Output returns to its long-run potential (Y F ), and the price level increases to P 105 (e 2 ). n If more rapid monetary growth continues in subsequent periods, AD and AS will continue to shift upward, leading to still higher prices (e 3 and points beyond). P 105 P 110 8% growth 3% growth AD 2 3 AS 2 3 e 3 e 2 n The net result of this process is sustained inflation. The Long-run Effects of More Rapid Expansion in the Money Supply

23 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. r.04 D 1 (expected rate of inflation = 0 %) S 1 (expected rate of inflation = 0 %) L oanable F unds I nterest R ate Q i.09 Q A higher expected rate of inflation increases the money interest rate. n When prices are stable, supply and demand in the loanable funds market are in balance at a real and nominal interest rate of 4%. n If more rapid monetary expansion leads to a long-term 5% inflation rate, borrowers and lenders will build the higher inflation rate into their decision making. n As a result, the nominal interest rate ( i ) will rise to 9% -- the 4% real rate plus the 5% inflationary premium. D 2 (expected rate of inflation = 5 %) S 2 (expected rate of inflation = 5 %) The Long-run Effects of More Rapid Expansion in the Money Supply

24 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. Monetary Policy When Effects Are Anticipated

25 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Monetary Policy When Effects Are Anticipated n When the effects of policy are anticipated prior to their occurrence, the short run impact of an increase in the money supply is similar to its impact in the long run. n Nominal prices and interest rates rise, but real output remains unchanged.

26 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level SRAS 1 AD 1 P 1 Y 1 1 E 2 Y 1 P 2 SRAS 2 2 E The Short-run Effects of An Anticipated Monetary Expansion n When decision makers fully anticipate the effects of a monetary expansion, the expansion does not alter real output even in the short-run. n Suppliers, including resource suppliers, build the expected price rise into their decisions. The anticipated inflation leads to a rise in nominal costs (including wages) causing aggregate supply to decline (shifts to SRAS 2 ). n While nominal wages, prices, and interests rates rise, their real counter- parts are unchanged – and so, inflation without any change in output.

27 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. Interest Rates and Monetary Policy

28 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Interest Rates and Monetary Policy n While the Fed can strongly influence short-term interest rates, its impact on long-term rates is much more limited. 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.

29 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. The Effects of Monetary Policy – A Summary

30 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Effects of Monetary Policy: -- A Summary n An unanticipated shift to a more expansionary (restrictive) monetary policy will temporarily stimulate (retard) output and employment. n The stabilizing effects of a change in monetary policy are dependent upon the state of the economy when the effects of the policy change are observed. n Persistent growth of the money supply at a rapid rate will cause inflation. n Money interest rates and the inflation rate will be directly related. n There will be only a loose year-to-year relationship between shifts in monetary policy and changes in output and prices.

31 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 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, such as those of , , , & , 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, such as & 1976, have often been followed by a rapid growth of GDP. Monetary Policy and Real GDP

32 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. A nnual R ate of I nflation (Percent) A nnual G rowth R ate of M oney S upply (Percent) M2 P P Source: Derived from computerized data supplied by FAME Economics. n Here we illustrate the relationship between the rate of growth in the money supply (M2) and the annual inflation rate 3 years later. n While the two are not perfectly correlated, the data do indicate that the periods of monetary acceleration (for example: & 75-76) tend to be associated with an increase in the inflation rate about 3 years later. Effect of Changes in Money Supply on Inflation M2 Money supply Inflation Rate (lagged 3 years) n Similarly, a slower growth rate of the money supply, like that of the 1990s, is generally associated with a reduction in the rate of inflation.

33 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved 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 n The expectation of inflation... thereby causing interest rates to rise. n Note how the short-term money rate of interest has tended to increase when the inflation rate accelerates (and declines as the inflation rate falls). u reduces the supply, and, u increases the demand for loanable funds,

34 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1, , R ate of M oney S upply G rowth (%, log scale) R ate of I nflation P er Y ear (%, log scale) Sources: International Monetary Fund, International Financial Statistics Yearbook, 1997 & International Financial Statistics (December 1998). Note: The money supply data are the actual growth rate of the money supply minus the growth rate of real GDP. Argentina Brazil Australia Switzerland France Thailand Belgium Canada Malaysia United States Germany Japan Italy Pakistan Chile Turkey South Africa Hungary Zambia Kenya Venezuela India Uganda Portugal Indonesia Syria Philippines Ecuador Poland Israel Ghana Mexico The relationship between the average annual growth rate of the money supply and the rate of inflation is show here for the period. Clearly, there is a close relationship between the two. Higher rates of money growth lead to higher rates of inflation. Money and Inflation – An International Comparison

35 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. What impact will an unanticipated increase in the money supply have on the real interest rate, real output, and employment in the short run? What will be the impact in the long run? Questions for Thought: 2. Political officials often call on the monetary authorities to expand the money supply more rapidly so that interest rates can be reduced. Will expansionary monetary policy reduce interest rates in the short run? Will it do so in the long run? Explain.

36 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 14


Download ppt "Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard."

Similar presentations


Ads by Google