Presentation on theme: "Monetary Theory and Policy"— Presentation transcript:
1 Monetary Theory and Policy Demand and supply of moneyThe supply of money and the equilibrium interest rateThe monetary transmission mechanismThe Quantity theory of moneyThe record of monetary policy
2 The money marketEarlier we said that the interest rate (i) influences aggregate spending—specifically investment and consumption. However, we have yet to develop a theory of the interest rateThe interest rate is governed by the demand and supply of money.
3 Why do agents hold money? To make planned expenditures/paymentsTo be prepared for unexpected expenditures/payments.To store wealth.
4 The interest rate (i) measures the opportunity cost of holding money The higher the interest rate, the more interest I give up by holding my wealth in money-- as opposed to an interest-bearing asset.
5 Demand for moneyThe money demand, Dm, slopes downward. As the interest rate falls, other things constant, so does the opportunity cost of holding money; the quantity of money demanded increases.Interest rateDmQuantity of money
6 The supply of moneyWe assume that the Fed (or central banks generally) determines the supply of money
7 Effect of an increase in the money supply Because the money supply is determined by the Federal Reserve, it can be represented by a vertical line.Interestrateii’SmS’mDmAt point a, the intersection of the money supply, Sm, and the money demand, Dm, determines the market interest rate, i.abFollowing an increase in the money supply to S’m, the quantity of money supplied exceeds the quantity demanded at the original interest rate, i.Quantity ofmoneyMM’People attempt to exchange money for bonds or other financial assets. In doing so, they push down the interest rate to i’, where quantity demanded equals quantity supplied. This new equilibrium occurs at point b.
8 Effects of an increase in the money supply on interest rates, investment, and aggregate demand (a) Supply and demandfor moneyInterest rateii’(b) Demand forinvestment(c) Aggregate demandPrice levelPSmS’mDmDIAD’ADaabbbaMoneyMM’InvestmentII’Real GDPYY’An increase in the money supply drives the interest rate down to i'.This sets off the spending multiplier process, so the aggregate output demanded at price level P increases from Y to Y ‘With the cost of borrowing lower, the amount invested increases from I to I‘.
10 The transmission mechanism Fed open market purchase injects reserves into the banking systemCommercial banks, thrifts, etc. expand loans and depositsThe money supply increasesThe equilibrium interest rate decreasesConsumption and investment increaseReal GDP, employment, and (perhaps ) the price level increase
11 Expansionary monetary policy to correct a contractionary gap Potential outputLRASAt a, the economy is producing less than its potential in the short run, resulting in a contractionary gap of $0.2 trillion.Pricelevel125130SRAS130AD’If the Federal Reserve increases the money supply by just the right amount, the aggregate demand curve shifts rightward from AD to AD’. A short-run and long-run equilibrium is established at b, with the pride level at 130 and output at the potential level of $14.0 trillionADbaReal GDP(trillions of dollars)14.013.8Contractionary gap
12 Fed "target" rateThe FOMC sets a target for the “federal funds” rate, which is the rate that banks charge other banks for “borrowed” reserves.
13 Recent ups and downs in the federal funds rate Global financialcrisis promptsrate cutsRate cutsto combat recessionRate increased to slow red-hot economyto limitimpact ofmortgagedefaults on economyRate increase tohead off inflationSince the early 1990s, the Fed has pursued monetary policy primarily through changes in the federal funds rate, the rate that banks charge one another for borrowing and lending excess reserves overnight.
15 The Equation of Exchange WhereM is the quantity of moneyV is the velocity of circulationP is the price levelY is real GDP
16 What is velocity (V)?Velocity (V) is the average number of times per year a unit of money is spent for new goods and services. Let(P Y) is nominal GDP. Let P = 1.25; Y = $8 trillion; and M= $2 trillion. Thus:Or, V = 5
17 Money and Aggregate Demand in LR Velocity depends onCustoms and convention of commerceInnovations facilitate exchangeHigher velocityFrequencyThe more often workers get paidStability (store of value)The better store of valueLower velocity
18 Equation of Exchange is Always True The equation simply states that what is spent for new goods and services (M V) is equal to the market value of new goods and services produced (P Y).
19 Illustration Using the numbers on a preceding slide, we can see that andthus
20 “Monetarist” interpretation of the equation of exchange The monetarists believe that price level changes (hence inflation) can be explained by changes in quantity of money“Inflation is always and everywhere a monetary phenomenon.”
21 ExampleAssume that V = 5 and is constant. Y is $8 trillion (also assumed to be constant). Initially, let M = $2 trillion
22 Our basic equation can be rearranged as follows: Now solve for the price level (P):Now let the money supply increase to $2.4 trillion. Notice that:Thus we have:Notice that:
23 Hence a 20 percent increase in the money supply causes the price level to increase by 20 percent. Monetarists put the blame for inflation squarely at the doorstep of the monetary authorities (in the U.S., the FED).
24 In the long run, an increase in the money supply results in a higher price level, or inflation Potential outputLRASPrice level130140The quantity theory of money predicts that if velocity is stable, then an increase in the supply of money in the long run results in a higher price level, or inflation. Because the long-run aggregate supply curve is fixed, increases in the money supply affect only the price level, not real output.AD’ADbaReal GDP(trillions of dollars)14.0
25 The velocity of M1 (a) Velocity of M1 M1 velocity fluctuated so much during the 1980s that M1 growth was abandonedas a short-run policy target.
26 The velocity of M2 (b) Velocity of M2 M2 velocity appears more stable than M1 velocity, but both are now considered by the Fed as too unpredictable for short-run policy use.
30 Record indicates that nations with high rates of monetary growth also suffer high rates of inflation A decade of annual inflation and money growth in 85 countries (average annual percent)
31 Targeting interest rate vs. targeting the money supply An increase in the price level or in real GDP, with velocity stable, shifts rightward the money demand curve from Dm to D'm.SmS’mInterest ratei’iD’mIf the Federal Reserve holds the money supply at Sm, the interest rate rises from i (at point e) to i ' (at point e').e’Dmee’’Alternatively, the Fed could hold the interest rate constant by increasing the supply of money to S'm. The Fed may choose any point along the money demand curve D'm.Quantity of moneyMM’
32 The Fed pulled on the string big time beginning in 1979—it was an anti-inflation strategy under Chairman Paul Volcker
33 Modeling Contractionary Monetary Policy Price LevelPotential GDPASAD2AD1Y1Real GDP