1. Monetary Policy Chapter 15 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 15-2 Monetary Policy Control over the money supply is a critical policy tool for altering macro outcomes –What’s the relationship between the 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

3. 15-3 Monetary Policy Some economists argue that monetary policy is more effective than fiscal policy; others contend the reverse is true Monetary policy: The use of money and credit controls to influence macroeconomic outcomes

4. 15-4 The Money Market Like other goods, there’s a supply of money and a demand for money The price of money is determined in the money market –Interest rate: The price paid for the use of money

5. 15-5 Money Balances Most of the money in the money supply is in the form of bank balances –Money Supply (M1): Currency held by the public, plus balances in transactions accounts –Money Supply (M2): M1 plus balances in most savings accounts and money market mutual funds

6. 15-6 The Demand for Money Demand for money: The quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus Portfolio decision: The choice of how (where) to hold idle funds

7. 15-7 The Demand for Money Transactions demand for money: Money held for making everyday market purchases Precautionary demand for money: Money held for unexpected market transactions or for emergencies Speculative demand for money: Money held for speculative purposes, for later financial opportunities

8. 15-8 The Money Market The quantity of money that people are willing and able to hold (demand) increases as interest rates fall, ceteris paribus The money supply curve is assumed to be a vertical line –The Federal Reserve has the power to regulate the money supply through its policy tools

9. 15-9 Equilibrium Equilibrium rate of interest occurs at the intersection of the money-demand and money- supply curves Equilibrium rate of interest: The interest rate at which the quantity of money demanded in a given time period equals the quantity of money supplied

10. 15-10 0 Interest Rate (%) Quantity Of Money Money Market Equilibrium Money supply 9 g1g1 7 E1E1 Money demand g2g2 The amount of money demanded (held) depends on interest rates

11. 15-11 Changing Interest Rates The Federal Reserve can alter the money supply through changes in reserve requirements, the discount rate, or through open market operations This changes the equilibrium rate of interest

12. 15-12 0 Changing Interest Rates Demand for money E1E1 E3E3 g1g1 g3g3 7 6 Money supply and demand set interest rates Interest Rate (%) Quantity Of Money Money supply

13. 15-13 Federal Funds Rate The federal funds rate is most directly affected when the Fed injects or withdraws reserves from the banking system The federal funds rate reflects the cost of funds for banks –Federal Funds Rate: The interest rate for interbank reserve loans

14. 15-14 Interest Rates and Spending When the cost of funds for banks changes, they change the rates they charge on loans Changes in interest rates affect consumer, investor, government, and net export spending

15. 15-15 Monetary Stimulus The goal of monetary stimulus is to increase aggregate demand Stimulating the economy is achieved through –An increase in the money supply –A reduction in interest rates –An increase in aggregate demand

16. 15-16 Monetary Stimulus An increase in the money supply lowers the rate of interest g1g1 g2g2 Quantity Of Money Interest Rate 7 6 0 Demand for money E1E1 E2E2 A reduction in the rate of interest stimulates investment Interest Rate 7 6 I1I1 I2I2 Rate Of Investment 0 Investment demand More investment increases aggregate demand (including multiplier effects) Price Level Income (Output) AD 1 AD 2 AS

17. 15-17 Monetary Restraint To lessen inflationary pressures, the Fed will apply a policy of monetary restraint This is achieved through –A decrease in the money supply –An increase in interest rates –A decrease in aggregate demand

18. 15-18 Policy Constraints Several constraints can limit the Fed’s ability to alter the money supply, interest rates, or aggregate demand –Short- vs. long-term rates –Reluctant lenders –Liquidity trap –Low expectations –Time lags

19. 15-19 Short- vs. Long-Term Rates Fed’s open market operations have the most direct effect on short-term rates The success of Fed intervention depends in part on how well changes in long-term interest rates mirror changes in short-term interest rates

20. 15-20 Reluctant Lenders Banks themselves must expand the money supply by making new loans Banks may be unwilling to make new loans even when the Fed is injecting excess reserves into the banking system

21. 15-21 Liquidity Trap & Low Expectations Liquidity trap: The portion of the money demand curve that is horizontal; people are willing to hold unlimited amounts of money at some (low) interest rate Gloomy expectations deter borrowing Investment demand that is slow to respond to lower interest rates is said to be inelastic

22. 15-22 Constraints on Monetary Stimulus A liquidity trap can stop interest rates from falling The liquidity trap Interest Rate E1E1 E2E2 g1g1 g2g2 Quantity Of Money Demand for money Interest Rate Inelastic demand Investment demand Rate Of Investment 7 6 0 Inelastic investment demand can also impede monetary policy

23. 15-23 Time Lags There is always a time lag between interest- rate changes and investment responses It may take 6–12 months before market behavior responds to monetary policy

24. 15-24 Limits on Monetary Restraint It is also harder for the Fed to restrain demand –Expectations - Optimistic consumers and investors may continue borrowing even though interest rates are higher –Global money - U.S. borrowers might tap global sources of money or local non-bank lenders not regulated by the Fed

25. 15-25 How Effective? Keynes believed that monetary policy would not be effective at ending a deep recession Combination of reluctant bankers, the liquidity trap, and low expectations could render monetary stimulus ineffective Limitations on monetary restraint are not considered as serious

26. 15-26 The Monetarist Perspective Keynesians believe that changes in the money supply affect macro outcomes primarily through changes in interest rates Monetarists believe monetary policy cannot effectively fight the short-run business cycle but is a powerful tool for managing inflation

27. 15-27 The Equation of Exchange Monetarists use the equation of exchange to express the potential of monetary policy Equation of exchange: Money supply (M) times velocity of circulation (V) equals level of aggregate spending (P  Q)

28. 15-28 The Equation of Exchange Income velocity of money (V): The number of times per year, on average, a dollar is used to purchase final goods and services –How often a dollar changes hands

29. 15-29 The Equation of Exchange The quantity of money in circulation and its velocity in product markets will always equal total spending and income (nominal GDP) The equation implies that if M increases, then prices (P) or output (Q) must rise or V must fall

30. 15-30 Money-Supply Focus Monetarists assume velocity (V) is stable If so, changes in money supply must alter total spending, regardless of interest rates Then the Fed should focus on the money supply itself, not interest rates

31. 15-31 “Natural” Unemployment Some monetarists assert that Q, as well as V, is stable at the natural rate of unemployment –Natural rate of unemployment: Long-term rate of unemployment determined by structural forces in labor and product markets The most extreme perspective concludes that changes in the money supply only affect prices

32. 15-32 REAL OUTPUT PRICE LEVEL The Monetarist View QNQN Long-run Aggregate Supply AD 2 AD 1 P2P2 P1P1 Fluctuations in aggregate demand affect the price level but not real output.

33. 15-33 Monetarist Policies Monetarists and Keynesians disagree on how to stabilize the economy –Keynesians concentrate on how the money supply affects interest rates, which affects spending, which affects output –Monetarists use a simple equation (MV=PQ) to produce straightforward monetary policy

34. 15-34 Fighting Inflation Keynesian anti-inflation policy is to shrink the money supply to drive up interest rates to slow spending Monetarists argue that this policy will push interest rates down rather than up Monetarists distinguish between nominal and real interest rates

35. 15-35 Real vs. Nominal Interest Monetarists believe that real interest rates are stable, so changes in the nominal interest rate reflect changes in anticipated inflation

36. 15-36 Short- vs. Long-Term Rates (again) According to Monetarists, reducing money supply growth may increase short term rates Long term rates won’t change unless people expect inflation to worsen The best policy is steady and predictable changes in money supply

37. 15-37 Fighting Unemployment The Keynesian cure for unemployment is to expand M and lower interest rates Using the equation of exchange, Monetarists fear an increase in M will lead to higher P –Rather than leading us out of recession, expansionary monetary policies heap inflation on top of our unemployment woes

38. 15-38 The Concern for Content Monetary policy, like fiscal policy, can affect the content of GDP as well as its level When interest rates change, not all spending decisions will be affected equally Monetary policy also redistributes money between lenders and borrowers

39. 15-39 Which Lever to Pull? The success in managing the macro economy depends on pulling the right policy levers at the right time Keynesians and Monetarists argue about which of the policy levers – M or V – is likely to be effective in altering aggregate spending

40. 15-40 The Policy Tools Monetarists point to money supply (M) as the principal macroeconomic policy lever Keynesian fiscal policy must rely on changes in velocity (V), as tax and expenditure policies have no direct impact on money supply

41. 15-41 Crowding Out If V is constant, changes in total spending can come about only through changes in money supply Increased G effectively “crowds out” some C or I, leaving total spending unchanged If the government raises taxes, households will have less money to spend

42. 15-42 How Fiscal Policy Matters

43. 15-43 How Money Matters

44. 15-44 Is Velocity Stable? The critical question of monetary policy appears to be whether V is stable or not The historical pattern justifies the Monetarist assumption of a stable V over long periods of time There is a pattern of short-run variations in velocity

45. 15-45 The Velocity of M2 Source: Federal Reserve

46. 15-46 Money Supply Targets The differing views of Keynesians and Monetarists lead to different conclusions about which policy lever to pull –Monetarists favor fixed money supply targets –Keynesians advocate targeting interest rates, not the money supply

47. 15-47 Inflation Targeting The Fed has tried both Monetarist and Keynesian strategies Price stability is current Fed’s primary goal Inflation targeting: The use of an inflation ceiling (“target”) to signal the need for monetary policy adjustments

48. Monetary Policy End of Chapter 15 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin