1. MACROECONOMICS Paul Krugman | Robin Wells
THIRD EDITION
ECONOMICS
and
MACROECONOMICS Paul Krugman | Robin Wells
Chapter 15(30)
Monetary Policy

2. WHAT YOU WILL LEARN IN THIS CHAPTER
What the money demand curve is
Why the liquidity preference model determines the interest rate in the short run
How the Federal Reserve can implement monetary policy moving the interest rate to affect aggregate output
Why monetary policy is the main tool for stabilizing the economy
How the behavior of the Federal Reserve compares with that of other central banks
Why economists believe in monetary neutrality — that monetary policy affects only the price level, not aggregate output, in the long run
WHAT YOU
WILL LEARN
IN THIS CHAPTER

3. The Demand for Money The Opportunity Cost of Holding Money
Short-term interest rates are the interest rates on financial assets that mature within six months or less.
Long-term interest rates are interest rates on financial assets that mature a number of years in the future.

4. Interest Rates and the Opportunity Cost of Holding Money
The Demand for Money
Interest Rates and the Opportunity Cost of Holding Money
Source: Federal Reserve Bank of St. Louis.

5. FOR INQUIRING MINDS Fear and Interest Rates
Treasury bills generally pay a slightly lower interest rate than other short-term assets in normal times.
In the third week of October 2008, one-month CDs were paying 4.04% interest, but one-month Treasury bills were paying only 0.26%.
The reason: fear. A sharp plunge in housing prices had led to big losses at a number of financial institutions, leaving investors nervous about the safety of many nongovernment assets.
On December 10, 2008, in fact, three-month Treasury bills paid 0% interest for a brief period.

6. The Money Demand Curve
The money demand curve shows the relationship between the quantity of money demanded and the interest rate.

7. The Money Demand Curve Interest rate, r Quantity of money
Figure Caption: Figure 15(30)-1: The Money Demand Curve
The money demand curve illustrates the relationship between the interest rate and the quantity of money demanded. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded.
Money demand curve, MD
Quantity of money

8. Shifts of the Real Money Demand Curve
Changes in aggregate price level
Changes in real GDP
Changes in technology
Changes in institutions

9. Increases and Decreases in the Demand for Money
A fall in money demand shifts the money demand curve to the left..
A rise in money demand
shifts the money demand
curve to the right.
Figure Caption: Figure 15(30)-2: Increases and Decreases in the Demand for Money
A rise in money demand shifts the money demand curve to the right, from MD1 to MD2, and the quantity of money demanded rises at any given interest rate. A fall in money demand shifts the money demand curve to the left, from MD1 to MD3, and the quantity of money demanded falls at any given interest rate.

10. ECONOMICS IN ACTION A Yen for Cash
Japan, say financial experts, is still a “cash society.” Why?
One reason the Japanese use cash so much is that their institutions never made the switch to heavy reliance on plastic.
For complex reasons, Japan's retail sector is still dominated by small mom-and-pop stores, which are reluctant to invest in credit card technology.
Japan’s banks have also been slow about pushing transaction technology.

11. ECONOMICS IN ACTION A Yen for Cash
But there’s another reason the Japanese hold so much cash: there’s little opportunity cost to doing so.
Short-term interest rates in Japan have been below 1% since the mid-1990s.
It also helps that the Japanese crime rate is quite low, so you are unlikely to have your cash-filled wallet stolen.

12. Money and Interest Rates
According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money.
The money supply curve shows how the nominal quantity of money supplied varies with the interest rate.

13. Equilibrium in the Money Market
Interest
rate, r
Money supply
curve, MS H r H
Equilibrium
Equilibrium interest rate E r E L
Figure Caption: Figure 15(30)-3: Equilibrium in the Money Market
The money supply curve, MS, is vertical at the money supply chosen by the Federal Reserve, M. The money market is in equilibrium at the interest rate rE: the quantity of money demanded by the public is equal to M, the quantity of money supplied. At a point such as L, the interest rate, rL, is below rE and the corresponding quantity of money demanded, ML, exceeds the money supply, M. In an attempt to shift their wealth out of non-money interest-bearing financial assets and raise their money holdings, investors drive the interest rate up to rE. At a point such as H, the interest rate rH is above rE and the corresponding quantity of money demanded, MH, is less than the money supply, M. In an attempt to shift out of money holdings into non-money interest-bearing financial assets, investors drive the interest rate down to rE. r MD L M M M H L
Quantity of money
Money supply
chosen by the Fed 13

14. The Effect of an Increase in the Money Supply on the Interest Rate
rate, r
An increase
in the money
supply . . . MS MS 1 2
Figure Caption: Figure 15(30)-4: The Effect of an Increase in the Money Supply on the Interest Rate
The Federal Reserve can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r1 to r2 in response to an increase in the money supply from M1 to M2. In order to induce people to hold a larger quantity of money, the interest rate must fall from r1 to r2. r E r 2
. . . leads to
a fall in the
interest rate. 1 1 E 2 MD M M
Quantity of money 1 2

15. Pitfalls The Target versus the Market
A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works.
You’ll sometimes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate.

16. Pitfalls The Target versus the Market
In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money.
The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate.
It’s important not to confuse a change in the Fed’s operating procedure with a change in the way the economy works.

17. Setting the Federal Funds Rate
Pushing the Interest Rate Down to the Target Rate
The target federal funds rate is the Federal Reserve’s desired federal funds rate.
Interest
rate, r 2 MS
An open-market
purchase . . . MS 1
. . . drives the interest rate down. E r 1 1 E
Figure Caption: Figure 15(30)-5: Setting the Federal Funds Rate
The Federal Reserve sets a target for the federal funds rate and uses open-market operations to achieve that target. In panel (a) the initial
equilibrium interest rate, r1, is above the target rate. The Fed increases the money supply by making an open-market purchase of Treasury bills, pushing the money supply curve rightward, from MS1 to MS2, and driving the interest rate down to rT. r 2 T MD M M 1
Quantity of money

18. Setting the Federal Funds Rate
Pushing the Interest Rate Up to the Target Rate
Interest
rate, r
An open-market
sale . . . MS MS 2 1
. . . drives the interest rate up. r E T 2
Figure Caption: Figure 15(30)-5: Setting the Federal Funds Rate
The Federal Reserve sets a target for the federal funds rate and uses open-market operations to achieve that target. In panel (b) the initial equilibrium interest rate, r1, is below the target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward, from MS1 to MS2, and driving the interest rate up to rT. E r 1 1 MD M 2 M 1
Quantity of money

19. Long-Term Interest Rates
Long-term interest rates don’t necessarily move with short-term interest rates.
If investors expect short-term interest rates to rise, investors may buy short-term bonds.
In practice, long-term interest rates reflect the average expectation in the market about what’s going to happen to short-term rates in the future.

20. ECONOMICS IN ACTION The Fed Reverses Course
On August 7, 2007, the Federal Open Market Committee decided to stand pat, making no change in its interest rate policy.
On September 18, the Fed cut the target federal funds rate “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.”

21. ECONOMICS IN ACTION The Fed Reverses Course
Given the increases in interest rates prior to 2007, this was a reversal of previous policy: previously, the Fed had generally been raising rates, not reducing them, out of concern that inflation might become a problem (more on that later in this chapter).
Starting in September 2007, fighting the financial crisis took priority.

22. The Fed Reverses Course
Figure Caption: Figure 15(30)-6: The Fed Reverses Course
In September 2007, the Fed, worried about the emerging financial crisis, began cutting the target federal funds rate. This was a reversal of its previous policy, which had involved a series of rate increases intended to control inflation. The actual federal funds rate fluctuated to some extent—that is, the Fed didn’t always succeed in hitting its target. Overall, however, the Fed achieved a large reduction in the rate at which banks lend to each other.
Source: Federal Reserve Bank of St. Louis.

23. The Fed Moves Interest Rates
Notes to the Instructor: Figure from the earlier edition: In early 2001, in response to a weakening economy, the Fed began cutting the federal funds rate. The prime rate—the interest rate on short-term bank loans to their best customers— fell in parallel. The 30-year mortgage rate, which is used by consumers buying homes, fell, too, though not as much. By 2004, in the face of a growing economy, the Fed began raising the federal funds rate.

24. Monetary Policy and Aggregate Demand
Expansionary monetary policy is monetary policy that increases aggregate demand.
Contractionary monetary policy is monetary policy that reduces aggregate demand.

25. Expansionary and Contractionary Monetary Policy
Figure Caption: Figure 15(30)-7: Expansionary and Contractionary Monetary Policy
The top portion of this figure shows what happens when the Fed increases the money supply. Interest rates fall, leading to higher investment spending, which raises income, which, in turn, raises consumer spending and shifts the AD curve to the right. The result is a rise in real GDP. The bottom part of the figure shows the opposite case, a reduction in the money supply. Interest rates rise, leading to lower investment spending, and then lower consumer spending.
The result: lower real GDP and a leftward shift of the AD curve.

26. Monetary Policy and Aggregate Demand
(a) Expansionary Monetary Policy
(b) Contractionary Monetary Policy
Aggregate price level
Aggregate price level
Monetary Policy and Aggregate Demand
An expansionary monetary policy, shown in panel (a), shifts the aggregate demand curve to the right from AD1 to AD2. A contractionary monetary policy, shown in panel (b), shifts the aggregate demand curve to the left, from AD1 to AD3. AD AD AD AD 1 2 3 1
Real GDP
Real GDP

27. (a) Expansionary Monetary Policy (b) Contractionary Monetary Policy
Expansionary and Contractionary Monetary Policy in the Income-Expenditure Model
(a) Expansionary Monetary Policy
(b) Contractionary Monetary Policy
Planned
aggregate
spending
Planned
aggregate
spending
45-degree line
45-degree line Y 2 AE AE 1 AE Y 2 AE 1
From earlier edition
Figure Caption: Expansionary and Contractionary Monetary Policy in the Income-Expenditure Model
Panel (a) shows how a reduction in the interest rate leads to a rise in planned investment, shifting AE upward from AE1 to AE2. Equilibrium real GDP rises from Y1 to Y2. Panel (b) shows the opposite case: an increase in the interest rate leads to a fall in planned investment, shifting AE downward from AE1 to AE2. Equilibrium real GDP falls from Y1 to Y2. Y
Real GDP Y
Real GDP 1 1

28. Expansionary Monetary Policy to Fight a Recessionary Gap
Notes to the Instructor: Figure from the earlier edition: Here, initial actual aggregate output, Y1, is below potential output, YP. An expansionary monetary policy reduces the interest rate, shifting the aggregate demand curve rightward from AD1 to AD2 and eliminating the recessionary gap.

29. Contractionary Monetary Policy to Fight an Inflationary Gap
Notes to the Instructor: Figure from the earlier edition: Here, initial actual aggregate output, Y1, is above potential output, YP. A contractionary monetary policy increases the interest rate, shifting the aggregate demand curve leftward from AD1 to AD2 and eliminating the inflationary gap.

30. Monetary Policy and the Multiplier
Notes to the Instructor: Figure from the earlier edition: An expansionary monetary policy drives down the interest rate, leading to an initial rise in investment spending, DI. This raises disposable income, which causes a rise in consumer spending, which further raises disposable income, and so on. In the end, the AD curve shifts rightward by a multiple of the initial rise in I.

31. Tracking Monetary Policy
Figure Caption: Figure 15(30)-8: Tracking Monetary Policy Using the Output Gap and Inflation
Panel (b) illustrates that the federal funds rate tends to be high when inflation is high and low when inflation is low.
Sources: Federal Reserve Bank of St. Louis; Bureau of Economic Analysis; Bureau of Labor Statistics.

32. Tracking Monetary Policy
Figure Caption: Figure 15(30)-9: The Taylor Rule and the Federal Funds Rate
The blue line shows the federal funds rate predicted by the San Francisco Fed’s version of the Taylor rule, which relates the interest rate to the inflation
rate and the unemployment rate. The red line shows the actual federal funds rate. The actual rate tracked the predicted rate quite closely through the end of After that, however, the Taylor rule called for negative interest rates, which aren’t possible.
Sources: Bureau of Labor Statistics; Congressional Budget Office; Federal Reserve Bank of St. Louis; Glenn D. Rudebusch, “The Fed’s Monetary Policy
Response to the Current Crisis,” FRBSF Economic Letter (May 22, 2009):

33. Inflation Targeting
Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy to hit that target.

34. GLOBAL COMPARISON: Inflation Targets
Global Comparison: This figure shows the target inflation rates of five central banks that have adopted inflation targeting. The central bank of New Zealand introduced inflation targeting in It has an inflation target range of from 1% to 3%. The central banks of Canada and Sweden have the same target range but also specify 2% as the precise target. The central banks of Britain and Norway have specific targets for inflation, 2% and 2.5%, respectively. Neither states by how much they’re prepared to miss those targets. In practice, these differences in detail don’t seem to lead to any significant difference in results. New Zealand aims for the middle of its range, at 2% inflation; Britain and Norway allow themselves considerable wiggle room around their target inflation rates.

35. ECONOMICS IN ACTION What the Fed Wants, the Fed Gets
Contractionary monetary policy is sometimes used to eliminate inflation that has become embedded in the economy.
In this case, the Fed needs to create a recessionary gap—not just eliminate an inflationary gap—to wring embedded inflation out of the economy.

36. ECONOMICS IN ACTION What the Fed Wants, the Fed Gets
In four of the five cases that Christina Romer and David Romer examined, the decision to contract the economy was followed, after a modest lag, by a rise in the unemployment rate.
On average, they found that the unemployment rate rises by 2 percentage points after the Fed decides that unemployment needs to go up.
So, the Fed gets what it wants.

37. ECONOMICS IN ACTION When the Fed Wants a Recession
Figure Caption: Figure 15(30)-10: When the Fed Wants a Recession
This figure shows the unemployment rate from 1952 to 1984; the vertical red lines indicate occasions on which the Federal Reserve, in effect, decided that the economy needed a recession to bring inflation under control. In four of the five episodes, this decision was soon followed by a substantial rise in the unemployment rate.
Sources: Bureau of Labor Statistics; Christina D. Romer and David H. Romer, “Monetary Policy Matters,” Journal of Monetary Economics 34 (August 1994): 75–88.

38. Money, Output, and Prices in the Long Run
Aggregate
price level Y 2 E P AD
An increase in the
money supply reduces
the interest rate and
increases aggregate
demand . . . L R AS AS 2 P 3
. . . but the eventual
rise in nominal wages
leads to a fall in
short-run aggregate
supply and aggregate
output falls back to
potential output. S R S R AS 1 E 3
Figure Caption: Figure 15(30)-11: The Short-Run and Long-Run Effects of an Increase in the Money Supply
An increase in the money supply generates a positive short-run effect, but no long-run effect, on real GDP. Here, the economy begins at E1, a point of short-run and long-run equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short-run equilibrium at E2 and a new real GDP of Y2. But E2 is not a long-run equilibrium: Y2 exceeds potential output, Y1, inducing over time an increase in nominal wages in the economy. In the long run, the increase in nominal wages will shift the short-run aggregate supply curve leftward, to a new position at SRAS2.
The economy reaches a new short-run and long-run equilibrium at E3 on the LRAS curve, and output falls back to potential output, Y1. The only long-run effect of an increase in the money supply is an increase in the aggregate price level, P1 to P3. P 1 E 1 AD 1 Y 1
Real GDP
Potential output

39. Monetary Neutrality
In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate.
In fact, there is monetary neutrality: changes in the money supply have no real effect on the economy. So, monetary policy is ineffectual in the long run.

40. The Long-Run Determination of the Interest Rate
rate, r r 2 E MS M
An increase in the money supply lowers the interest rate in the short run… MS 1 MD 2
…but in the long run higher
prices lead to greater money
demand, raising the interest
rate to its original level. E 1 E r 3 1
Figure Caption: Figure 15(30)-12: The Long-Run Determination of the Interest Rate
In the short run, an increase in the money supply from M1 to M2 pushes the interest rate down from r1 to r2 and the economy moves to E2, a short-run equilibrium. In the long run, however, the aggregate price level rises in proportion to the increase in the money supply, leading to an increase in money demand at any given interest rate in proportion to the increase in the aggregate price level, as shown by the shift from MD1 to MD2. The result is that the quantity of money demanded at any given interest rate rises by the same amount as the quantity of money supplied. The economy moves to long-run equilibrium at E3 and the interest rate returns to r1. MD 1 M
Quantity of money 1

41. ECONOMICS IN ACTION International Evidence of Monetary Neutrality
All of the major central banks try to keep the aggregate price level roughly stable.
However, if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply.
Between 1970 and the present, the money supply rose only a few percent per year in some countries.

42. ECONOMICS IN ACTION International Evidence of Monetary Neutrality
The figure on the next slide shows the annual percentage increases in the money supply and average annual increases in the aggregate price.
The scatter of points clearly lies close to a 45-degree line, showing a more or less proportional relationship between money and the aggregate price level.
The data support the concept of monetary neutrality in the long run.

43. The Long-Run Relationship Between Money and Inflation
Figure Caption: Figure 15(30)-13: The Long-Run Relationship Between Money and Inflation
The horizontal axis measures the annual percent increase in a country’s money supply between 1970 and The vertical axis measures the annual percent increase in a country’s aggregate price level over the same period. Each point represents a specific country. The scatter of points lies close to a 45-degree line, demonstrating that in the long run increases in the money supply lead to roughly equal percent increases in the aggregate price level.
Source: OECD.

44. Summary
The money demand curve arises from a trade-off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short-term interest rates, not long-term interest rates. Changes in the aggregate price level, real GDP, technology, and institutions shift the money demand curve.

45. Summary
According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shifting the money supply curve. In practice, the Fed uses open-market operations to achieve a target federal funds rate, which other short-term interest rates generally track.

46. Summary
Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. Contractionary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run.

47. Summary
The Federal Reserve and other central banks try to stabilize the economy, limiting fluctuations of actual output around potential output, while also keeping inflation low but positive. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflation, or a positive output gap, or both; the target interest rate falls when inflation is low or negative, or when the output gap is negative, or both.

48. Summary
(Cont.) Some central banks engage in inflation targeting, which is a forward-looking policy rule, whereas the Taylor rule is a backward-looking policy rule. In practice, the Fed appears to operate on a loosely defined version of the Taylor rule. Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the preferred policy tool for stabilizing the economy.

49. Summary
In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run.

50. Key Terms Short-term interest rates Taylor rule for monetary policy
Long-term interest rates
Inflation targeting
Money demand curve
Monetary neutrality
Liquidity preference model of the interest rate
Money supply curve
Target federal funds rate
Expansionary monetary policy
Contractionary monetary policy