ECO 104: Introduction to Macroeconomics Lecture 9 Chapter 15: Monetary Policy 1Naveen Abedin

Transmission Mechanisms Changes in one market can often ripple outward to affect other markets. These routes or channels that these ripple effects travel through are known as transmission mechanisms. Two main transmission mechanisms are the Keynesian and the monetarist methods. 2Naveen Abedin

The Money Market Money market has two sides as well – a demand side and a supply side Demand for Money (balances): The price of holding money, or rather the opportunity cost of holding money is the interest rate. By holding money, individuals forfeit the opportunity to hold that portion of their wealth in other forms. For example, the person who holds $1000 in cash gives up the opportunity to purchase a $1000 asset that yields interest, such as a bond or a fixed deposit account. The demand for money is downward sloping. As the interest rate gets higher and higher, the opportunity cost of holding money increases. Supply of Money: The supply of money is a vertical line at the quantity of money that is prevailing in society, which is largely determined by the Central Bank. 3Naveen Abedin

The Money Market (cont.) They money market is in equilibrium when the quantity demanded of money equals the quantity supplied. At equilibrium point, we have the equilibrium interest rate. At a higher interest rate, quantity supplied of money is greater than the quantity demanded, so there is a surplus of money in the economy. At a lower interest rate, the quantity demanded of money is greater than the quantity supplied, so there is excess demand for money, or shortage of money. 4Naveen Abedin

The Keynesian Transmission Mechanism: Indirect The route between money market and the goods and services market under Keynesian theory is an indirect one. The Money Market: Suppose initially, the money market is in equilibrium. Then the Central Bank decides to increase money supply in the economy by engaging in open market purchases. This shifts the supply of money to the right. This increased money supply allows banks to extend more loans, which puts a downward pressure on interest rate. The Investment Goods Market: A fall in interest rate stimulates investment. As a result, there is a quantity increase in investment goods market from I1 to I2. The Goods and Services Market (AD-AS Framework: With the increase in investment in the goods market as a result of reduced interest rate, total spending in the economy increases, which shifts AD to the right. As a result, Real GDP rises from Q1 to Q2. Price level does not change (horizontal segment of AS) *The process works in reverse as well 5Naveen Abedin

The Keynesian Transmission Mechanism: Indirect Naveen Abedin6

Impediments to The Keynesian Transmission Mechanism The effect on the goods and services market as a result of changes in money supply occurs indirectly through the investment goods market. Any negative interference in the investment goods market can cause this link to break. 1)Interest-Insensitive Investment: Recall that Keynesians believe that investments are not always responsive to interest rates. Suppose investment is not dependent on interest rate at all, hence even if interest rates fall, it will not increase investment. hence Real GDP will remain unaffected by interest rates. Therefore, the Keynesian transmission mechanism will be unsuccessful. Naveen Abedin7

Impediments to The Keynesian Transmission Mechanism (cont.) The Liquidity Trap: There might be a situation where demand for money curve becomes perfectly horizontal at a certain low rate of interest. This perfectly horizontal section is referred to as the liquidity trap. In this situation, if money supply increases while the economy is in a Liquidity Trap, then this will not lower the interest rate, meaning that this will neither increase investments, aggregate demand nor Real GDP. Naveen Abedin8

The Monetarist Transmission Mechanism: Direct The Monetarist theory proposes a direct link between money market and the goods and services market. When money supply increases, individuals have excess money. As a result they increase spending – buying computers, cars, clothes etc. Businesses also have additional money to buy equipment, machinery. As a result, Total Spending increases; AD increases and shifts right and increases Real GDP. Naveen Abedin9

Monetary Policy and Recessionary Gap Non-Classical Economists might suggest that since the economy is not self- regulating, an intermediary mechanism is required to facilitate economic recovery to long-run equilibrium. Aside from fiscal policy, there is Monetary Policy, which is achieving economic stability using the money supply. Expansionary Monetary Policy can be used in times of Recessionary Gaps, so that an increase in money supply shifts AD to the right and returns the economy to long-run equilibrium. Naveen Abedin10

Monetary Policy and Inflationary Gap A contractionary monetary policy, which is reducing the money supply, may be used to shift the AD curve to the left in times of inflationary gaps. Naveen Abedin11

Activists vs. Non-Activists There are two schools of thought concerning Monetary Policy:- Activist: This is a group that supports the deliberate use of monetary policy to allow the economy to recover from recessionary or inflationary gaps. They are in favor of economic fine-tuning, which means using monetary policy to counter any economic instability. This is also known as activist or discretionary monetary policy. Non-activists argue against the use of activist or discretionary monetary policy. Instead they support rules- based monetary policy, which may be based on a predetermined steady growth rate. For instance, they say that money supply targets should be independent of economic activities, i.e. if money supply is allowed to increase by 3%, it should increase no matter what may happen in the economy. Naveen Abedin12

Case for Activists 1.The economy does not always equilibrate quickly enough to Natural Real GDP: Classical Economists are under the impression that since the economy is self-regulating, in the event of a recessionary or inflationary gap, the economy will recover its position of long-term equilibrium. However, this does not normally happen instantaneously, and as a result, it is often required to speed up the process through interventions. 2.Activist monetary policy works; it is effective at smoothing out business cycles: A monetary policy is believed to be capable of countering economic instability with more proficiency rather than letting the economy help itself. 3.Activist monetary policy is flexible; non-activist (rule-based) monetary policy is not: Flexibility is an important characteristic of activist monetary policy. Therefore, activist monetary policy allows the economy to respond to different economic decisions, whereas non-activist policies are rigid and independent of other economic factors. Naveen Abedin13

Case for Non-Activists (rules-based) Monetary Policy 1)Wages and prices are sufficiently flexible to allow the economy to equilibrate at reasonable speed at Natural Real GDP: Non-activists take the position of Classical Economists believing that any economic instability corrects itself within a reasonable period of time. They believe that the laissez-faire or hands-off approach is more suitable when it concerns economic activities. 2)Activist monetary policy may not work: When monetary policy is anticipated by the public, it may not be effective in changing Real GDP or unemployment rate. For instance, suppose that the Central Bank has announced that in the next month, money supply will increase. This we know will cause total spending to increase, and hence AD to shift to the right. In fear of inflationary pressures, workers put increasing pressures on wages. When wages rates increase in response to pressure from the workforce, the SRAS curve shifts left by the same degree as the rightward shift in AD. In the end, Real GDP does not change. Naveen Abedin14

Case for Non-Activists (rules-based) Monetary Policy (cont.) Activist monetary policy are likely to be destabilizing rather than stabilizing; they are likely to make matters worse, than better: There will be lags regarding activist monetary policy, i.e. implementing a policy based on current circumstances will take time to see effect in the economy. By the time the economy responds to a certain Monetary Policy, the economy may already stabilized on its own. Hence the added monetary policy will only seek to disrupt a stabilizing economy. Naveen Abedin15

Non-Activist Monetary Proposals There are 5 rules-based monetary proposals: Constant-money-growth-rate rule Predetermined-money-growth-rate rule The Taylor Rule Inflation targeting (Nominal) GDP targeting Naveen Abedin16

Constant-money-growth-rate rule The goal of a non-activist monetary policy is to eventually see the price level stabilize. The mechanism ensures that annual money supply growth rate will be constant at the average annual growth rate of Real GDP. For instance, if average annual Real GDP growth rate is 3.3%, then money supply should also growth at 3.3% annually. Money supply will grow at the average Real GDP growth rate regardless of whether the economy is in a recessionary or inflationary gap. In years when Real GDP growth rate is below average growth rate, price level will increase. In other years when growth rate in Real GDP is above its average rate, price level will fall. Overtime, price level will become stable. Naveen Abedin17

Predetermined-Money-Growth-Rate Rule The predetermined money supply growth rate rule advocates explain that since velocity is not always constant, the annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity. With this rule, the growth rate of money supply is not fixed. Rather it varies from year to year and is dependent on growth rates of Real GDP and velocity. Naveen Abedin18

Taylor Rule Taylor’s Rule is a compromise between activists and non-activist monetary policy. Taylor’s Rule is based on the understanding that there is some federal funds rate target that can allow inflation to achieve stability if not reduce inflation. This federal funds rate can allow Real GDP to stabilize around full-employment level. According to Taylor, the ideal federal funds rate for achieving stable inflation and stabilize Real GDP near full employment is GDP gap is the percentage deviation of Real GDP from its potential level. Naveen Abedin19

Inflation Targeting This requires the Central Bank to keep inflation rate near a predetermined level. Under this rule, the Central Bank would undertake monetary policy actions to keep actual inflation rate near or at its target. For instance if the actual rate is 5%, but the target rate is 2%, then Central Bank would try to reduce the money supply and ensure that inflation is near target. This policy is oriented towards achieving price level stability. Naveen Abedin20

Nominal GDP Targeting This policy advocates setting a nominal GDP target. This policy originated from the 2008 financial crisis. Recall that MV ≡ PQ, where PQ = GDP (nominal). Due to the financial crisis, people were spending less money, thus holding on to more money. As a result, velocity fell. If the money supply does not increase by a sufficiently large percentage, then GDP will decline. This reduces people’s nominal income, and hence they find it more difficult to pay back debts. As a result, they reduce spending to save money for repaying debt. This causes AD to decrease, and plunge the economy into a recessionary gap. Workers are laid off and unemployment escalates. Naveen Abedin21