Money, Banking, Prices, and Monetary Policy Chapter 12 Money, Banking, Prices, and Monetary Policy Copyright © 2014 Pearson Education, Inc.

The Inflation Rate (1) and The Fisher Relation (2) (2 approx) © 2014 Pearson Education, Inc.

Substitute using the approximate Fisher relation. Nominal Money Demand Substitute using the approximate Fisher relation. For some of our experiments, suppose inflation rate is zero (harmless, it’s short run). © 2014 Pearson Education, Inc.

Figure 12.5 The Nominal Money Demand Curve in the Monetary Intertemporal Model © 2014 Pearson Education, Inc.

Figure 12.6 The Effect of an Increase in Current Real Income on the Nominal Money Demand Curve per dato P an increase in r does the opposite (more convenient investing in bonds) © 2014 Pearson Education, Inc.

Figure 12.7 The Current Money Market in the Monetary Intertemporal Model (with inflation) ↑ Ms => P ↑ (old story) ↑ Md (e.g. ↑ liquidity preference) => r ↑ => I ↓ => Y ↓ => P ↓ © 2014 Pearson Education, Inc.

Labor Demand and Labor Supply Real wage = w = W/P Nd=labor demand (employers) Ns=labor supply(employees, workers): if r (from today onwards) ↑ => better to work harder today and save for tomorrow (intertemporal model) Ns also positively depends upon W (nominal) © 2014 Pearson Education, Inc.

Figure 12.9 A Level Increase in the Money Supply in the Current Period © 2014 Pearson Education, Inc.

Figure 12.10 The Effects of a Level Increase in M The Neutrality of Money (hp perfect information) In a monetary intertemporal model, a level increase in the money supply increases the price level and the nominal wage in proportion to the money supply increase, but has no effect on any real macroeconomic variable. © 2014 Pearson Education, Inc.

The Short-Run Nonneutrality of Money: Friedman-Lucas Money Surprise Model (hp imperfect information) Different aggregate shocks hit the economy – money supply shocks and productivity shocks – and consumers cannot observe these shocks directly. Imperfect information: consumers know the market nominal wage, but they do not observe all prices simultaneously, so they do not know their real wage. © 2014 Pearson Education, Inc.

Figure 12.14 The Effects of an Unanticipated Increase in the Money Supply in the Money Surprise Model Money supply increases: workers see an increase in their nominal wage, and think that their real wage has increased. Workers supply more labor, labor becomes cheaper and output increases. Nonneutrality of money, but only because people are fooled into working harder. © 2014 Pearson Education, Inc.

Shifts in Money Demand: now the CB is uninformed! These shifts are important for how monetary policy should be conducted. Shifts in the demand for money that occur within a day, week or month (the very short run) are a critical for the central bank. © 2014 Pearson Education, Inc.

A Shift in the Demand for Money © 2014 Pearson Education, Inc.

Instability in Money Demand © 2014 Pearson Education, Inc.

Shocks that the central bank is concerned with money demand, output demand, output supply Key problem for the central bank: it cannot observe the shocks directly, and does not have timely information on all economic variables. Two alternative policy rules which central banks have adopted: money supply targeting, interest rate targeting. © 2014 Pearson Education, Inc.

Figure 12.15: A Surprise Increase in Money Demand When There Is MONETARY TARGETING by the Central Bank (constant M, or CONSTANT GROWTH RATE of M) 2) P↓, W (nom.)↓ workers reduce labor supply N↓, w (real)↑ Interest rate targeting would be less (output) destabilizing 3) less labor (more expensive) => Y supply ↓ + money dem. ↑ => r ↑ Typo in the book: switch Y1 and Y2 1) Money demand increases (e.g. preference for liquidity): P↓ © 2014 Pearson Education, Inc.

Figure 12.16 A Total Factor Productivity Increase When There Is Interest Rate Targeting by the Central Bank TFP↑ => employers ↑ labor demand N ↑, w (real)↑ 4) P↓ => W↓=> employees ↓ labor supply Notice: W↓= w ↑*P↓↓ 2) pressure for Y supply↑ and decrease in prices => pressure for r↓ 3) In order to prevent r↓ the CB must ↓Ms => P↓ This destabilizes prices! © 2014 Pearson Education, Inc.

Optimal Central Banking What tends to work well in practice is for the central bank to target a short-term nominal interest rate in the very short run, and to consider changing this target every few weeks. There is much volatility in money demand in the very short run – interest rate targeting accommodates this. Productivity shocks are slower moving – the interest rate target can change in response. Mostly used: Taylor rule © 2014 Pearson Education, Inc.

The Zero Lower Bound and Quantitative Easing Zero lower bound: The nominal interest rate cannot go below zero What happens when r = 0 ? At the zero lower bound there is a liquidity trap. Increasing the money supply through conventional means does not do anything – even prices do not change. © 2014 Pearson Education, Inc.

Figure 12.18 A Typical Yield Curve © 2014 Pearson Education, Inc.

But in a liquidity trap, this does not work. Quantitative Easing Under conventional accommodative monetary policy, the central bank swaps money for short-term government securities, drives down short-term interest rates and stimulates short-run investment. But in a liquidity trap, this does not work. However, long-term nominal interest rates can be positive when short-term rates are zero. What if the central bank purchases long-term government securities? Long-term interest rates should go down => long term investment should increase and Y can also increase © 2014 Pearson Education, Inc.