Prepared by: Jamal Husein C H A P T E R 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy and Inflation

2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Investment: A Plunge Into the Unknown  An investment is an action today that costs today but provides benefits in the future.  The hope of future payoffs is uncertain; and the trade-off between costs today and (uncertain) future gains is an important aspect of investment.  Financial markets make it easier for economies to invest in the future.

3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Volatility of Investment Spending  John Maynard Keynes referred to the volatility of investment spending as “animal spirits.”  Although it is a much smaller component of GDP than consumption, investment is a much more volatile component of GDP.  The volatility of investment is associated with fluctuations in GDP. Projections of the future and investors’ current animal spirits, both are likely to move in conjunction with real GDP growth.

4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Accelerator Theory  The accelerator theory emphasizes the role of expected growth in real GDP on investment spending.  When real GDP growth is expected to be high, firms anticipate that their investments in plant and equipment will be profitable and therefore increase their total investment spending.

5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Accelerator Theory  In his multiplier-accelerator theory, Nobel laureate Paul Samuelson explained how a downturn in real GDP leads to a sharp fall in investment, which further reduces GDP through the multiplier for investment spending.

6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Investment Spending as a Share of U.S. GDP,  Investment is highly procyclical.

7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Nominal and Real Interest Rates  Nominal interest rates are the rates actually charged in the market—the rates that individuals and firms pay or receive when they borrow or lend money.  Real interest rates are nominal rates adjusted for inflation—by subtracting the inflation rate. This is a concept associated with the reality principle. Reality PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value.

8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Nominal and Real Interest Rates Impact of Inflation for lenders Nominal interest rate6% minus the inflation rate4% = real rate of interest2% Investor lends$100 Receives one year later ($100 x 1.06) $106 minus impact of inflation (100 x 0.04) -$4 = actual real gain$2 Individual borrows$100 pays back after one year ($100 x 1.1) $110 minus impact of inflation (100 x 0.06) -$6 = actual cost to borrower $4 Impact of Inflation for borrowers Nominal interest rate10% minus the inflation rate6% = real rate of interest4%

9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Expected Real Interest Rate  Before individuals lend or borrow, they must form an expectation of the inflation rate in the future.  For a given nominal interest rate, the expected real interest rate is the nominal interest rate minus the expected inflation rate.

10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Investment Spending and Interest Rates  The decision to invest is based on the principle of opportunity cost. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.  The interest rate prevailing in the economy provides a measure of the opportunity cost of investment.  If the net return from an investment exceeds the opportunity cost of the funds, the investment should be undertaken.

11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Returns on Investment  A firm has a menu of investment projects it would like to undertake.  At a market interest rate of 2% per year, for example, only investment A is unprofitable. All the other investments have a return greater than the opportunity cost of the funds. Investment CostReturn A$100$101 B C D E  As market interest rates rise, there will be fewer profitable investments.

12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Interest Rates and Investment  There is a negative relationship between real investment spending and the real interest rate. As the real rate of interest rises, fewer investment projects will be profitable.  Nominal rates of interest are not a good indicator of the true cost of investing.  The firm makes its investment decisions by comparing its expected real net return from investment projects to the real rate of interest.

13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Model of the Money Market  The model of the money market combines the supply of money, determined by the Fed, with the demand for money, determined by the public, to see how interest rates are determined in the short run.

14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Demand for Money  Money is simply a part of your wealth. You can hold assets such as stocks or bonds, or hold wealth in the form of money.  Holding wealth in currency or checking deposits that pay little or no interest means that you sacrifice the potential income from interest and dividends earned on stocks and bonds.  So why hold money? Because it makes it easier to conduct transactions.

15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Demand for Money  The transactions demand for money is based on the principle of opportunity cost: PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.  The opportunity cost of holding money is the return that you could have earned by holding your wealth in other assets.  The market rate of interest is a measure of the opportunity cost of holding money.

16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Demand for Money  As interest rates increase, the opportunity cost of holding money increases, and the public will demand less money.  Conversely, the demand for money will decrease with an increase in interest rates—or an equivalent increase in the opportunity cost of holding money.

17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Demand for Money A decrease in real GDP An increase in real GDP A decrease in the price level An increase in the price level Factors That Decrease the Demand for Money Factors That Increase the Demand for Money

18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Demand for Money  The liquidity demand for money refers to the desire of individuals to hold assets that can be easily transferable into the medium of exchange, such as currency or checking accounts, so they can make transactions on quick notice.  Individuals also demand some types of money found in M2, such as a savings account, in order to avoid the risk of falling stock or bond prices. This demand for money that is safer than other assets is called speculative demand for money.  In practice, the demand for money is the sum of transactions, liquidity, and speculative demands.

19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money Market Equilibrium  The supply of money is determined by the Fed, so we assume that it is independent of the interest rate.  In the model of the money market, the money supply is a vertical supply curve.  Combining the supply of money with the demand for money yields the equilibrium interest rate.

20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money Market Equilibrium  At the equilibrium interest rate, r 0, the quantity of money supplied equals the quantity demanded.  A higher interest rate yields an excess supply of money. The interest rate will tend to fall.  A lower interest rate causes an excess demand for money. The interest rate will tend to rise.

21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Interest Rate Intervention  An increase in the money supply, through an open market purchase of bonds, causes the money supply to shift rightward.  The increase in the money supply leads to a lower interest rate.  On the other hand, if the Fed sells bonds in the open market, the money supply decreases and interest rates will increase.

22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Interest Rates, Investment, & Output  The supply and demand for money determine the equilibrium interest rate. At the equilibrium interest rate, the level of investment in the economy will be given by I *. MdMd MsMs I Money Investment Interest rates r*r* r*r* I*I*

23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy  The Federal Reserve can change the level of output in the short run: An open market purchase of government bonds increases the supply of money, which in return, causes interest rates to fall; With the decrease in interest rates, investment spending goes up; The increase in investment spending will shift AD to the right, causing both output and prices to rise in the short run.

24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy The sequence of the two main events for an open market operation by the Federal reserve is as follows: Open Market sale decrease in money supply Rise in interest rate Fall in Investment spending Decrease In GDP or Open Market purchase increase in money supply Decrease in interest rate increase in Investment spending increase In GDP

25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy  As the money supply increases, equilibrium interest rates fall from r 0 to r 1. Investment spending increases from I 0 to I 1. MdMd M0sM0s I Money Investment Interest rates r0r0 I0I0 M1sM1s I1I1 r1r1

26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy in an Open Economy  When we take into account the effect of international trade, monetary policy operates through an additional route.  International trade or movements of financial funds across countries are affected by interest rates and exchange rates.

27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Exchange Rate  The exchange rate is the rate at which one currency trades for another currency. Supply and demand for a currency determine the exchange rate. In effect, the exchange rate is the price of a given currency in the foreign exchange market.  A decrease in the value of a currency is called depreciation, while an increase in the exchange rate is called appreciation.

28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Interest Rates and Exchange Rates  There is a direct relationship between a country’s interest rates and its exchange rate.  Higher interest rates in the United States cause an increase in the demand for dollars as foreign investors seek higher returns in United States banks. A higher demand for dollars leads to a higher exchange rate of the dollar against foreign currencies. The dollar appreciates.  Lower U.S. interest rates induce investors to sell their dollars and buy the foreign currency of a more attractive country in which to invest. A higher supply of dollars leads to dollar depreciation.

29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Exchange Rates and Net Exports  As the dollar appreciates, U.S. goods become more expensive on world markets. U.S. exports decline. Meanwhile, a higher value of the dollar makes it cheaper for U.S. residents to buy foreign goods. U.S. imports rise. Lower exports combined with higher imports result in a decrease in net exports.  Conversely, dollar depreciation leads to an increase in net exports. If the economy were in a recession, dollar depreciation could help increase GDP through higher net exports.

30 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy in an Open Economy  The effect of interest rates on net exports accentuates the effect of monetary policy. Monetary policy is even more powerful in an open economy than in a closed economy. Take the case of a decision by the Fed to adopt expansionary monetary policy: Net exports increase Open market purchase Money supply increases Interest rates fall Exchange rate falls GDP increases

31 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monetary Policy in an Open Economy  The case of a decision by the Fed to adopt contractionary monetary policy: Net exports decrease Open market sale Money supply decreases Interest rates rise Exchange rate rises GDP decreases

32 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money & Inflation in the Long Run  What is the relationship between money growth, inflation and interest rates?  Economists believe that, in the long run, changes in the supply of money have no effect on any real variables in the economy, such as employment, output, or real interest rates.

33 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Long-run Neutrality of Money  The assertion that, in the long run, changes in the money supply are “neutral” with respect to real variables in the economy, is known as the long run neutrality of money.  Money is, however, not neutral in the short run. In the short run, changes in the money supply affect interest rates, investment spending, and output.

34 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Long-run Neutrality of Money  Monetary expansion that initially leads to output above full employment, higher prices and wages, and higher demand for money, eventually results in higher interest rates, lower investment, and a return to full employment.

35 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Long-run Neutrality of Money  If every green dollar was replaced by two blue dollars, then: Everyone would have twice as many blue dollars as they formerly had of green dollars. Prices and wages quoted in the blue currency would simply be twice as high as for the green dollars. The purchasing power of blue money would be the same as it was for green money, therefore, real wages would be the same as before.

36 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Long-run Neutrality of Money  In the long run, the currency conversion has no effect on the real economy, and will be neutral. Prices adjust to the amount of nominal money available.  Whether the money comes from an open market purchase or a currency conversion, it will be neutral in the long run.

37 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money & Inflation in the Long Run  In the short run, changes in money growth affect real output, or real GDP.  In the long run, changes in the money supply do not affect real variables in the economy.  In the long run, the rate of money growth determines the rate of inflation and not real GDP.  In the long run, money is neutral. If nominal wages and prices rise at the same rate, say 5% per year, then real wages remain constant.

38 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money & Inflation in the Long Run  Continued inflation has a tendency to become the normal state of affairs in an economy.  For example, when producers hold their expectations of inflation at 5%, they will on average expect input prices and wages to be 5% higher next year. Expectations of inflation become ingrained in decisions made in all aspects of life.

39 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money & Inflation in the Long Run  Workers would understand that a 5% increase in wages would be matched by a 5% increase in the prices of the goods they buy.  When workers fail to recognize that the only reason why nominal wages rise by 5% is because of a general 5% inflation, we say that they suffer from money illusion.

40 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money & Inflation in the Long Run  When the public holds expectations of inflation, real and nominal rates of interest will differ. Nominal rate of interest = Real rate of interest + Expected rate of inflation  In the long run, changes in the money supply do not affect real variables, including the real interest rate. But nominal rates, which depend on the rate of inflation, will be affected by the growth of the money supply.

41 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Money & Inflation in the Long Run  Because of inflation, countries with higher money growth typically have higher nominal interest rates than the nominal interest rates in countries with lower money growth rates.  Money demand is also affected by expectations of inflation. Inflation increases the demand for money to match the expected increase in inflation.