Chapter 17: Domestic and International Dimensions of Monetary Policy ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 17: Domestic and International Dimensions of Monetary Policy Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. 1 1 1

What’s So Special About Money? The demand for money, what people wish to hold People have certain motivation that causes them to want to hold money balances. There is a demand for money by the public, motivated by several factors. Transactions demand Precautionary demand Asset demand

What’s So Special About Money? (cont'd) Money Balances Synonymous with money, money stock, and money holdings Transactions Demand Holding money as a medium of exchange to make payments The level varies directly with nominal GDP.

What’s So Special About Money? (cont'd) Precautionary Demand Holding money to meet unplanned expenditures and emergencies Asset Demand Holding money as a store of value instead of other assets such as certificates of deposit, corporate bonds, and stocks

What’s So Special About Money? (cont'd) The demand for money curve Assume the amount of money demanded for transactions purposes is proportionate to income Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate).

Figure 17-1 The Demand for Money Curve

The Demand for Money Curve • When the interest rate rises the opportunity cost of holding money increases and the quantity of money demanded falls • The location of Md is determined by the level of income Md B r2 Q1 Interest Rate A r1 Q2 Quantity of Money

The Tools of Monetary Policy The Fed seeks to alter consumption, investment, and aggregate demand as a whole by altering the rate of growth of the money supply.

The Tools of Monetary Policy (cont'd) The Fed has three tools at its disposal as part of its policymaking action. Open market operations Discount rate changes Reserve requirement changes

The Tools of Monetary Policy (cont'd) Open market operations Fed purchases and sells government bonds issued by the U.S. Treasury At first, there is some equilibrium level of interest rate (and bond prices). An open market operation must cause a change in the price of bonds.

Figure 17-2 Determining the Price of Bonds, Panel (a) Contractionary Policy • Fed sells bonds • Supply of bonds increases • Bond prices fall

Figure 17-2 Determining the Price of Bonds, Panel (b) Expansionary Policy • Fed buys bonds • Supply of bonds falls • Bond prices rise

The Tools of Monetary Policy (cont'd) Relationship between the price of existing bonds and the rate of interest There is an inverse relationship between the price of existing bonds and the rate of interest.

The Tools of Monetary Policy (cont'd) Example You pay $1,000 for a bond that pays $50/year in interest. Bond yield = $50 $1,000 = 5% Now suppose you pay $500 for the same bond. Bond yield = $50 $500 = 10%

The Tools of Monetary Policy (cont'd) The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.

The Tools of Monetary Policy (cont'd) Changes in the difference between the discount rate and the federal funds rate The discount rate is generally kept at 1 percentage point above the market-determined federal funds rate. Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves.

The Tools of Monetary Policy (cont'd) Changes in the reserve requirements An increase (decrease) in the required reserve ratio Makes it more (less) expensive for banks to meet reserve requirements Reduces (expands) bank lending

Effects of an Increase in The Money Supply (cont'd) Direct effect Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services.

Effects of an Increase in The Money Supply (cont'd) Indirect effect Not everybody will necessarily spend the newfound money on goods and services. Some of the money gets deposited, so banks have higher reserves (and they lend the excess out).

Effects of an Increase in The Money Supply (cont'd) Indirect effect Banks lower rates to induce borrowing. Businesses engage in investment. Individuals consume durable goods (like housing and autos). Increased loans generate an increase in aggregate demand. More people are involved in more spending (even those who didn’t get money from the helicopter!).

Graphing the Effects of an Expansionary Monetary Policy Assume the economy is operating at less than full employment Expansionary monetary policy can close the recessionary gap. Direct and indirect effects cause the aggregate demand curve to shift outward.

Figure 17-3 Expansionary Monetary Policy with Underutilized Resources The recessionary gap is due to insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment

Graphing the Effects of Contractionary Monetary Policy Assume there is an inflationary gap Contractionary monetary policy can eliminate this inflationary gap. Direct and indirect effects cause the aggregate demand curve to shift inward.

Figure 17-4 Contractionary Monetary Policy with Overutilized Resources The inflationary gap is shown To decrease AD, use contractionary monetary policy AD decreases and real GDP decreases

Open Economy Transmission of Monetary Policy So far we have discussed monetary policy in a closed economy. When we move to an open economy, monetary policy becomes more complex.

Open Economy Transmission of Monetary Policy (cont'd) The net export effect Impact of expansionary (contractionary) monetary Lower (higher) interest rates Financial capital flows out of (into) the United States Demand for dollars will decrease (increase) International price of dollar goes down (up) Foreign goods look more (less) expensive in United States Net exports increase (decrease) and imports fall (go up)

Open Economy Transmission of Monetary Policy (cont'd) Globalization of international money markets Global money markets reduce the Fed's ability to control the rate of growth in the money supply. Foreign entities can influence both the supply of and demand for U.S. dollars. Their actions can reinforce or offset the Fed strategy.

Monetary Policy and Inflation Most theories of inflation relate to the short run and the price index in the short run can fluctuate due to Oil price shocks, labor union strikes In the long run, there is a more stable relationship between growth in the money supply and inflation.

Monetary Policy and Inflation (cont'd) Simple supply and demand analysis can be used to explain Why the price level rises when the money supply is increased If the supply of money expands relative to the demand for money It takes more units of money to purchase given quantities of goods and services (i.e., the price level has risen)

Monetary Policy and Inflation (cont'd) The Equation of Exchange The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP MsV = PY

Monetary Policy and Inflation (cont'd) V = Income Velocity of Money The number of times per year the dollar is spent on final goods and services; equal to the nominal GDP divided by the money supply.

Monetary Policy and Inflation (cont'd) The equation of exchange and the quantity theory: MSV = PY MS = actual money balances held by nonbanking public V = income velocity of money; the number of times, on average per year, each monetary unit is spent on final goods and services P = price level or price index Y = real GDP per year

Monetary Policy and Inflation (cont'd) The equation of exchange as an identity Total funds spent on final output MsV equals total funds received PY The value of goods purchased is equal to the value of goods sold MsV = PY = nominal GDP

Monetary Policy and Inflation (cont'd) Quantity Theory of Money and Prices The hypothesis that changes in the money supply lead to proportional changes in the price level Assume: V is constant Y is stable Increases in Ms must be matched by equal increases in the price level MsV = PY

Figure 17-5 The Relationship Between Money Supply Growth Rates and Rates of Inflation

Monetary Policy in Action: The Transmission Mechanism Recall we talked about the direct and indirect effects of monetary policy. Direct effect: implies increase in money supply causes people to have excess money balances. Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.

Figure 17-6 The Interest-Rate-Based Money Transmission Mechanism

Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a) At lower rates, a larger quantity of money will be demanded

Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (b) The decrease in the interest rate stimulates investment

Figure 17-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c) The increase in investment shifts the AD curve to the right

Fed Target Choice: Interest Rates or Money Supply? It is not possible to stabilize the money supply and interest rates simultaneously. The Fed has often sought to achieve an interest rate target. There is a fundamental tension between targeting interest rates and controlling the money supply. The Fed, in the short run, can select an interest rate or a money supply target but not both.

Figure 17-8 Choosing a Monetary Policy Target If the Fed selects re, it must accept Ms If the Fed selects M’s, it must allow the interest rate to fall

Fed Target Choice: Interest Rates or Money Supply? (cont'd) The Fed, in the short run, can select an interest rate or a money supply target but not both.

Fed Target Choice: Interest Rates or Money Supply? (cont'd) Choosing a policy target Money supply When variations in private spending occur Interest rates When the demand for (or supply of) money is unstable Interest rate targets are preferred

The Way Fed Policy is Currently Implemented At present the Fed announces an interest rate target. The rate referred to is the federal funds rate of interest. Or, the rate at which banks can borrow excess reserves from each other.

The Way Fed Policy is Currently Implemented (cont'd) If the Fed wants to raise “the” interest rate, it engages in contractionary open market operations. Fed sells more Treasury securities than it buys, thereby reducing the money supply. This tends to boost “the” rate of interest.

The Way Fed Policy is Currently Implemented (cont'd) Conversely, if the Fed wants to decrease “the” rate of interest, it engages in expansionary open market operations. Fed buys more Treasury securities, increasing the money supply. This tends to lower “the” rate of interest.

The Way Fed Policy is Currently Implemented (cont'd) FOMC Directive A document that summarizes the Federal Open Market Committee’s general policy strategy Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth

The Way Fed Policy is Currently Implemented (cont'd) Trading Desk An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC

Chapter 17: Domestic and International Dimensions of Monetary Policy ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 17: Domestic and International Dimensions of Monetary Policy Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. 50 50 50 50