Domestic and International Dimensions of Monetary Policy Chapter 17 Domestic and International Dimensions of Monetary Policy

Introduction It is up to the Federal Reserve Board of Governors to determine whether the pace of money supply growth will be aimed at maintaining a steady rate of inflation. If so, then the interest rate will fluctuate. Why are these two variables related?

Learning Objectives Identify the key factors that influence the quantity of money that people desire to hold Describe how the Federal Reserve’s tools of monetary policy affect the level of real GDP and the price level Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run

Learning Objectives Understand the equation of exchange and its importance in the crude quantity theory of money and prices Distinguish between the Keynesian and monetarist views on the transmission mechanism of monetary policy Explain why the Federal Reserve cannot stabilize both the money supply and the interest rate simultaneously

Chapter Outline What’s So Special About Money? The Tools of Monetary Policy Effects of an Increase in the Money Supply Open Economy Transmission of Monetary Policy

Chapter Outline Monetary Policy and Inflation Monetary Policy in Action: The Transmission Mechanism Fed Target Choice: Interest Rates or Money Supply? The Way Fed Policy is Currently Announced

Did You Know That… The European Central Bank oversees the EMU money supply, including transaction account balances held within the member nations? The level of the money supply in an economy will affect the position of the aggregate demand curve?

What’s So Special About Money? Money is the product of a “social contract” in which we all agree to: Express all prices in terms of a common unit of account, which in the United States we call the dollar Use a specific medium of exchange for market transactions

What’s So Special About Money? Anything that affects the amount of money in existence is going to affect all markets. Holding money To use money, one must hold money. If people desire to hold money, there is a demand for money.

What’s So Special About Money? The demand for money: the amount of money people wish to hold Transactions demand Precautionary demand Asset demand

What’s So Special About Money? Transactions Demand Holding money as a medium of exchange to make payments The level varies directly with nominal national income

What’s So Special About Money? Precautionary Demand Holding money to meet unplanned expenditures and emergencies The level varies with the interest rate

What’s So Special About Money? Asset Demand Holding money as a store of value instead of other assets The level varies with the interest rate

What’s So Special About Money? The demand for money curve The amount of money demanded for transactions purposes is fixed given the level of income Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate)

The Demand for Money Curve Md Interest Rate Quantity of Money Figure 17-1

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 Open market operations The Fed changes reserves by buying and selling government bonds issued by the U.S. Treasury.

Determining the Price of Bonds Contractionary Policy • Fed sells bonds • Supply of bonds increases • Bond prices fall P1 Price of Bonds Quantity of Bonds per Unit Time Period Figure 17-2, Panel (a)

Determining the Price of Bonds Contractionary Policy • Fed sells bonds • Supply of bonds increases • Bond prices fall P1 P2 Price of Bonds Quantity of Bonds per Unit Time Period Figure 17-2, Panel (a)

Determining the Price of Bonds Expansionary Policy • Fed buys bonds • Supply of bonds falls • Bond prices rise Price of Bonds P1 Quantity of Bonds per Unit Time Period Figure 17-2, Panel (b)

Determining the Price of Bonds Expansionary Policy • Fed buys bonds • Supply of bonds falls • Bond prices rise P3 Price of Bonds P1 Quantity of Bonds per Unit Time Period Figure 17-2, Panel (b)

The Tools of Monetary Policy Relationship between the price of existing bonds and the rate of interest What happens to the interest on a bond when the price of a bond increases (decreases)?

The Tools of Monetary Policy Example You pay $1,000 for a bond that pays $50/year in interest Rate of interest = $50 $1000 = 5%

The Tools of Monetary Policy Example Now suppose you pay $500 for the same bond Rate of interest = $50 $500 = 10%

The Tools of Monetary Policy 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 Changes in the discount rate Increasing the discount rate increases the cost of borrowed funds for depository institutions that borrow reserves Decreasing the discount rate decreases the cost of borrowed funds for depository institutions that borrow reserves

The Tools of Monetary Policy Changes in the discount rate Why is the discount rate a less important monetary tool today that in the 1920s? Since 2002, the Fed has kept the discount rate 1 percentage point above the market-determined federal funds rate.

The Tools of Monetary Policy Changing the discount rate relative to the federal funds rate The Fed has been keeping the discount rate one percentage point above the federal funds rate. This discourages borrowing from the Fed.

The Tools of Monetary Policy Changes in the reserve requirements An increase in the required reserve ratio Makes it more expensive for banks to meet reserve requirements Reduces bank lending A decrease in the required reserve ratio Makes it less expensive for banks to meet reserve requirements Increases bank lending

Effects of an Increase in the Money Supply When the money supply increases, people have too much money. How can this be? Have you ever had too much money? If you have a savings account, then at some point you had too much money. Money is not the same thing as income.

International Example: Controlling Growth of the Money Supply In Zimbabwe, government officials tried to stem an inflationary growth of the money supply by no longer printing the highest denomination currency note. But this did not reduce the demand for money, as citizens simply chose to hold more lower denomination notes.

Monetary Policy During Periods of Underutilized Resources Monetary policy can generate increases in the equilibrium level of real GDP.

Expansionary Monetary Policy with Underutilized Resources 12.0 LRAS SRAS • The contractionary gap is caused by insufficient AD • To increase AD, use expansionary monetary policy • AD increases and real GDP increases to full employment AD1 Price Level 11.5 120 E1 Recessionary gap Real GDP per Year ($ trillions) Figure 17-3

Expansionary Monetary Policy with Underutilized Resources 12.0 LRAS SRAS AD2 • The contractionary gap is caused by insufficient AD • To increase AD, use expansionary monetary policy • AD increases and real GDP increases to full employment 125 E2 AD1 Price Level 11.5 120 E1 Recessionary gap Real GDP per Year ($ trillions) Figure 17-3

Tools of Monetary Policy Contractionary monetary policy: effects on aggregate demand, the price level, and real GDP Question What will happen?

Contractionary Monetary Policy via Open Market Operations Figure 17-4

Open Economy Transmission of Monetary Policy The net export effect Impact of expansionary monetary policy increase the money supply interest rates fall value of the dollar falls net exports increase the net export effect complements the effectiveness of monetary policy

Open Economy Transmission of Monetary Policy The net export effect Impact of expansionary fiscal policy revisited larger deficit higher interest rates attracts foreign capital value of the dollar appreciates net exports fall net export effect reduces the effectiveness of fiscal policy

International Policy Example: The Effect of the Exchange Rate on Net Exports In 2003, nominal interest rates in Switzerland were close to zero, as an expansionary monetary policy had been employed to combat a recession. The expansionary policy served also to depreciate the Swiss franc, which stimulated net exports. It was this open economy effect that accounted for the eventual increase in aggregate demand, ending the recession.

Open Economy Transmission of Monetary Policy Globalization of international money markets How will global money markets impact the Fed's ability to control the rate of growth in the money supply?

Monetary Policy and Inflation Short-run inflation Temporarily shocks the SRAS and AD Long-run inflation The supply of money expands relative to the demand for money Takes more units of money to purchase given quantities of goods and services (i.e., the price level has risen)

Monetary Policy and Inflation 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 output (or nominal national income) MsV = PY

Monetary Policy and Inflation The equation of exchange and the quantity theory: MSV = PY MS = actual money balances held by non-banking public V = income velocity of money; the number of times, on average, cash monetary units are spent on final goods and services

Monetary Policy and Inflation The equation of exchange and the quantity theory: MSV = PY P = price level Y = real national output per year

Monetary Policy and Inflation The equation of exchange as an identity MsV = PY PY = nominal national income MsV = nominal national spending

Monetary Policy and Inflation The crude quantity theory of money and prices Assume: V is constant Q is stable MsV = PY

Monetary Policy and Inflation The crude quantity theory of money and prices Increases in Ms must be matched by equal increases in the price level MsV = PY

Adding Monetary Policy to the Keynesian Model MS M’S Md r1 Interest Rate Quantity of Money Figure 17-7, Panel (a)

Adding Monetary Policy to the Keynesian Model MS M’S At lower rates, a larger quantity of money will be demanded Md r1 Interest Rate Interest rate falls r2 Quantity of Money Figure 17-7, Panel (a)

Adding Monetary Policy to the Keynesian Model Interest Rate Planned Investment Figure 17-7, Panel (b)

Adding Monetary Policy to the Keynesian Model The decrease in the interest rate stimulates investment I1 Interest Rate r2 I2 Planned Investment Figure 17-7, Panel (b)

Adding Monetary Policy to the Keynesian Model 12.0 LRAS SRAS AD1 Price Level 11.5 E1 Real GDP per Year ($ trillions) Figure 17-7, Panel (c)

Adding Monetary Policy to the Keynesian Model 12.0 LRAS SRAS AD2 AD1 E2 Price Level 11.5 E1 The increase in investment shifts the AD curve to the right Real GDP per Year ($ trillions) Figure 17-7, Panel (c)

Monetary Policy in Action: The Transmission Mechanism The monetarist’s views of money supply changes Macroeconomists who believe that inflation is always caused by excessive monetary growth and that changes in the money supply affect AD both directly and indirectly

Monetary Policy in Action: The Transmission Mechanism The monetarist’s views of money supply changes Increase in the money supply increases aggregate demand directly Based on the equation of exchange, prices always rise when the money supply is increased

Monetary Policy in Action: The Transmission Mechanism Monetarists’ criticism of monetary policy Time lags are too long to use monetary policy effectively Monetary policy is seen as a destabilizing force

Monetary Policy in Action: The Transmission Mechanism Monetary Rule A monetary policy that incorporates a rule specifying the annual rate of growth of some monetary aggregate Example Increase in the money supply smoothly at a rate consistent with the economy’s long-run average growth rate

Monetary Policy in Action: The Transmission Mechanism What do you think? What would happen to the effectiveness of the monetary rule if the velocity of money is not stable?

Fed Target Choice: Interest Rates or Money Supply? It is not possible to stabilize the money supply and interest rate simultaneously.

Choosing a Monetary Policy Target MS M’S Md Interest Rate Quantity of Money Figure 17-8

Choosing a Monetary Policy Target MS M’S Md If the Fed selects re, it must accept Ms re A D If the Fed selects M’s, it must allow the interest rate to fall Interest Rate r1 C B Quantity of Money Figure 17-8

Fed Target Choice: Interest Rates or Money Supply? Target interest rates The money supply will be unstable Target the money supply The interest rate will be unstable

Fed Target Choice: Interest Rates or Money Supply? Choosing a target Interest rates When the demand for money is unstable Money supply When variations in private spending occur

The Way Fed Policy is Currently Announced No matter what the Fed is actually targeting, it only announces an interest rate target. The current strategy is outlined in the FOMC directive. This strategy is implemented through open market operations conducted by the Trading Desk of the New York Federal Reserve.

Issues and Applications: Maintaining Federal Reserve Targets The Trading Desk of the New York Federal Reserve Bank implements the Federal Open Market Committee directives. If a lowering of interest rates is called for, then the Fed will purchase bonds, pumping reserves into the banking system.

Issues and Applications: Maintaining Federal Reserve Targets The Fed sells bonds, drawing reserves from the banking system, when a contractionary measure in needed. The Fed does not set the federal funds rate explicitly, but it changes the level of reserves in depository institutions, and this influences the money supply.

Summary Discussion of Learning Objectives Key factors that influence the quantity of money that people desire to hold: To make transactions To hold for precautionary reasons To hold as an asset (store of value)

Summary Discussion of Learning Objectives How the Federal Reserve’s monetary policy tools influence market interest rates Open market purchases, reducing the discount rate, or reducing the required reserve ratio increases the money supply and lowers the interest rate. Open market sales, raising the discount rate, or increasing the required reserve ratio decreases the money supply and raises the interest rate.

Summary Discussion of Learning Objectives How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run Expansionary monetary policy Increase real GDP Decrease the price level Contractionary monetary policy Decrease real GDP

Summary Discussion of Learning Objectives The equation of exchange and the crude quantity theory of money and prices Equation of exchange MV = PY Crude quantity theory of money and prices V is constant and Y is Stable Increases in M cause proportionate increases in P

Summary Discussion of Learning Objectives Keynesian versus monetarist views on the transmission mechanism of monetary policy Keynesian transmission mechanism Changes in interest rates cause changes in investment which change equilibrium real GDP Monetarist transmission mechanism Changes in the money supply change desired spending

Summary Discussion of Learning Objectives Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes To target the money supply the Fed must permit the interest rate to vary when the demand for money changes

Domestic and International Dimensions of Monetary Policy End of Chapter 17 Domestic and International Dimensions of Monetary Policy