1. Monetary Policy and Aggregate Demand
Chapter 10
Monetary Policy and Aggregate Demand

2. Preview
To understand the positive relationship between real interest rates and inflation, which is called the monetary policy (MP) curve
To develop the aggregate demand curve using the monetary policy curve and the IS curve 2

3. The Federal Reserve and Monetary Policy
The Fed of the United States conducts monetary policy by setting the federal funds rate—the interest rate at which banks lend to each other
Because the real interest rate is (Ch. 2), and if prices are sticky, changes in monetary policy does not immediately affect inflation and expected inflation
When the Federal Reserve lowers the federal funds rate, real interest rates fall; and when the Federal Reserve raises the federal funds rate, real interest rates rise. 3

4. The Monetary Policy Curve
The monetary policy (MP) curve shows how monetary policy, measured by the real interest rate, reacts to the inflation rate, :
The MP curve is upward sloping: real interest rates rise when the inflation rate rises 4

5. FIGURE 10.1 The Monetary Policy Curve5

6. Schematically, if a central bank allows r to fall when rises, then:
The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope
The key reason for an upward sloping MP curve is that central banks seek to keep inflation stable
Taylor principle: To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation, so that r rises when rises
Schematically, if a central bank allows r to fall when rises, then: 6 6

7. Two types of monetary policy actions that affect interest rates:
Shifts in the MP Curve
Two types of monetary policy actions that affect interest rates:
Automatic (Taylor principle) changes as reflected by movements along the MP curve
Autonomous changes that shift the MP curve
Autonomous tightening of monetary policy that shifts the MP curve upward (in order to reduce inflation)
Autonomous easing of monetary policy that shifts the MP curve downward (in order to stimulate the economy) 7

8. FIGURE 10.2 Shifts in the Monetary Policy Curve8

9. Those actions represented movements along the MP curve
Policy and Practice: Movements Along the MP Curve: The Rise in the Federal Funds Rate Target,
Beginning in 2004, the economy was growing rapidly and inflationary pressure began to rise
Between June 2004 and June 2006, the FOMC decided to raise the federal funds rate at every meeting
Those actions represented movements along the MP curve 9

10. FIGURE 10.3 The Inflation Rate and the Federal Funds Rate, 2003-2013
Source: Federal Reserve Bank of St. Louis. FRED database. 10

11. Instead the Fed lowered the federal funds rate
Policy and Practice: Autonomous Monetary Easing at the Onset of the Financial Crisis
When the financial crisis started in August 2007, inflation was rising and economic growth was quite strong
The MP curve would have suggested that the Fed would continue to keep raising the federal funds rate
Instead the Fed lowered the federal funds rate
This reflects that the Fed pursued autonomous monetary policy easing, thus shifting the MP curve down, because the Fed perceived the economy to weaken in the near future due to the financial crisis 11

12. The Aggregate Demand Curve
The aggregate demand curve represents the relationship between the inflation rate and aggregate demand when the goods market is in equilibrium 12

13. Deriving the Aggregate Demand Curve Graphically
The AD curve is derived from:
The MP curve
The IS curve
The AD curve has a downward slope: As inflation rises, the real interest rate rises, so that spending and equilibrium aggregate output fall 13

14. FIGURE 10.4 Deriving the AD Curve14

15. Box: Deriving the Aggregate Demand Curve Algebraically
The numerical version of the AD curve can be derived from (1) the numerical IS curve from Chapter , and (2) then substituting in for r from the numerical MP curve
Similarly, the general version of the AD curve can be derived by substituting in for r from the MP curve using the algebraic version of the IS curve in Chapter 9: 15

16. Factors that Shift the Aggregate Demand Curve
Shifts in the IS curve
Autonomous consumption expenditure
Autonomous investment spending
Government purchases
Taxes
Autonomous net exports
Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction 16

17. FIGURE 10.5 Shift in the AD Curve From Shifts in the IS Curve17

18. Factors that Shift the Aggregate Demand Curve (cont’d)
Shifts in the MP curve
An autonomous tightening of monetary policy, that is a rise in real interest rate at any given inflation rate, shifts the aggregate demand curve to the left
Similarly, an autonomous easing of monetary policy shifts the aggregate demand curve to the right 18

19. FIGURE 10.6 Shift in the AD Curve From Autonomous Monetary Policy Tightening19

20. The Money Market and Interest Rates
The liquidity preference framework determines the equilibrium nominal interest rate by equating the supply of and demand for money
John Maynard Keynes developed a theory of money demand that he described as liquidity preference theory
Real money balances—the quantity of money in real terms—reflect how much money people want to hold (demand) 20

21. Liquidity Preference and the Demand for Money
According to Keynes, the demand for money can be expressed in the form of the liquidity preference function: 21

22. Liquidity Preference and the Demand for Money (cont’d)
Why are real money balances negatively related to i?
i represents the opportunity cost of holding money 22

23. Liquidity Preference and the Demand for Money (cont’d)
Why are real money balances positively related to Y?
As income rises, households and firms conduct more transactions and so keep more money on hand to make purchases
Higher incomes make households and firms wealthier, and the wealthy tend to hold larger quantities of all financial assets, including money 23 23

24. As a result, the demand curve for money slopes downward
In short-run analysis, prices are assumed to be sticky so the price level is fixed at
All else being equal, lower real interest rates mean the opportunity cost of holding money falls, so that firms and households desire to higher quantities of real money balances
As a result, the demand curve for money slopes downward 24

25. Supply Curve for Money
The Fed fixes the money supply by open market operations
When the Fed buys (sells) government securities in open market operations, it increases (decreases) deposits at banks, so that bank reserves and liquidity in the banking system increase (decrease) 25

26. Supply Curve for Money
An open market purchase leads to an increase in liquidity and the money supply
An open market sale of government securities leads to a decrease in liquidity and a decrease in the money supply 26 26

27. Supply Curve for Money (cont’d)
The supply curve for money (MS) shows the quantity of real money balances supplied at each price level
The line MS is a vertical line because:
The money supply is fixed by the Fed at
The price level in the short run is fixed at
Thus, the quantity of real money balances supplied is 27 27

28. FIGURE 10.7 Equilibrium in the Money Market28

29. Equilibrium in the Money Market
Equilibrium in the money market occurs when the quantity of real money balances demanded equals the quantity of real money balances supplied:
Graphically, equilibrium occurs where MD and MS curves intersect at i*
An excess supply (demand) of money results in a decrease (an increase) in i 29

30. Changes in the Equilibrium Interest Rate
A shift in the MD (or MS) curve occurs when the quantity demanded (or supplied) changes at each given interest rate in response to a change in some other factor besides the interest rate 30 30

31. Changes in the Equilibrium Interest Rate (cont’d)
Examples of factors that shifts the MD or MS:
When income rises, MD shifts to the right and so interest rates will rise
When the money supply increases, MS shifts to the right and so interest rates will decline
When the price level rises, MS shifts to the right and so interest rates will rise 31 31

32. FIGURE 10.8 Response to Shift in the Demand Curve from a Rise in Income32

33. FIGURE 10.9 Response to Shifts in the Supply Curve (a)33

34. FIGURE 10.9 Response to Shifts in the Supply Curve (b)34

35. Chapter 10 Appendix The Demand for Money35

36. Keynesian Theories of Money Demand
Three motives behind the demand for money in Keynes’ liquidity preference theory:
Transactions motive
People hold money to carry out everyday transactions
Affected by payment technology (e.g., credit cards)
Precautionary motive
Money holding as a cushion against unexpected needs
Proportional to income, Y
Speculative motive
Money as a store of wealth
As the interest rate i rises, the opportunity cost of money rises (it is more costly to hold money relative to bonds) and the quantity of money demanded falls 36 36

37. Putting the Three Motives Together
Keynes’ liquidity preference function that combines the 3 motives together:
An important implication is that velocity, V, is not a constant buy will fluctuate with changes in interest rates. This is because , so that (assuming Md=M): 37 37

38. Portfolio Theories of Money Demand
In Keynes’ portfolio theories of money demand, the main determinants of the demand for an asset:
Wealth—total resources owned by individuals, including all assets
Expected return—the return expected on the asset relative to other assets
Risk—the degree of uncertainty associated with the return on the asset relative to other assets. Most people do not like risk (risk averse)
Liquidity—the ease and speed with which an asset can be turned into cash relative to other assets 38 38

39. Portfolio Theory and Keynesian Liquidity Preference
Portfolio theory justifies Keynesian liquidity preference theory as the demand for real money balances in both theories is:
positively related to income
negatively related to the nominal interest rate 39 39

40. Other Factors That Affect the Demand for Money
Wealth
Portfolio theory posits that as wealth increases, investors have more resources to purchase assets, increasing the demand for money (such as M1, known as dominated assets because they are perceived as safe) 40 40

41. Other Factors That Affect the Demand for Money (cont’d)
Risk
When the stock market becomes more volatile, the demand for money, which is perceived as less risky, increases
An increase in the variability of the real return on money reduces its money as people shift into alternative assets as inflation hedges 41 41

42. Other Factors That Affect the Demand for Money (cont’d)
Liquidity of other assets
The development of new liquidity assets, e.g., money market mutual funds, reduces the relative liquidity of money, so that the demand for money falls 42 42

43. TABLE 10A1.1 FACTORS THAT DETERMINE THE DEMAND FOR MONEY43 43

44. Empirical Evidence on the Demand for Money
Is the demand for money sensitive to changes in interest rates?
The liquidity trap is an extreme case of ultrasensitivity in the demand for money to interest rates, implying that a change in the money supply has no effect on interest rates
There is little evidence of a liquidity trap, except in recent years when interest rates fell to near zero 44 44

45. Empirical Evidence on the Demand for Money (cont’d)
Is the demand for money function stable?
By the early 1970s, evidence strongly supported the stability of the money demand function.
After 1973, there is evidence substantial instability in estimated money demand functions because of the rapid pace of financial innovation, which changed which items could be used for money. 45 45