1. Lecture 9 Monetary Policy 3 13

2. Impact of Monetary Policy Evolution of the modern view: The Keynesian view dominated during the 1950s and 1960s. Keynesians argued that the money supply did not matter much. Monetarists challenged the Keynesian view during the1960s and 1970s. Monetarists argued that changes in the money supply caused both inflation and economic instability. While minor disagreements remain, the modern view emerged from this debate. Modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy. The following slides present this modern view.

3. The Federal Reserve and Interest Rates Example How much money should Kims restaurants hold? Currently holding $50,000/day Two ways to reduce cash holdings: 1.Increase cash pickups costing $500/yr; reduce cash holdings by $10,000. 2.Use a computerized cash management service costing $700/yr, along with more pickups would reduce cash holdings by $20,000

4. The Federal Reserve and Interest Rates Example How much money should Kims restaurants hold? Interest rate = 6% Earn $600/$10,000 for reduction in cash Benefit ($600) > Cost ($500) of cash pickups Benefit ($600) < Cost ($700) of management system

5. The Federal Reserve and Interest Rates Example How much money should Kims restaurants hold? Interest rate = 8% Earn $800/$10,000 for reduction in cash Benefit ($800) > Cost ($500) of cash pickups Benefit ($800) > Cost ($700) of management system

6. The Federal Reserve and Interest Rates Example How much money should Kims restaurants hold? If the interest rate = 6%, hold $40,000 in cash If the interest rate = 8%, hold $30,000 in cash

7. The Federal Reserve and Interest Rates Macroeconomic Factors that Affect the Demand for Money Cost of holding money The nominal interest rate (i) The quantity of money demanded is inversely related to the nominal interest rate

8. The Federal Reserve and Interest Rates Macroeconomic Factors that Affect the Demand for Money Benefit of holding money Real income or output (Y) An increase in real income will increase the demand for money and vice versa The price level (P) The higher the price level, the greater the demand for money and vice versa

9. The Money Demand Curve Money M Nominal interest rate i MdMd Demand for money is inversely related to the nominal interest rate (i)

10. A Shift In The Money Demand Curve Money M Nominal interest rate i MdMd M d Shifts in MD Changes in Y & P MD will increase if Y or P increase Technological changes Foreign demand

11. Quantity of money Money interest rate The supply of money is vertical because it is established by the Fed and, hence, determined independent of the interest rate. Money Supply The Supply of Money

12. The Federal Reserve and Interest Rates The Supply of Money and Money Market Equilibrium The Fed controls the supply of money with open-market operations. An open-market purchase of bonds by the Fed will increase the money supply. An open-market sale of bonds by the Fed will decrease the money supply.

13. Equilibrium in the Market for Money Money Money demand curve, M d E Money supply curve, M s M i M1M1 i1i1 If interest = i 1 Q md > Q ms People sell interest bearing assets to hold more money Price of financial assets falls and interest rates rise Nominal interest rate

14. The Fed Lowers the Nominal Interest Rate Nominal interest rate MdMd E MsMs M Money i M i F M s The Fed wants to lower i Fed buys bonds The money supply increases Creates a surplus of money People buy interest bearing assets Non-money asset prices rise and interest rates fall

15. The Federal Funds Rate, 1970-2004

16. Money interest rate Equilibrium: The money interest rate gravitates toward the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the Fed has supplied. Money Supply The Demand and Supply of Money Money Demand i3i3 ieie i2i2 Excess supply at i 2 Excess demand at i 3 At i e, people are willing to hold the money supply set by the Fed. Quantity of money

17. D1D1 Money interest rate S1S1 D S1S1 i1i1 QsQs r1r1 Q1Q1 i2i2 QbQb r2r2 Q2Q2 S2S2 S2S2 Real interest rate Quantity of money Qty of loanable funds Fed buys bonds, expands money supply Transmission of Monetary Policy Increase in banks with additional reserves. Increased supply of loanable funds Reduction in interest rates

18. Price Level Goods & Services (real GDP) D S1S1 r1r1 Q1Q1 r2r2 Q2Q2 S2S2 Real interest rate P1P1 Y1Y1 Y2Y2 AS 1 AD 1 P2P2 AD 2 Transmission of Monetary Policy As the real interest rate falls, AD increases (to AD 2 ). If this is unanticipated, the expansion in AD leads to a short- run increase in output (from Y 1 to Y 2 ) Increase in the price level (from P 1 to P 2 ) – inflation. The impact of a shift in monetary policy is transmitted through interest rates, exchange rates, and asset prices. Qty of loanable funds

19. Unanticipated Expansionary Monetary Policy Fed buys bonds Transmission of Monetary Policy Real interest rates fall Increases in investment & consumption Depreciation of the dollar Increase in asset prices Increases in investment & consumption Net exports rise Increase in aggregate demand This increases money supply and bank reserves

20. AD 1 If the increase in AD accompanying expansionary monetary policy is felt when the economy is operating below capacity, the policy will help direct the economy toward long-run full-employment equilibrium Y F. Expansionary Monetary Policy Price Level LRAS Y F Y1Y1 AD 2 Goods & Services (real GDP) P2P2 SRAS 1 P1P1 E2E2 e1e1 Here, the increase in output from Y 1 to Y F will be long term.

21. AD 1 Alternatively, if the demand-stimulus effects are imposed on an economy already at full-employment Y F, they will lead to excess demand, higher product prices, and temporarily higher output (Y 2 ). Price Level LRAS YFYF P2P2 Goods & Services (real GDP) P1P1 SRAS 1 E1E1 Y2Y2 AD Increase Disrupts Equilibrium AD 2 e2e2

22. AD 1 Price Level LRAS Y F P2P2 Goods & Services (real GDP) P1P1 SRAS 1 AD 2 E1E1 e2e2 Y2Y2 In the long-run, the strong demand pushes up resource prices, shifting short run aggregate supply (from SRAS 1 to SRAS 2 ). P3P3 AD Increase: Long Run SRAS 2 The price level rises (from P 2 to P 3 ) and output falls back to full-employment output again (Y F from its temporary high,Y 2 ). E3E3

23. A Shift to More Restrictive Monetary Policy The Fed institutes restrictive monetary policy by selling bonds, increasing the discount rate, or raising the reserve requirements. The Fed generally sells bonds, which: depresses bond prices, drains reserves from the banking system, which then, places upward pressure on real interest rates. As a result, an unanticipated shift to a more restrictive monetary policy reduces aggregate demand and thereby decreases both output and employment.

24. Price Level Goods & Services (real GDP) D r2r2 Q2Q2 r1r1 Q1Q1 S1S1 S2S2 Real interest rate P2P2 Y2Y2 Y1Y1 AS 1 P1P1 AD 1 AD 2 Short-run Effects of More Restrictive Monetary Policy Increased interest rates Qty of loanable funds Higher interest rates decrease aggregate demand (to AD 2 ). If unanticipated, real output will decline (to Y 2 ) and downward pressure on prices will result.

25. The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its impact. Price Level LRAS Y F P1P1 Goods & Services (real GDP) P2P2 SRAS 1 AD 1 e1e1 Y1Y1 Restrictive Monetary Policy AD 2 Restrictive monetary policy will reduce aggregate demand. If the demand restraint occurs during a period of strong demand and an overheated economy, then it may limit or prevent an inflationary boom. E2E2

26. In contrast, if the reduction in aggregate demand takes place when the economy is at full-employment, then it will disrupt long-run equilibrium, and result in a recession. AD Decrease Disrupts Equilibrium AD 1 Price Level LRAS YFYF Y2Y2 AD 2 Goods & Services (real GDP) P1P1 SRAS 1 P2P2 E1E1 e2e2

27. Proper Timing If a change in monetary policy is timed poorly, it can be a source of economic instability. It can cause either recession or inflation. Proper timing of monetary policy is not easy: While the Fed can institute policy changes rapidly, there may be a time lag before the change exerts much impact on output & prices. This time lag may be 6 to 18 months in the case of output, and even longer, perhaps as much as 36 months, before there is a significant impact on the price level. Given our limited ability to forecast the future, these lengthy time lags clearly reduce the effectiveness of discretionary monetary policy as a stabilization tool.

28. Questions for Thought: 1. What are the determinants of the demand for money? The supply of money? 2. If the Fed shifts to more restrictive monetary policy, it typically sells bonds. How will this action influence the following? a. the reserves available to banks b. real interest rates c. household spending on consumer durables d. the exchange rate value of the dollar e. net exports f. the price of stocks and real assets like apartment or office buildings g. real GDP

29. Questions for Thought: 3. Timing a change in monetary policy correctly is difficult because a.monetary policy makers cannot act without congressional approval. b.it is often 6 to 18 months in the future before the primary effects of the policy change will be felt. 4.When the Fed shifts to a more expansionary monetary policy, it often announces that it is reducing its target federal funds rate. What does the Fed generally do to reduce the federal funds rate?

30. Questions for Thought: 5. The demand curve for money: a. shows the amount of money balances that individuals and business wish to hold at various interest rates. b. reflects the open market operations policy of the Federal Reserve.

31. Monetary Policy in the Long Run

32. = xx M V P Y M oney V elocity P rice Y = Income The Quantity Theory of Money The quantity theory of money: If V and Y are constant, then an increase in M will lead to a proportional increase in P.

33. Long-run Impact of Monetary Policy -- The modern View Long-run implications of expansionary policy: When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and real output will return to their long-run normal levels. Thus, in the long run, growth of the money supply will lead primarily to higher prices (inflation) just as the quantity theory of money implies.

34. Price level (ratio scale) Time periods Money supply growth rate 3 1 6 9 23 4 Real GDP AD 1 LRAS YFYF SRAS 1 (a) Growth rate of the money supply. (b) Impact in the goods & services market. 3% growth AD 2 8% growth Long-run Effects of a Rapid Expansion in the Money Supply Here we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3 to 8 percent. Initially, prices are stable (P 100 ) when the money supply is expanding by 3% annually. The acceleration in the growth rate of the money supply increases aggregate demand (shift to AD 2 ). P 100 E1 E1

35. At first, real output may expand beyond the economys potential Y F … Time periods 3 1 6 9 23 4 Real GDP AD 1 LRAS YFYF SRAS 1 E1 E1 P 100 (a) Growth rate of the money supply. (b) Impact in the goods & services market. 3% growth AD 2 SRAS 2 8% growth Long-run Effects of a Rapid Expansion in the Money Supply however low unemployment and strong demand create upward pressure on wages and other resource prices, shifting SRAS 1 to SRAS 2. Output returns to its long-run potential Y F, and the price level increases to P 105 (E 2 ). E2 E2 P 105 Y1Y1 Price level (ratio scale) Money supply growth rate

36. Time periods 3 1 6 9 23 4 Real GDP AD 1 LRAS YFYF SRAS 1 E1 E1 P 100 (a) Growth rate of the money supply. (b) Impact in the goods & services market. 3% growth AD 2 SRAS 2 8% growth Long-run Effects of a Rapid Expansion in the Money Supply If the more rapid monetary growth continues, then AD and SRAS will continue to shift upward, leading to still higher prices (E 3 and points beyond). The net result of this process is sustained inflation. E2 E2 P 105 AD 3 P 110 SRAS 3 Price level (ratio scale) Money supply growth rate E3 E3