4 Money Supply What is the value of the money multiplier if r = 10% and c = 20 %?m = 4.
5 Bank of England’s View on Transmission Mechanisms of Monetary Policy: How Does Money Supply Affect the Price Level?i,r,er,PePC+I+GMSYπX,MTwo Conditions to have real effect of Monetary policyCentral bank controls monetary base M1 = R + CuPrices do not adjust instantaneously
6 An Increase in Money Supply Can Lower Real and Nominal Interest Rates in the Short but not in the Long RunFisher EquationirTtimet0Monetary policy can have some real effect in the short run but not in the long run. Short runs become shorter with more accurate expectations
8 Bank of England’s Fan Chart for Forecast of an Economic Variable Percentage increase in prices on a year earlierB&W Figure 9.7Source: Inflation Report, Bank of England, November 2000
9 Objective Targets and Instruments of Monetary Policy
10 Transmission Mechanisms of Monetary Policy Credit ChannelLower interestMore reservesMore lendingHigher aggregate demandDeficit financingRediscounting of Treasury BillsInterest rate ChannelLower interest rateMore borrowing and SpendingMore aggregate demandOpen Market OperationExchange Rate ChannelLower interest rateDepreciation of domestic currencyMore exports and less importsHigher aggregate demandBuy back own currencies selling some foreign assets to avoid depreciation - sterilisationselling its currency to avoid appreciationBalance Sheet ChannelLower interest rateIncrease in prices of stocks, bonds and other assetsMore wealthMore aggregate demandMoral hazards - bank panics, systematic risk, regulation - bank supervision
11 Open Market Operation: Interest Rate Channel Expansionary Monetary PolicyShort run:Central bank reduces the repo rateCommercial banks and financial institutions find it profitable to sell bonds to the central bankCentral bank raises their reservesCommercial banks have more money to lendFirms and households find it cheaper to borrowThey borrow and create more depositsDemand for goods and services risesMoney supply expandsLong run:Prices will eventually rise following higher demandReal money supply (M/P) shrinksInterest rises back to natural position
12 Open Market Operation: Interest Rate Channel Contractionary Monetary PolicyShort run:Central bank raises the repo rateCommercial banks and financial institutions find it profitable to buy bonds from the central bankCentral bank sell bonds and reduces reserves of the financial institutionsCommercial banks have less money to lendFirms and households find it expensive to borrowThey pay back loans and close deposits accountsDemand for goods and services fallsMoney supply contractsLong run:Prices will eventually fallReal money supply increasesInterest rises back to natural position
13 Contribution of Monetarism in Macroeconomic Policy Supply of money is the determinant of the national incomeIn the long run, the influence of money is primarily on the price level and other nominal magnitudes. Real output and employment are not determined by monetary factors.In the short run the supply of money does affect the output. Money is the dominant factor in causing cyclical fluctuations in output and employment in the short run.Private sector is inherently stable and instability is primarily the result of the government policy.
14 Small Change in money supply has a larger output effect than a Controversy Over Macroeconomic Impacts of Fiscal and Monetary PoliciesMonetarist Model:Monetary policy moreEffectiveKeynesian ModelFiscal Policy ismore effectiveiiLM0bIS1aLM1IS0cIS1LM0Is0LM1YYSmall Change in money supplyhas a larger output effect than abigger change in public spendingSmall Change in public Spendinghas a larger output effect than aLarger change in money supply
15 Basic Structure of the Keynesian Static Model for Monetary Policy
16 Multiplier Effect of Increase in Money Supply on Output and Interest Rate Shortcoming of the Keynesian Model: Missing Supply Side
17 Assets and Liabilities of the Financial System of An Economy RESERVEMonetaryBase
18 References Blanchard (14,17,25) Bernanke B. S. and F.S. Mishkin (1997) Inflation Targeting: A New Fremework for Monetary Policy, Journal of Economic Perspectives, vol. II, no.2, Spring, ppBhattarai (2002) An Analysis of Interest Determination in the UK and Four Major Leading Economies, Research Memorandum no. University of Hull.Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII MarchGoodhart Charles (1989) The Conduct of Monetary Policy, Economic Journal, 99, June, ppHicks, J. R. (1937) Mr. Keynes and the “Classics”; A Suggested Interpretations, Econometrica 5:1:Kydland, F. E. and E.C. Prescott (1977) Rules Rather than Discretion: The Inconsistency of Optimal Plans, JPE vol. 85, no. 3, ppMonetary Policy Committee, Bank of England Transmission Mechanism of Monetary Policy.Laidler D and M Parkin (1975) Inflation: A Survey, The Economic Journal, vol. 85, Issue 340, December,