Monetary PolicyChapter 15

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

15-2

Monetary Policy

• Control over the money supply is a critical policy tool for altering macro outcomes– What’s the relationship between the money supply,

interest rates, and aggregate demand?– How can the Fed use its control of the money

supply or interest rates to alter macro outcomes?– How effective is monetary policy, compared to

fiscal policy

15-3

Monetary Policy

• Some economists argue that monetary policy is more effective than fiscal policy; others contend the reverse is true

• Monetary policy: The use of money and credit controls to influence macroeconomic outcomes

15-4

The Money Market

• Like other goods, there’s a supply of money and a demand for money

• The price of money is determined in the money market– Interest rate: The price paid for the use of money

15-5

Money Balances

• Most of the money in the money supply is in the form of bank balances– Money Supply (M1): Currency held by the

public, plus balances in transactions accounts– Money Supply (M2): M1 plus balances in most

savings accounts and money market mutual funds

15-6

The Demand for Money

• Demand for money: The quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus

• Portfolio decision: The choice of how (where) to hold idle funds

15-7

The Demand for Money

• Transactions demand for money: Money held for making everyday market purchases

• Precautionary demand for money: Money held for unexpected market transactions or for emergencies

• Speculative demand for money: Money held for speculative purposes, for later financial opportunities

15-8

The Money Market

• The quantity of money that people are willing and able to hold (demand) increases as interest rates fall, ceteris paribus

• The money supply curve is assumed to be a vertical line– The Federal Reserve has the power to regulate the

money supply through its policy tools

15-9

Equilibrium

• Equilibrium rate of interest occurs at the intersection of the money-demand and money-supply curves

• Equilibrium rate of interest: The interest rate at which the quantity of money demanded in a given time period equals the quantity of money supplied

15-10

0

Inte

rest

Rat

e (%

)

Quantity Of Money

Money Market Equilibrium

Money supply

9

g1

7E1

Money demand

g2

The amount of money demanded (held) depends

on interest rates

15-11

Changing Interest Rates

• The Federal Reserve can alter the money supply through changes in reserve requirements, the discount rate, or through open market operations

• This changes the equilibrium rate of interest

15-12

0

Changing Interest Rates

Demand for money

E1E3

g1 g3

7

6

Money supply and demand set

interest rates

Inte

rest

Rat

e (%

)

Quantity Of Money

Money supply

15-13

Federal Funds Rate

• The federal funds rate is most directly affected when the Fed injects or withdraws reserves from the banking system

• The federal funds rate reflects the cost of funds for banks– Federal Funds Rate: The interest rate for

interbank reserve loans

15-14

Interest Rates and Spending

• When the cost of funds for banks changes, they change the rates they charge on loans

• Changes in interest rates affect consumer, investor, government, and net export spending

15-15

Monetary Stimulus

• The goal of monetary stimulus is to increase aggregate demand

• Stimulating the economy is achieved through– An increase in the money supply– A reduction in interest rates– An increase in aggregate demand

15-16

Monetary StimulusAn increase in the

money supply lowers the rate of interest

g1 g2

Quantity Of Money

Inte

rest

Rat

e

7

6

0

Demand for money

E1

E2

A reduction in the rate of interest stimulates

investment

Inte

rest

Rat

e

7

6

I1 I2 Rate Of Investment

0

Investment demand

More investment increases aggregate demand

(including multiplier effects)

Pri

ce L

evel

Income (Output)

AD1

AD2

AS

15-17

Monetary Restraint

• To lessen inflationary pressures, the Fed will apply a policy of monetary restraint

• This is achieved through– A decrease in the money supply– An increase in interest rates– A decrease in aggregate demand

15-18

Policy Constraints

• Several constraints can limit the Fed’s ability to alter the money supply, interest rates, or aggregate demand

– Short- vs. long-term rates

– Reluctant lenders

– Liquidity trap– Low expectations– Time lags

15-19

Short- vs. Long-Term Rates

• Fed’s open market operations have the most direct effect on short-term rates

• The success of Fed intervention depends in part on how well changes in long-term interest rates mirror changes in short-term interest rates

15-20

Reluctant Lenders

• Banks themselves must expand the money supply by making new loans

• Banks may be unwilling to make new loans even when the Fed is injecting excess reserves into the banking system

15-21

Liquidity Trap & Low Expectations

• Liquidity trap: The portion of the money demand curve that is horizontal; people are willing to hold unlimited amounts of money at some (low) interest rate

• Gloomy expectations deter borrowing

• Investment demand that is slow to respond to lower interest rates is said to be inelastic

15-22

Constraints on Monetary Stimulus

A liquidity trap can stop interest rates from falling

The liquidity

trap

Inte

rest

Rat

e

E1 E2

g1 g2Quantity Of Money

Demand for

money

Inte

rest

Rat

e

Inelastic demand

Investment demand

Rate Of Investment

7

6

0

Inelastic investment demand can also impede monetary policy

15-23

Time Lags

• There is always a time lag between interest-rate changes and investment responses

• It may take 6–12 months before market behavior responds to monetary policy

15-24

Limits on Monetary Restraint

• It is also harder for the Fed to restrain demand– Expectations - Optimistic consumers and investors

may continue borrowing even though interest rates are higher

– Global money - U.S. borrowers might tap global sources of money or local non-bank lenders not regulated by the Fed

15-25

How Effective?

• Keynes believed that monetary policy would not be effective at ending a deep recession

• Combination of reluctant bankers, the liquidity trap, and low expectations could render monetary stimulus ineffective

• Limitations on monetary restraint are not considered as serious

15-26

The Monetarist Perspective

• Keynesians believe that changes in the money supply affect macro outcomes primarily through changes in interest rates

• Monetarists believe monetary policy cannot effectively fight the short-run business cycle but is a powerful tool for managing inflation

15-27

The Equation of Exchange

• Monetarists use the equation of exchange to express the potential of monetary policy

• Equation of exchange: Money supply (M) times velocity of circulation (V) equals level of aggregate spending (P Q)

MV PQ

15-28

The Equation of Exchange

• Income velocity of money (V): The number of times per year, on average, a dollar is used to purchase final goods and services– How often a dollar changes hands

PQV

M

15-29

The Equation of Exchange

• The quantity of money in circulation and its velocity in product markets will always equal total spending and income (nominal GDP)

• The equation implies that if M increases, then prices (P) or output (Q) must rise or V must fall

M V P Q

15-30

Money-Supply Focus

• Monetarists assume velocity (V) is stable

• If so, changes in money supply must alter total spending, regardless of interest rates

• Then the Fed should focus on the money supply itself, not interest rates

15-31

“Natural” Unemployment

• Some monetarists assert that Q, as well as V, is stable at the natural rate of unemployment– Natural rate of unemployment: Long-term rate

of unemployment determined by structural forces in labor and product markets

• The most extreme perspective concludes that changes in the money supply only affect prices

15-32

REAL OUTPUT

PR

ICE

LE

VE

LThe Monetarist View

QN

Long-run Aggregate Supply

AD2

AD1

P2

P1

Fluctuations in aggregate demand affect the price level but not real output.

15-33

Monetarist Policies• Monetarists and Keynesians disagree on

how to stabilize the economy– Keynesians concentrate on how the money

supply affects interest rates, which affects spending, which affects output

– Monetarists use a simple equation (MV=PQ) to produce straightforward monetary policy

15-34

Fighting Inflation

• Keynesian anti-inflation policy is to shrink the money supply to drive up interest rates to slow spending

• Monetarists argue that this policy will push interest rates down rather than up

• Monetarists distinguish between nominal and real interest rates

15-35

Real vs. Nominal Interest

• Monetarists believe that real interest rates are stable, so changes in the nominal interest rate reflect changes in anticipated inflation

Real nominal anticipated interest rate interest rate inflation rate

Nominal real anticipated interest rate interest rate inflation rate

15-36

Short- vs. Long-Term Rates (again)

• According to Monetarists, reducing money supply growth may increase short term rates

• Long term rates won’t change unless people expect inflation to worsen

• The best policy is steady and predictable changes in money supply

15-37

Fighting Unemployment

• The Keynesian cure for unemployment is to expand M and lower interest rates

• Using the equation of exchange, Monetarists fear an increase in M will lead to higher P– Rather than leading us out of recession,

expansionary monetary policies heap inflation on top of our unemployment woes

15-38

The Concern for Content

• Monetary policy, like fiscal policy, can affect the content of GDP as well as its level

• When interest rates change, not all spending decisions will be affected equally

• Monetary policy also redistributes money between lenders and borrowers

15-39

Which Lever to Pull?

• The success in managing the macro economy depends on pulling the right policy levers at the right time

• Keynesians and Monetarists argue about which of the policy levers – M or V – is likely to be effective in altering aggregate spending

15-40

The Policy Tools

• Monetarists point to money supply (M) as the principal macroeconomic policy lever

• Keynesian fiscal policy must rely on changes in velocity (V), as tax and expenditure policies have no direct impact on money supply

15-41

Crowding Out

• If V is constant, changes in total spending can come about only through changes in money supply

• Increased G effectively “crowds out” some C or I, leaving total spending unchanged

• If the government raises taxes, households will have less money to spend

15-42

How Fiscal Policy Matters

15-43

How Money Matters

15-44

Is Velocity Stable?

• The critical question of monetary policy appears to be whether V is stable or not

• The historical pattern justifies the Monetarist assumption of a stable V over long periods of time

• There is a pattern of short-run variations in velocity

15-45

The Velocity of M2

Source: Federal Reserve

15-46

Money Supply Targets

• The differing views of Keynesians and Monetarists lead to different conclusions about which policy lever to pull– Monetarists favor fixed money supply targets– Keynesians advocate targeting interest rates, not

the money supply

15-47

Inflation Targeting

• The Fed has tried both Monetarist and Keynesian strategies

• Price stability is current Fed’s primary goal

• Inflation targeting: The use of an inflation ceiling (“target”) to signal the need for monetary policy adjustments

Monetary PolicyEnd of Chapter 15

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin