Upload
cmsrahaman
View
1.467
Download
1
Tags:
Embed Size (px)
Citation preview
MONETARY POLICYGT01003
Macroeconomics
Learning Objectives
1. Analyze how changes in real interest rates affect planned aggregate expenditures (PAE) and short-run equilibrium output
2. Show how the demand for money and the supply of money determine equilibrium nominal interest rate
3. Discuss how central bank uses control of the money supply to influence nominal and real interest rates
Introduction: Monetary Policy• Monetary policy is a major stabilization tool• Quickly decided and implemented• More flexible and responsive
Introduction: Central Banks• Responsibilities of Central Banks are
• Conduct monetary policy• Oversight and regulation of financial markets
• Central to solving financial crises
Introduction: Central Bank and the Economy
Eliminate output gaps by changing the money supply
Changes in money supply cause changes in nominal interest rate
Interest rates affect planned aggregate expenditures, PAE
HOW DOES INTEREST RATE AFFECT PAE & SHORT-RUN EQUILIBRIUM OUTPUT??
PAE and Real Interest Rate• Planned Aggregate Expenditures have components that
are affected by r• Savings decisions of households
• More saving at higher real interest rates• Higher saving means less consumption
• Investment by firms• Higher interest rates mean less investment
• Investments are made if the cost of borrowing is less than the return on the investment
• Both consumption and planned investment decrease when the interest rate increases
Interest in the Keynesian Model – An Example
• Components of aggregate spending areC = 640 + 0.8 (Y – T) – 400rIP = 250 – 600 r
G = 300
NX = 20
T = 250
• If r increases from 0.04 to 0.05 (that is, from 4% to 5%)• Consumption decreases by 400 (0.01) = 4• Planned investment decreases by 600 (0.01) = 6
• A one percentage point increase in r reduces planned spending by 10 – before the multiplier is considered
Planned Aggregate Expenditures
PAE = C + IP + G + NX
PAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r + 300 + 20
PAE = 1,010 – 1,000 r + 0.8 Y
• In this example, planned aggregate expenditure depends on both the real interest rate and the level of output• Equilibrium output can only be found once we know the value of r
Planned Aggregate Expenditures
PAE = 1,010 – 1,000 r + 0.8 Y• Suppose the real interest rate is 5%, or 0.05• Planned aggregate expenditures becomes
PAE = 1,010 – 1,000 (0.05) + 0.8 Y
PAE = 960 + 0.8 Y• Short-run equilibrium output is PAE = Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800• The graphical solution is the same as before
Can Central Bank Control the Real Interest Rates?• Central Bank controls the money supply to control
nominal interest rates, i• Investment and saving decisions are based on the real
interest rate, r• Central bank has some control over the real interest rate
r = i - where is the rate of inflation
• Central Bank has good control over i• Inflation changes relatively slowly
• Changes in nominal rates become changes in real rates
Monetary Policy and Economic Fluctuations
r C, IP PAE Y via the multiplier
r C, IP PAE Y via the multiplier
Recessionary Gap
Expansionary Gap
Central Bank Fights a Recession
Output (Y)
Pla
nn
ed a
gg
rega
te e
xpe
ndi
ture
(P
AE
)
Y = PAE
E
Expenditure line (r = 5%)
4,800
A reduction in r shifts the expenditure line upward and closes the recessionary gap
5,000Y*
Expenditure line (r = 1%)
F
Central Bank Fights Inflation• Expansionary gap can lead to inflation
• Planned spending is greater than normal output levels at the established prices
• Short-run unplanned decreases in inventories• If gap persists, prices will increase
• Central bank attempts to close expansionary gaps• Raise interest rates• Decrease consumption and planned investment• Decrease planned aggregate expenditures• Decrease equilibrium output
Monetary Policy for an Expansionary Gap
PAE = 1,010 – 1,000 r + 0.8 Y• The real interest rate, r, is 5%
• Short-run equilibrium output is $4,800
• Potential output is $4,600• Expansionary gap is $200
• Monetary policy can be used to decrease PAE• The Central Bank should decrease the real interest rate to
9%
Central Bank Fights Inflation
Output (Y)
Pla
nn
ed a
gg
rega
te e
xpe
ndi
ture
(P
AE
)
Y = PAE
E
Expenditure line (r = 5%)
4,800
An increase in r shifts the expenditure line down and closes the expansionary gap
4,600Y*
Expenditure line (r = 9%)
G
Central Bank Fights Inflation
r
Planned C and I
PAE
Y
r
Planned C and I
PAE
Y
Expansionary Gap Recessionary Gap
HOW DO CENTRAL BANKS CONTROL INTEREST RATES?
Central Bank and Interest Rates• Controlling the money supply is the primary task of a
central bank:• Money supply and demand determine the interest rate• Central bank manipulates supply to achieve its desired interest rate
• To better understand how the central bank determines interest rates, we will look first at the market for money – the demand for money and the supply of money.
Demand for Money• Demand for money is sometimes called
an individual's liquidity preference• The Cost – Benefit Principle indicates people
will balance the marginal cost of holding money versus the marginal benefit• Money's benefit is the ability to make
transactions
• Quantity of money demanded increases with income
• Technologies such as online banking and ATMs have reduced the demand for money• M1 has decreased from 28% of GDP in 1960 to
12% in 2004
Demand for Money• Demand for money depends on
• Nominal interest rate (i)• The higher the interest rate, the lower the quantity of money demanded
• Real income or output (Y)• The higher the level of income, the greater the quantity of money
demanded
• The price level (P)• The higher the price level, the greater the quantity of money demanded
Demand for Money• The marginal cost of holding money is the interest
foregone• Most forms of money pay little or no interest
• Assume the nominal interest rate on money is 0• Alternative assets such as stocks or bonds have a positive nominal
interest rate
• The higher the nominal interest rate, the smaller the quantity of money demanded
• Business demand for money is similar to individuals'• Businesses hold more than half of the money stock
The Money Demand Curve• Interaction of the aggregate demand for money and the
supply of money determines the nominal interest rate• The money demand curve shows the relationship
between the aggregate quantity of money demanded, M, and the nominal interest rate• An increase in the
nominal interest rate increases the opportunity cost of holding money• Negative slope
Money (M)
Nom
inal
inte
rest
rat
e (i)
MD
The Money Demand Curve• Changes in factors other than the nominal interest rate
cause a shift in the money demand curve• An increase in demand for money can result from
• An increase in output• Higher price levels• Technological advances• Financial advances• Foreign demand for
dollars
Money (M)Nom
inal
inte
rest
rat
e (i)
MDMD'
Supply of Money• Central bank primarily controls the supply of money with
open-market operations• An open-market purchase of bonds by central bank increases the
money supply (expansionary monetary policy)• An open-market sale of
bonds by central bank decreases the money supply (contractionary monetary policy)
• Supply of money is vertical• Equilibrium is at E
Money (M)
MD
E
MS
M
i
No
min
al in
tere
st r
ate
(i
)
Central Bank Controls the Nominal Interest Rate
• Initial equilibrium at E• Central Bank increases the money
supply to MS'• New equilibrium at F• Interest rated decrease to i'
to convince the marketto hold the new, largeramount of money
Money (M)
MD
MS
M
Ei
Nom
inal
inte
rest
rat
e (i)
Fi'
M'
MS'
Central Bank (CB) Controls the Nominal Interest Rate
CB sells bonds to the public
Supply of bonds increases
Price of bonds decrease
Interest rate increases
To Decrease the Money Supply
CB buys bonds from the public
Demand for bonds increases
Price of bonds increase
Interest rate decreases
To Increase the Money Supply
The US Federal Funds Rate, 1970-2008
26-M
ay-0
4
15-S
ep-0
4
5-Ja
n-05
27-A
pr-0
5
17-A
ug-0
5
7-Dec
-05
29-M
ar-0
6
19-J
ul-06
8-Nov
-06
28-F
eb-0
7
20-J
un-0
7
10-O
ct-0
7
30-J
an-0
8
21-M
ay-0
8
10-S
ep-0
8
31-D
ec-0
8
22-A
pr-0
9
12-A
ug-0
9
2-Dec
-09
24-M
ar-1
0
14-J
ul-10
3-Nov
-10
23-F
eb-1
1
15-J
un-1
1
5-Oct
-11
25-J
an-1
2
16-M
ay-1
2
5-Sep
-12
26-D
ec-1
20
0.5
1
1.5
2
2.5
3
3.5
4
Malaysian Overnight Policy Rates
Overnight Policy Rates
Additional Controls over the Money Supply
• Open market operations are the main tool of money supply
• Central bank offers lending facility to banks• If a bank needs reserves, it can borrow from the
Central Bank at the discount rate
• The discount rate is the rate the Central Bank charges banks to borrow reserves
• Lending increases reserves and ultimately increases the money supply
• Changes in the discount rate signal tightening or loosening of the money supply
Additional Controls over the Money Supply
• Central Bank can also change the reserve requirement for banks• The reserve requirement is the minimum percentage of bank
deposits that must be held in reserves• The reserve requirement is rarely changed
• The Central Bank could increase the money supply by decreasing the reserve requirement• Banks would have excess reserves to loan
• The Central Bank could decrease the money supply by increasing the reserve requirement
Conclusion
Keynesian Model
Open Market Operations
Discount Rate
Reserve Requirement
Money Market
Monetary Policy
Demand for Money
Supply of Money
Central Bank
Stabilization Policy
Interest Rates