Monetary Policy

1
Monetary Policy
Money Supply
Interest Rates
2
Demand for Money
Cash, not wealth
Transactions Demand
Bills
Assets Demand
Interest rate
3
Demand for Money
Transactions Demand
Assets Demand
Interest Rate
Quantity of Money
4
Supply of Money
Determined by the FRS
Interest Rate
Quantity of Money
5
Surpluses and Shortages
Money interestrate
Money Supply
i2
ie
i3
Money Demand
Quantity of money
6
The Equation of Exchange
P
Y
M
V
Y
M
V
P
- the amount of money in circulation
- the number of times each is spent in a year
(considered to be stable)
- the level of prices
- the actual output of goods and services
7
The Equation of Exchange
P
Y
M
V

• If V and P are constant, then an increase in M
  will lead to a proportional increase in Y
  GDP increases.

• but if V and Y are constant (at full employment),
  then an increase in M will lead to a proportional
  increase in P Inflation.

8
The Demand for Money

• 1. The total demand for money is equal to the
  transaction plus the asset demand for money.
• Assume each dollar held for transaction purposes
  is spent (on the average) four times per year to
  buy final goods and services.
• This means that transaction demand for money will
  be equal to (what fraction or percent)
  ____________ of the nominal GDP and
• If the nominal GDP is 2000 billion, the
  transaction demand will be _______ billion.

9
Easy Money Policy
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
10
Easy Money Policy

• Fed buys bonds money supply increases

• The banks have new reserves.

both have downward pressure on interest rates (a
reduction to r2).
Moneyinterestrate
S1
Realinterestrate
S1
i1
r1
i2
r2
D1
D
Qty of loanable funds
Quantityof money
Qs
Q1
Qb
Q2
11
Easy Money Policy
As the real interest rate falls, AD increases (to
AD2).
The expansion in AD leads to a short-run increase
in output (from Y1 to Y2) and an increase in the
price level (from P1 to P2) inflation.
PriceLevel
S1
Realinterestrate
S2
r1
P2
P1
r2
D
AD1
Qty of loanable funds
Goods Services (real GDP)
Q1
Q2
Y1
Y2
12
Easy Money Policy
LRAS
PriceLevel
SRAS1
P2
P1
e1
AD1
Goods Services(real GDP)
YF
Y1

• If the increase in AD is when the economy is
  below capacity, the policy will help direct the
  economy toward long-run full-employment
  equilibrium YF.

13
LRAS
PriceLevel
SRAS1
P2
P1
E1
AD1
Goods Services(real GDP)
YF
Y2
If the increase is at full-employment YF, they
will lead to excess demand, higher product
prices, and temporarily higher output Y2.
14
LRAS
PriceLevel
SRAS1
P3
P2
e2
P1
E1
AD2
AD1
Goods Services(real GDP)
YF
Y2
In the long-run, the strong demand pushes up
resource prices, shifting short run aggregate
supply (from SRAS1 to SRAS2).
The price level rises (from P2 to P3) and output
falls back to YF from its temporary high,Y2.
15
Tight Money Policy
a. The Reserve Requirement
Increase or decrease?
b. The Discount Rate
Raise or Lower?
c. Open Market Operations
Buy or Sell?
16
Tight Money Policy
Restrictive monetary policy, will increase real
interest rates.
Higher interest rates decrease AD (to AD2).
Real output will decline (to Y2) and downward
pressure on prices will result.
Realinterestrate
S1
r2
P1
P2
r1
AD1
D
Qty of loanable funds
Q2
Q1
Y2
Y1
17
LRAS
PriceLevel
SRAS1
P1
e1
P2
AD1
Goods Services(real GDP)
YF
Y1
If the demand restraint occurs during a period of
strong demand and an overheated economy, then it
may limit or prevent an inflationary boom.
18
LRAS
PriceLevel
SRAS1
P1
E1
P2
AD1
Goods Services(real GDP)
YF
Y2
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.
19
Monetary Policy In the Long Run
20
The Equation of Exchange
P
Y
M
V
Y
M
V
P
- the amount of money in circulation
- the number of times each is spent in a year
(considered to be stable)
- the level of prices
- the actual output of goods and services
21
The Equation of Exchange
P
Y
M
V

• If V and P are constant, then an increase in M
  will lead to a proportional increase in Y
  GDP increases.

• but if V and Y are constant (at full employment),
  then an increase in M will lead to a proportional
  increase in P Inflation.

22
In the Long Run
This highlights the linkage between the growth of
the money supply and inflation
23
In the Long Run
a. Output is set, Price affected
b. With rising prices, decision makers build
inflation rate into their choices
c. Interest rates, wages and incomes cause
Aggregate Supply to decrease
d. Output drops back to Full Employment level
24
Graphically
Increasing the money supply from 3 to 8

• aggregate demand shifts to AD2

Price level(ratio scale)
Money supply growth rate
9
8 growth
6
P100
3
3 growth
Timeperiods
RealGDP
1
2
3
4
25
Output may expand from YF to Y1
This creates upward pressure on wages and other
resource prices, shifting SRAS1 to SRAS2.

• Output returns to its long-run potential YF, and
  the price level increases to P105 (E2).

Price level(ratio scale)
Money supply growth rate
LRAS
9
8 growth
SRAS1
P105
6
E1
P100
3
3 growth
AD2
AD1
Timeperiods
RealGDP
YF
Y1
1
2
3
4
26
If it continues, then AD and SRAS will continue
to shift upward, leading to still higher prices
(E3 and points beyond).
The net result of this process is sustained
inflation.
Price level(ratio scale)
Money supply growth rate
LRAS
SRAS2
P110
9
8 growth
SRAS1
P105
E2
6
E1
P100
3
3 growth
AD2
AD1
Timeperiods
RealGDP
YF
1
2
3
4
27
With stable prices supply and demand in the
loanable funds market are in balance at a real
nominal interest rate of 4.
Loanable FundsMarket
Interestrate
(expected rate
S1
of inflation 0 )
i.09
r.04
(expected rate
D1
of inflation 0 )
Quantity of loanable funds
Q
If monetary expansion leads to 5 inflation,
borrowers and lenders will build the higher
inflation rate into their decision making.
As a result, the nominal interest rate i will
rise to 9.
28
Anticipated Changes
LRAS
PriceLevel
SRAS1
P3
P1
E1
AD1
Goods Services(real GDP)
YF
When monetary expansion is anticipated, output is
not changed.
Suppliers build the expected price rise into
their decisions, causing aggregate supply to
shift in.
Nominal wages, prices, interest rates rise, but
their real values remain constant. Inflation
results.
29
Monetary Policy's Effect on Interest Rates
In the long run (at full employment)
a. expansionary monetary policy leads to
inflation and high interest rates, rather than
low interest rates
b. restrictive monetary policy, when pursued
over a lengthy time period, leads to low
inflation and low interest rates.
30
Summary of Monetary Policy's Effects
1. An unanticipated change in monetary policy
will temporarily stimulate or retard output and
employment.
2. The effects depend on the state of the
economy. (Full employment or unemployment)
31
Summary of Monetary Policy's Effects
3. Persistent growth of the money supply at a
rapid rate will cause inflation.
4. Money interest rates and the inflation rate
will be directly related.
32
The Story in Pictures
16
14
12
10
8
6
4
2
0
-2
1960
1965
1970
1975
1980
1985
1990
1995
2000
2003
a Annual percent change in M2
b 4-quarter percent change in real GDP
Source Federal Reserve Bank of St. Louis,
http//www.stls.frb.org.
Decreases in Money Supply have generally preceded
reductions in real GDP and recessions (indicated
by shading).
Increases in the money supply, have often been
followed by a rapid growth of GDP.
33
Money Supply Changes Inflation
14
12
12
10
10
8
8
6
4
6
4
2
2
0
? M2
19601963
19651968
19701973
19751978
19801983
19851988
19901993
19951998
20002003
? P
a 4-quarter percent change in M2
b inflation calculated as 4-quarter moving average
Source Federal Reserve Bank of St. Louis,
http//www.stls.frb.org. The CPI was used to
measure the annual rate of inflation.

• This shows the growth rate of the money supply M2
  and the annual rate of inflation 3 years later.

• The data indicate that the periods of monetary
  accelerationtend to be associated with an
  increase in the rate of inflation about 3 years
  later.

• Similarly, a slower growth rate of the money
  supply is associated with a reduction in the
  inflation rate.

34
Inflation and Interest Rates
16
12
8
4
0
2003
1960
1965
1970
1975
1980
1985
1990
1995
2000
a annual rate of inflation calculated using the
CPI
Source Federal Reserve Bank of St. Louis,
http//www.stls.frb.org.

• The expectation of inflation . . .

• reduces the supply of, and,
• increases the demand for loanable funds,

• Note how the short-term money rate of interest
  has tended to increase when the inflation rate
  accelerates (and decline as the inflation rate
  falls).

35
Inflation and Growth Rate of Money
Internationally

• The average annual growth rate of the money
  supply and the rate of inflation , 1980-1999.

1000
100
Rate of inflation (, log scale)

• higher rates of money growth lead to higher
  rates of inflation.

10
1
100
1,000
1
10
Rate of money supply growth (, log scale)
36
Inflation Money An International Comparison
1985 - 2005
1000
Note The money supply data are the actual
growth rate of the money supply minus the growth
rate of real GDP.
100
Rate of inflation (, log scale)
10
1
100
1,000
1
10
Rate of money supply growth (, log scale)
37
The Taylor Rule

• Most economists believe that price indexes
  slightly overstate the rate of inflation.
• The 2 desired rate of inflation might be thought
  of as approximate price stability.

38
The Taylor Rule

• Developed by John Taylor of Stanford,
• an estimate of the federal funds interest rate
  that would be consistent with both price
  stability and full employment.
• The equation

f

r

p

.5

(p-p)

.5

(y-yp)
f - the target fed funds rate r - equilibrium
real interest rate (assumed to be 2.5) p -
actual inflation rate p - the desired inflation
rate (assumed to be 2) y - output yp - potential
output
39

• When inflation is high and output is large
  relative to the potential, more restrictive
  monetary policy and a higher target fed funds
  rate would be appropriate.
• But, when inflation is low and current output
  well below its potential, more expansionary
  monetary policy and a lower fed funds rate would
  be called for.

40
Why is the Taylor Rule Important?

• It provides a guide for the conduct of monetary
  policy and a tool for the evaluation of how well
  it is being conducted.
• 2. If the actual fed funds rate is below the
  target rate implied by the Taylor rule, this
  indicates monetary policy is overly expansionary.
• 3. On the other hand, when the actual federal
  funds rate is above the target rate, this signals
  monetary policy is too restrictive.
• 4. When the actual and target rates are equal,
  this indicates monetary policy is on target.

41
The Taylor Rule and Monetary Policy, 1960-2009
Actual Fed Funds Rate
Taylor Rule Target

• Both quite close during most of the 1960s and
  1986-1999 .
• indicates that monetary policy was appropriate
  for the maintenance of full employment and low
  inflation.

42
The Taylor Rule and Monetary Policy, 1960-2009
Actual Fed Funds Rate
Taylor Rule Target

• However the actual fed funds rate was
  substantially less than the target rate in the
  inflationary 1970s and during 2002-mid-year 2005.
• Shows monetary policy was too expansionary then.

43
Did Monetary Policy Cause the Crisis of 2008?

• Between January 2002 and mid-year 2006, housing
  prices increased by 87.
• This boom in housing prices was fueled by several
  factors including
• government regulations that eroded lending
  standards and promoted the purchase of housing
  with little or no down payment
• heavily leveraged borrowing for the financing of
  mortgage-backed securities

44
Did Monetary Policy Cause the Crisis of 2008?

• But, the expansionary Fed policy of 2002-2004,
  followed by the shift to a more restrictive
  monetary policy in 2005-2006 also contributed to
  the housing boom and subsequent bust.

45
Short-Term Interest Rates, 1998-2009
Federal Funds
1-Year T-Bill

• Rising short-term interest rates are indicative
  of monetary restriction, while falling rates
  imply expansion.
• Note, how the Fed pushed short-term interest
  rates to historic lows during 2002-2004, and
  housing prices soared.

46
Inflation, 1998-2009

• As inflation rose in 2005-2006, the Fed shifted
  toward restriction and pushed short-term interest
  rates upward.
• The Feds low interest rate policy (2002-2004),
  followed by its more restrictive policy
  (2005-2006), contributed to the boom and bust in
  housing prices, and the Crisis of 2008.

47
Current Fed Policy and the Future

• During the second half of 2008, the Fed shifted
  toward a highly expansionary monetary policy.
• Vast amounts of reserves were injected into the
  banking system, short-term interest rates were
  pushed to near zero, and the monetary base was
  approximately doubled.
• Monetary policy works with a lag. It will take
  some time for the expansionary monetary policy to
  stimulate demand and economic recovery.

48
Current Fed Policy and the Future

• New dilemma
• If it shifts toward restriction too quickly, the
  recovery may falter.
• But, if the Fed continues with the expansionary
  monetary policy for too long, it will lead to
  serious future inflation.

49
Current Fed Policy and the Future

• The problem is not the Feds ability to control
  the money supply, but its ability to time shifts
  properly. Given the long and variable lags, it
  is hard for monetary policy-makers to institute
  stop-go policy in a stabilizing manner.
• We are in the middle of another great monetary
  policy experiment.

50

• 1. The velocity of money is
• the rate at which the price index for consumer
  goods rises.
• the multiple by which an increase in government
  expenditures will cause output to rise.
• c. set by the Board of Governors of the Federal
  Reserve.
• the average number of times one dollar is used to
  buy final goods and services during a year.
• During 2001, the Fed injected additional reserves
  into the banking system, which reduced the
  federal funds rate and other short-term interest
  rates. Other things constant, which of the
  following is most likely to result from this
  policy shift?
• a. an increase in the rate of unemployment
• b. a reduction in the growth of employment
• c. an increase in aggregate demand and real GDP
• d. a reduction in the long-run rate of inflation

51
3. The demand curve for money a. shows the
amount of money balances that individuals and
businesses wish to hold at various interest
rates. b. reflects the open market operations
policy of the Federal Reserve. c. shows the
amount of money that individuals and businesses
wish to hold at various price levels. d.
reflects the discount rate policy of the Federal
Reserve.
52
4. A shift to a more expansionary monetary policy
will a. help bring inflation under
control. b. exert a stabilizing impact on the
economy if the effects of the policy are felt
during an economic downturn. c. exert a
stabilizing impact if the effects of the policy
are felt when the economy is operating at its
full-employment capacity. d. reduce the natural
rate of unemployment.
5. Persistently expansionary monetary policy that
stimulates aggregate demand and leads to
inflation will a. lead to higher rates of real
output in the long run. b. fail to increase real
output once decision makers fully anticipate the
inflation. c. lead to lower nominal interest
rates once decision makers fully anticipate the
inflation. d. permanently reduce the rate of
unemployment below its natural rate.
53
6. The highest interest rates in the world are
found in countries a. that have followed a
monetary policy that is highly restrictive. b. wit
h governments that have run large budget
surpluses. c. with governments that have run
sizable budget deficits. d. that have followed an
expansionary monetary policy that resulted in
high rates of inflation.
The End