Monetary Theory and Policy

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Monetary Theory and Policy

• Demand and supply of money
• The supply of money and the equilibrium interest
  rate
• The monetary transmission mechanism
• The Quantity theory of money
• The record of monetary policy

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The money market
Earlier we said that the interest rate (i)
influences aggregate spendingspecifically
investment and consumption. However, we have yet
to develop a theory of the interest rate
The interest rate is governed by the demand and
supply of money.
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Why do agents hold money?

1. To make planned expenditures/payments
2. To be prepared for unexpected expenditures/payment
   s.
3. To store wealth.

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The interest rate (i) measuresthe opportunity
cost of holding money
The higher the interest rate, the more interest I
give up by holding my wealth in money-- as
opposed to an interest-bearing asset.
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Demand for money
The money demand, Dm, slopes downward. As the
interest rate falls, other things constant, so
does the opportunity cost of holding money the
quantity of money demanded increases.
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Demand for Money
Nominal Interest Rate ()

• As we move along MD, the price level and real GDP
  are held constant.
• The movement from point E to F is a change in the
  demand for money as a store of value in reaction
  to a decrease in the yield of bonds.

E
6
F
3
MD
0
1.0
1.2
Money(Trillions)
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Effect of a Change in Price Level (P) or Real GDP
(Y)

• MD1 ?MD2
• Increase in P, ceteris paribus.
• Increase in Y, ceteris paribus

Nominal Interest Rate ()
E
G
6
H
F
3
MD2
MD1
0
1.0
1.2
1.12
1.5
Money(Trillions)
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Bond Prices and the Rate Of Interest
Bond prices and interest rates (or yields), move
inversely
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Example
Suppose you paid 800 for a bond that
promises to pay 1,000 to its holder one year
from today. What is the interest rate or
percentage yield of the bond? Notice first that
your interest income would be equal to 200.
Hence to compute the yield, use the following
equation Yield () (interest income/price of
the bond) ? 100 Thus, we have Yield ()
(200/800) ? 100 25 percent Now suppose,
instead of paying 800 for the bond, you paid
900. What is the yield now? Yield ()
(100/900) ? 100 11 percent
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The supply of money
We assume that the Fed (or central banks
generally) determines the supply of money
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• Effect of an increase in the money supply

Because the money supply is determined by the
Federal Reserve, it can be represented by a
vertical line.
At point a, the intersection of the money supply,
Sm, and the money demand, Dm, determines the
market interest rate, i.
Following an increase in the money supply to Sm,
the quantity of money supplied exceeds the
quantity demanded at the original interest rate,
i.
People attempt to exchange money for bonds or
other financial assets. In doing so, they push
down the interest rate to i, where quantity
demanded equals quantity supplied. This new
equilibrium occurs at point b.
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• Effects of an increase in the money supply on
  interest rates, investment, and aggregate demand

(c) Aggregate demand
(a) Supply and demand for money
(b) Demand for investment
An increase in the money supply drives the
interest rate down to i'.
This sets off the spending multiplier process, so
the aggregate output demanded at price level P
increases from Y to Y
With the cost of borrowing lower, the amount
invested increases from I to I.
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Chain of cause and effect
M??i??I??AD??Y?
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The transmission mechanism
Fed open market purchase injects reserves into
the banking system
Commercial banks, thrifts, etc. expand loans and
deposits
The money supply increases
The equilibrium interest rate decreases
Consumption and investment increase
Real GDP, employment, and (perhaps ) the price
level increase
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• Expansionary monetary policy to correct a
  contractionary gap

At a, the economy is producing less than its
potential in the short run, resulting in a
contractionary gap of 0.2 trillion.
If the Federal Reserve increases the money supply
by just the right amount, the aggregate demand
curve shifts rightward from AD to AD. A
short-run and long-run equilibrium is established
at b, with the pride level at 130 and output at
the potential level of 14.0 trillion
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Fed "target" rate
The FOMC sets a target for the federal funds
rate, which is the rate that banks charge other
banks for borrowed reserves.
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• Recent ups and downs in the federal funds rate

Since the early 1990s, the Fed has pursued
monetary policy primarily through changes in the
federal funds rate, the rate that banks charge
one another for borrowing and lending excess
reserves overnight.
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The Fed has cut rates sharply in 2008
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The Equation of Exchange

• Where
• M is the quantity of money
• V is the velocity of circulation
• P is the price level
• Y is real GDP

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What is velocity (V)?
Velocity (V) is the average number of times
per year a unit of money is spent for new goods
and services. Let
(P ? Y) is nominal GDP. Let P 1.25 Y 8
trillion and M 2 trillion. Thus
Or, V 5
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Money and Aggregate Demand in LR

• Velocity depends on
• Customs and convention of commerce
• Innovations facilitate exchange
• Higher velocity
• Frequency
• The more often workers get paid
• Higher velocity
• Stability (store of value)
• The better store of value
• Lower velocity

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Equation of Exchange is Always True
The equation simply states that what is spent for
new goods and services (M ? V) is equal to the
market value of new goods and services produced
(P ? Y).
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Illustration
Using the numbers on a preceding slide, we can
see that
and
thus
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Monetarist interpretation of the equation of
exchange
The monetarists believe that price level changes
(hence inflation) can be explained by changes in
quantity of money
Inflation is always and everywhere a monetary
phenomenon.
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Example
Assume that V 5 and is constant. Y is 8
trillion (also assumed to be constant).
Initially, let M 2 trillion
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Our basic equation can be rearranged as follows
Now solve for the price level (P)
Now let the money supply increase to 2.4
trillion. Notice that
Thus we have
Notice that
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Hence a 20 percent increase in the money supply
causes the price level to increase by 20 percent.
Monetarists put the blame for inflation squarely
at the doorstep of the monetary authorities (in
the U.S., the FED).
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• In the long run, an increase in the money
  supply results in a higher price level, or
  inflation

The quantity theory of money predicts that if
velocity is stable, then an increase in the
supply of money in the long run results in a
higher price level, or inflation. Because the
long-run aggregate supply curve is fixed,
increases in the money supply affect only the
price level, not real output.
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The velocity of M1
(a) Velocity of M1
M1 velocity fluctuated so much during the 1980s
that M1 growth was abandoned as a short-run
policy target.
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The velocity of M2
(b) Velocity of M2
M2 velocity appears more stable than M1 velocity,
but both are now considered by the Fed as too
unpredictable for short-run policy use.
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German Hyperinflation and Money
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Record indicates that nations with high rates of
monetary growth also suffer high rates of
inflation

• A decade of annual inflation and money growth in
  85 countries (average annual percent)

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• Targeting interest rate vs. targeting the
  money supply

An increase in the price level or in real GDP,
with velocity stable, shifts rightward the money
demand curve from Dm to D'm.
If the Federal Reserve holds the money supply at
Sm, the interest rate rises from i (at point e)
to i ' (at point e').
Alternatively, the Fed could hold the interest
rate constant by increasing the supply of money
to S'm. The Fed may choose any point along the
money demand curve D'm.
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The Fed pulled on the string big time beginning
in 1979it was an anti-inflation strategy under
Chairman Paul Volcker
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Modeling Contractionary Monetary Policy
Price Level
Potential GDP
AS
AD2
AD1
0
Y1
Real GDP
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Conventional 30 year
www.economagic.com
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Monthly payments on a 110,000 30 year mortgage
note
Mortgage rate Monthly Payment1
8 807.14
10 965.33
12 1,131.47
14 1,303.36
16 1,479.23
1 Does not include prorated insurance or property
taxes.
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Data in thousands of units
www.economagic.gov
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More recently, the Fed raised the federal funds
rate six times between May 1999 and May 2000from
4.75 to 6.5 . Evidently unemployment was
getting too low.
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The FOMC reversed course in July 2000 and cut the
funds rate 17 times, to a low of 1.00 percent in
July 2003.
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Inflation Monster
Beginning in 2004, and until summer of 2007, the
FED was mainly concerned about inflation.