Monetary Policy

2. Monetary Policy • Control over the money supply is a critical policy tool for altering macroeconomic outcomes. • The quantity of money in circulation influences its value in the marketplace. • Interest rates and access to credit are basic determinants of spending behavior. • Therefore, the effectiveness of monetary policy is of significance.

3. Learning Objectives • 15-01. Explain how interest rates are set in the money market. • 15-02. Describe how monetary policy affects macro outcomes. • 15-03. Summarize the constraints on monetary policy impact. • 15-04. Identify the differences between Keynesian and monetarist monetary theories.

4. The Money Market • Money is like any other commodity. It is traded in the marketplace. • There is a money supply (controlled by the Fed) and a money demand by the people. • They determine the “price” of money: the interest rate. • At high interest rates, money is expensive to acquire. • At low interest rates, money is cheap to acquire.

5. The Money Market • If people hold cash as M1, they suffer an opportunity cost: the forgone interest they could have earned. • Money demand: the quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus. • At low interest rates, the opportunity cost of holding money is low, so people will hold more of it, and vice versa.

6. The Demand for Money • Why would people want to hold money – that is, have a demand for money? • Transactions demand: people need to hold money for the purpose of making everyday market purchases. • Precautionary demand: people also hold money for unexpected market transactions or for emergencies. • Speculative demand: some people also hold money to be able to take advantage of an investment opportunity in the near future.

7. Money Market Equilibrium • Money demand: the quantity of money people are willing and able to hold (demand) increases as interest rates fall, and vice versa. • Money supply: since the Fed controls the money supply, it is represented by a vertical line.

8. Money Market Equilibrium • The intersection of money demand and money supply (E1) establishes the equilibrium rate of interest.

9. Money Market Equilibrium • If interest rates are higher than equilibrium, there is a money surplus. • People must hold more money as M1 than they wish. • They will move money out of M1 into M2 or other assets (such as bonds). • The interest rate will then fall to E1.

10. Money Market Equilibrium • If interest rates are lower than equilibrium, there is a money shortage. • People must hold less money as M1 than they wish. • They will move money into M1 from M2 or other assets (such as bonds). • The interest rate will then rise to E1.

11. Changing Interest Rates • The Fed controls the money supply. • By using the Fed policy tools, it can alter the equilibrium rate of interest. • By increasing the money supply (causing a surplus), the Fed tends to lower the equilibrium rate of interest. • By decreasing the money supply (causing a shortage), the Fed tends to raise the equilibrium rate of interest.

12. Interest Rates and Spending • Lowering interest rates is a tactic of monetary stimulus, the purpose of which is to increase aggregate demand (AD). • Lower interest rates reduce the cost of investment spending (most of which is done with borrowed funds) and the cost of holding inventory. Investment spending will increase. • An investment spending increase is an injection into the circular flow, and will kick off the multiplier effect. AD will shift right because of this.

13. Interest Rates and Spending • Raising interest rates is a tactic of monetary restraint, the purpose of which is to decrease aggregate demand (AD). • Higher interest rates increase the cost of investment spending (most of which is done with borrowed funds) and the cost of holding inventory. Investment spending will decrease. • An investment spending decrease will kick off a negative multiplier effect. AD will shift left because of this.

14. Policy Constraints • Short- vs. long-term rates. • The Fed has greater influence on short-term rates (that is, the Fed funds rate) than long-term rates (mortgages and installment loans). • The Fed’s monetary stimulus will be most effective is long-term interest rate changes mirror short-term rate changes. • If not, the AD increase will be less than hoped for.

15. Policy Constraints • Reluctant lenders. • The banking system must be willing to increase lending activity. • Banks may pile up excess reserves instead of making loans. • They might have concerns about their financial well-being and about making loans to those who might not pay back the money. • They might be uncertain about how new bank regulations may affect profitability.

16. Policy Constraints • Liquidity trap. • When interest rates are low, the opportunity cost of holding money is also low. • Lowering interest rates further might not elicit the response desired by the Fed because people and firms simply hold the money instead of investing. • This is the liquidity trap: • People are willing to hold unlimited amounts of money at some low interest rate. • The money demand curve becomes horizontal.

17. Policy Constraints • Low expectations: • Investment decisions are influenced by expectations. • In a recession, firms have little incentive to expand production capability. • There would be little expectation of future profit, or “payoff,” from new investment. • Consumers may be reluctant to take on added debt when future income prospects are uncertain. • Thus AD does not increase when interest rates are reduced.

18. Policy Constraints • Time lags: • It takes time to develop and implement new investments in response to lower interest rates. • Consumers also may take time to decide to increase their borrowing. • It may take 6 to 12 months before market behavior responds to monetary policy.

19. The Monetarist Perspective • The Keynesian view of monetary policy says that changes in the money supply affect macro outcomes primarily through changes in interest rates. • The monetarist view is different. They believe that only the price level is affected by Fed policy … and then only by changes in the money supply. • They say monetary policy is not effective for fighting recession, but is a powerful tool for managing inflation.

20. The Equation of Exchange • The equation of exchange is • In this equation, total spending is price (P) times quantity (Q). This spending is financed by the money supply (M) times the velocity of its circulation (V). • Velocity (V): the number of times per year, on average, that a dollar is used to purchase final goods and services. MV = PQ where M is the money supply, V is its velocity in circulation, P is the average price, and Q is the quantity of goods sold.

21. The Equation of Exchange MV = PQ • PQ is the same as nominal GDP. • The quantity of money in circulation and the velocity with which it exchanges hands will always be equal to the value of nominal GDP. • Monetarist view: If M increases, P or Q must rise, or V must fall.

22. The Equation of Exchange MV = PQ • Assume V is stable – that is, does not change. • V is a function of how people handle their money and the institutions they use to do so. Neither should change much in the short run. • Thus total spending (PQ) must rise if money supply (M) grows and velocity (V) is stable, regardless of interest rates.

23. Money Supply Focus • If spending increases when the money supply grows, then the Fed should focus on the money supply, not interest rates. • Fed policy should not be to manipulate interest rates. • Fed policy should focus on the size and growth of the money supply.

24. “Natural” Unemployment MV = PQ • Monetarists insert another perspective: • Q is stable also. It is a function of productive capacity, labor efficiency, and other “structural” forces. • This leads to a “natural” rate of unemployment that is fairly immune to short-run policy intervention. • Natural rate of unemployment: the long-term rate of unemployment determined by structural forces. • Thus if both V and Q are stable, any increase in M in the long run only increases P.

25. “Natural” Unemployment MV = PQ • If both V and Q are stable, any increase in M in the long-run only increases P. • If prices rise, costs of production will rise also, so there is no profit incentive to increase Q. • In the long run, the aggregate supply is vertical. • Any increase in AD directly increases the price level.

26. Monetarist: Fighting Inflation • The policy goal is to reduce aggregate demand. • Keynesians: shrink the money supply and drive up interest rates. • Monetarists: interest rates are likely to be high already. A decrease in the money supply will lower nominal interest rates, not raise them.

27. Monetarist: Fighting Inflation • Interest rates are likely to be high already. A decrease in the money supply will lower nominal interest rates, not raise them. • Nominal interest rate: the interest rate we actually see and pay. • Real interest rate: the nominal rate minus the anticipated inflation rate. • As the money supply shrinks, the price level falls and anticipated inflation decreases, so nominal interest rates fall, not rise.

28. Monetarist: Fighting Inflation • To close an inflationary GDP gap using monetary policy, reduce the money supply. • Keynesians: interest rates rise, reducing spending. • Monetarists: once the people are convinced the Fed is reducing money supply, anticipated inflation falls and nominal interest rates will fall. Short-term rates will rise in response to the Fed action, but long-term rates will react more slowly. • Monetarists advise steady and predictable changes in the money supply, to reduce uncertainty and thus stabilize both long-term interest rates and GDP growth.

29. Monetarist: Fighting Unemployment • The policy goal is to increase aggregate demand. • Keynesians: expand the money supply and drive down interest rates. • Monetarists: increased money supply leads to higher prices, immediately raising people’s inflationary expectations. Long-term interest rates might actually rise, defeating the purpose of monetary stimulus. • Monetarists conclude that expansionary monetary policy can’t lead us out of recession.