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Modern Macroeconomics – Monetary Policy

Chapter 14. Modern Macroeconomics – Monetary Policy. 1. Impact of Monetary Policy. Impact of Monetary Policy. The Keynesian View dominated during the 1950s and 1960s. Keynesians argued that the money supply did not matter much.

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Modern Macroeconomics – Monetary Policy

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  1. Chapter 14 Modern Macroeconomics – Monetary Policy

  2. 1. Impact of Monetary Policy

  3. Impact of Monetary Policy • The Keynesian View dominated during the 1950s and 1960s. • Keynesians argued that the money supply did not matter much. • Monetarists challenged the Keynesian view during 1960s and 1970s. • According to monetarists, changes in the money supply caused of both inflation and economic instability. • While minor disagreements remain, the modern view emerged from this debate. -- Modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy. • Evolution of Modern View:

  4. Money Interest Rate MoneyDemand Quantity of Money The Demand and Supply of Money: • The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earnings assets like bonds.

  5. Money Interest Rate MoneySupply Determined by the Fed Quantity of Money The Demand and Supply of Money: • The supply of money is vertical because it is determined by the Fed.

  6. i e Supply Excess at i2 i At , people are 2 willing to hold the money supply set by Fed i S Money Interest Rate e MoneySupply i 3 Q (Set by the Fed) s D Demand Excess MoneyDemand at I3 Quantity of Money The Demand and Supply of Money: • Equilibrium: -- The money interest rate will gravitate toward the rate where the quantity of money people want to hold (the demand) is just equal to the stock of money the Fed has supplied (the supply). Quantity of money

  7. S1 S1 S2 S2 r i 1 1 Money Interest Rate Real Interest Rate r i 2 2 D1 D Quantity of Money Quantity of Loanable Funds Qs Q1 Transmission of Monetary Policy • This increase in the money supply (shifting S1 to S2 in the market for money) will supply the banking system with additional reserves. • When the Fed shifts to a more expansionary monetary policy, it will generally buy additional bonds thereby expanding the money supply. • Both the Fed’s bond purchases and the bank’s use of the additional reserves to extend new loans will increase the supply of loanable funds (shifting S1 to S2 in the loanable funds market) . . . and put downward pressure on the real rate of interest (reduction to r2). Qb Q2

  8. S1 AS1 S2 r P P 2 2 1 AD2 AD1 Transmission of Monetary Policy • Since the effects of the monetary expansion were unanticipated, the expansion in AD leads to a short-run increase in current output (from Y1 to Y2) . . . and increase in prices (from P1 to P2) – inflation. • As the real rate of interest falls, aggregate demand increases (to AD2). • The path that monetary policy takes through the macroeconomic system is called the Transmission of Monetary Policy. • The impact of a shift in monetary policy is generally transmitted through interest rates, exchange rates, and asset prices. Real Interest Rate Price Level D Quantity of Loanable Funds Goods & Services (Real GDP) Q2 Y1 Y2

  9. A Shift to a More Expansionary Monetary Policy • During expansionary monetary policy the Fed may buy bonds, reduce the discount rate, or reduce the reserve requirements for deposits. • The Fed generally buys bonds, which: • increases bond prices, and, • creates additional bank reserves, while it, • places downward pressure on real interest rates. • As a result, an unanticipated shift to a more expansionary policy will stimulate aggregate demand and thereby increase both output and employment.

  10. Price level LRAS SRAS1 e1 E2 P P 1 2 AD1 AD2 Goods &Services(real GDP) Y Y Y F 1 F The Effects ofExpansionary Monetary Policy • If the impact of an increase in aggregate demand accompanying expansionary monetary policy is felt when the economy is operating below capacity, the policy will help direct the economy back to a long-run full-employment output equilibrium (YF). • In this case, the increase in output from Y1 to YF will be long term.

  11. Price level SRAS2 SRAS1 LRAS E2 e2 P P P 1 2 3 E1 AD2 AD1 Goods &Services(real GDP) Y Y Y Y F F F 2 The Effects ofExpansionary Monetary Policy • In contrast, if the demand-stimulus effects are imposed on an economy already at full-employment (YF), they will lead to excess demand, higher product prices, and temporarily higher output (Y2). • In the long-run, the strong demand will push up resource prices, shifting short run aggregate supply (from SRAS to SRAS2). • The price level rises to P3 (from P2) and output falls back to full-employment output once again (YFfrom it temporary high,Y2).

  12. A Shift to a More Restrictive Monetary Policy • During restrictive monetary policy the Fed may sell bonds, increase the discount rate, or increase the reserve requirements for deposits. • The Fed generally sells bonds, which: • depresses bond prices, and, • drains bank reserves from the banking system, while it, • places upward pressure on real interest rates. • As a result, an unanticipated shift to a more restrictive policy will reduce aggregate demand and thereby decrease both output and employment.

  13. AS1 S2 S1 r 2 Real Interest Rate Price Level r P P 1 2 1 AD1 AD2 D Quantity of Loanable Funds Goods & Services (Real GDP) Q1 Y1 Short-run Effects of a More Restrictive Monetary Policy • The higher interest rates will decrease aggregate demand (shifting from AD1 to AD2). • When the Fed shifts to a more restrictive policy, it sells bonds, reducing the reserves available to banks, decreasing the supply of loanable funds and placing upward pressure on interest rates. • When the reduction in aggregate demand is unanticipated, real output will decline (to Y2) and downward pressure on prices will result. Q2 Y2

  14. Price level LRAS SRAS e1 P P 2 1 E2 AD1 AD2 Goods &Services(real GDP) Y Y Y F F 1 The Effects ofRestrictive Monetary Policy • The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its primary impact. • Restrictive monetary policy will reduce aggregate demand. • If the demand restraint comes during a period of strong demand and an overheated economy, then it will limit or even prevent the occurrence of an inflationary boom.

  15. Price level LRAS SRAS e2 P P 2 1 E1 AD1 AD2 Goods &Services(real GDP) Y Y Y F 2 F The Effects ofExpansionary Monetary Policy • In contrast, 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.

  16. Proper Timing • Proper Timing: • The proper timing of monetary policy is not an easy task. • While the Fed can institute policy changes rapidly, there may be a substantial time lag before the change will exert a significant impact on AD.

  17. 1. What are the determinants of the demand for money? How is the supply of money determined? Questions for Thought: 2. If the Fed shifts to a more restrictive monetarypolicy, it will generally sell bonds in the open market. How will this action influence each of the following? (a) The reserves available to banks. (b) Real interest rates. (c) Household spending on consumer durables. (d) The exchange rate value of the dollar. (e) Net exports. (f) The prices of stocks and real assets like apartment or office buildings.(g) Real GDP.

  18. 2. Monetary Policy in the Long Run

  19. = * * Money Y= Income Velocity Price Monetary Policy in the Long Run • The Quantity Theory of Money: Y P M V • If Vand Yare constant, than an increase in M would lead to a proportional increase in P.

  20. Monetary Policy in the Long Run • The Long-Run Implications of Modern Analysis: • In the long run, the primary impact will be on prices rather than on real output. • When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. • As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.

  21. LRAS AS AD AS AD 1 1 2 2 Annual Growth Rateof the Money Supply Price Level(ratio scale) P e 100 1 9.0 8% growth Y F 6.0 (a) Growth rate of the money supply. 3.0 TimePeriods RealGDP 4 1 2 3 (b) Impact in the goods and services market. The Long-run Effects of More Rapid Expansion in the Money Supply • Initially, prices are stable (P100) when the money supply is expanding by 3% annually. • Here we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3 to 8 percent. • The acceleration in the growth rate of the money supply increases aggregate demand (shifting to AD2). • At first, real output may expand beyond the economy’s potential (YF), however low unemployment and strong demand create upward pressure on wages and other resource prices, shifting AS to AS2. 3% growth

  22. LRAS AD AD AS AS AS AD 1 3 2 3 2 1 P e 110 3 P e 105 2 Annual Growth Rateof the Money Supply Price Level(ratio scale) P e 100 1 9.0 Y 6.0 F (a) Growth rate of the money supply. 3.0 TimePeriods RealGDP 4 1 2 3 (b) Impact in the goods and services market. The Long-run Effects of More Rapid Expansion in the Money Supply • Output returns to its long-run potential (YF), and the price level increases to P105 (e2). • If more rapid monetary growth continues in subsequent periods, AD and AS will continue to shift upward, leading to still higher prices (e3 and points beyond). • The net result of this process is sustained inflation. 8% growth 3% growth

  23. InterestRate A higher expected rate of inflation increases the money interest rate. i .09 r (expected rate (expected rate (expected rate (expected rate of inflation = 5 %) of inflation = 5 %) of inflation = 0 %) of inflation = 0 %) .04 LoanableFunds Q S D S D 1 1 2 2 The Long-run Effects of More Rapid Expansion in the Money Supply Q • When prices are stable, supply and demand in the loanable funds market are in balance at a real and nominal interest rate of 4%. • If more rapid monetary expansion leads to a long-term 5% inflation rate, 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% -- the 4% real rate plus the 5% inflationary premium.

  24. 3. Monetary Policy When Effects Are Anticipated

  25. Monetary Policy When Effects Are Anticipated • When the effects of policy are anticipated prior to their occurrence, the short‑run impact of an increase in the money supply is similar to its impact in the long run. • Nominal prices and interest rates rise, but real output remains unchanged.

  26. Price level SRAS SRAS 2 1 E P 2 2 E P 1 1 Goods &Services(real GDP) AD 2 AD 1 Y Y 1 1 The Short-run Effects of AnAnticipated Monetary Expansion • When decision makers fully anticipate the effects of a monetary expansion, the expansion does not alter real output even in the short-run. • Suppliers, including resource suppliers, build the expected price rise into their decisions. The anticipated inflation leads to a rise in nominal costs (including wages) causing aggregate supply to decline (shifts to SRAS2). • While nominal wages, prices, and interests rates rise, their real counter-parts are unchanged – and so, inflation without any change in output.

  27. 4. Interest Rates and Monetary Policy

  28. Interest Rates and Monetary Policy • While the Fed can strongly influence short-term interest rates, its impact on long-term rates is much more limited. • Interest rates can be a misleading indicator of monetary policy: • In the long run, expansionary monetary policy leads to inflation and high interest rates, rather than low interest rates. • Similarly, restrictive monetary policy, when pursued over a lengthy time period, leads to low inflation and low interest rates.

  29. 5. The Effects of Monetary Policy – A Summary

  30. The Effects of Monetary Policy: -- A Summary • An unanticipated shift to a more expansionary (restrictive) monetary policy will temporarily stimulate (retard) output and employment. • The stabilizing effects of a change in monetary policy are dependent upon the state of the economy when the effects of the policy change are observed. • Persistent growth of the money supply at a rapid rate will cause inflation. • Money interest rates and the inflation rate will be directly related. • There will be only a loose year-to-year relationship between shifts in monetary policy and changes in output and prices.

  31. Annual % Change in Money Supply(M2) % Change in Real GDP(4-Quarter Moving Avg.) M2 Money supply Real GDP 14 14 12 12 Note that the growth 10 10 rate of the money supply 8 has been slower and 8 more stable during the 6 6 last decade. 4 4 2 2 0 0 -2 -2 -4 -4 -6 -6 1960 1965 1970 1975 1980 1985 1990 1995 1998 Source: Derived from computerized data supplied by FAME Economics. Monetary Policy and Real GDP • Sharp declines in the growth rate of the money supply, such as those of 1968-1969, 1973-1974, 1977-1978, & 1988-1991, have generally preceded reductions in real GDP and recessions (indicated by shading). • Conversely, periods of sharp acceleration in the growth rate of the money supply, such as 1971-1972 & 1976, have often been followed by a rapid growth of GDP.

  32. Annual Rate of Inflation(Percent) Annual Growth Rate of Money Supply(Percent) M2 Money supply 12 14 10 12 8 10 6 8 4 6 2 4 0 2 - 2 0 Inflation Rate(lagged 3 years) M2 1960 1965 1970 1980 1985 1990 1995 1975 M2 1963 1968 1973 1983 1988 1993 1998 1978 P P Source: Derived from computerized data supplied by FAME Economics. Effect of Changes in Money Supply on Inflation • Here we illustrate the relationship between the rate of growth in the money supply (M2) and the annual inflation rate3 years later. • While the two are not perfectly correlated, the data do indicate that the periods of monetary acceleration (for example: ’71-’72 & ’75-’76) tend to be associated with an increase in the inflation rate about 3 years later. • Similarly, a slower growth rate of the money supply, like that of the 1990’s, is generally associated with a reduction in the rate of inflation.

  33. Interest Rate(3 month Treasury bills) Percent 16 Annual Rate of Inflation 12 8 4 0 1960 1965 1970 1975 1980 1985 1990 1995 1998 Source: Derived from computerized data supplied by FAME Economics. Inflation Rate and the Money Interest Rate • The expectation of inflation . . . • reduces the supply, and, • increases the demand for loanable funds, — thereby causing interest rates to rise. • Note how the short-term money rate of interest has tended to increase when the inflation rate accelerates (and declines as the inflation rate falls).

  34. Rate of InflationPer Year (%, log scale) 1,000 Brazil Argentina 100 Uganda Turkey Israel Zambia Poland Mexico Ecuador Ghana Venezuela Hungary Syria Chile Portugal Kenya 10 Philippines South Africa India Pakistan Indonesia Italy Australia France Thailand United States Belgium Malaysia Canada Switzerland Germany Japan 1 10 100 1,000 1 Rate of Money Supply Growth(%, log scale) Sources: International Monetary Fund, International Financial Statistics Yearbook, 1997 & International Financial Statistics (December 1998). Note: The money supply data are the actual growth rate of the money supply minus the growth rate of real GDP. Money and Inflation– An International Comparison 1980 - 1996 • The relationship between the average annual growth rate of the money supply and the rate of inflation is show here for the 1980-1996 period. • Clearly, there is a close relationship between the two. • Higher rates of money growth lead to higher rates of inflation.

  35. 1. What impact will an unanticipated increase in the money supply have on the real interest rate, real output, and employment in the short run? What will be the impact in the long run? Questions for Thought: 2. Political officials often call on the monetary authorities to expand the money supply more rapidly so that interest rates can be reduced. Will expansionary monetary policy reduce interest rates in the short run? Will it do so in the long run? Explain.

  36. EndChapter 14

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