MODULE 31 Monetary Policy and the Interest Rate

2. MODULE 31Monetary Policy and the Interest Rate

3. How the Federal Reserve can implement monetary policy moving the interest rate to affect aggregate output • Why monetary policy is the main tool for stabilizing the economy

4. Monetary Policy and the Interest Rate • By increasing or decreasing the money supply, the Federal Reserve can set the interest rate. • In practice, the Federal Open Market Committee sets a target federal funds rate. • The Open Market Desk then adjusts the money supply through open-market operations. • The Open Market Desk is facilitated at the New York Fed

5. . . . leads to a fall in the interest rate. r 2 The Effect of an Increase in the Money Supply on the Interest Rate Interest rate, r An increase in the money supply . . . MS MS 1 2 E r 1 1 E 2 MD Quantity of money M M 1 2

6. An open-market purchase . . . . . . drives the interest rate down. MS 2 2 Setting the Federal Funds Rate Pushing the Interest Rate Down to the Target Rate The target federal funds rate is the Federal Reserve’s desired federal funds rate. Interest rate, r MS 1 E r 1 1 E 2 r T MD Quantity of money M M 1

7. Setting the Federal Funds Rate Pushing the Interest Rate Up to the Target Rate Interest rate, r An open-market sale . . . MS MS 2 1 . . . drives the interest rate up. E r 2 T E 1 r 1 MD M M 2 Quantity of money 1

8. The Fed Reverses Course

9. Monetary Policy and Aggregate Demand • Expansionary monetary policy is monetary policy that increases aggregate demand. • Contractionary monetary policy is monetary policy that reduces aggregate demand.

10. Monetary Policy and Aggregate Demand (b) Contractionary Monetary Policy (a) Expansionary Monetary Policy Aggregate price level Aggregate price level AD AD AD AD 3 1 2 1 Real GDP Real GDP

11. Monetary Policy in Practice • Policy makers try to fight recessions, but they also try to ensure price stability. • The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. • Monetary policy is the main tool of stabilization policy. Federal funds rate = 1+(1.5 x inflation rate) + (0.5 x output gap)

12. Tracking Monetary Policy

13. Tracking Monetary Policy

14. Tracking Monetary Policy

15. Inflation Targeting • Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target. • In the US, no explicit target but is usually 2%.

16. Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. • Contractionary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run. • The Federal Reserve and other central banks try to stabilize the economy, limiting fluctuations of actual output around potential output, while also keeping inflation low but positive.

17. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflation, or a positive output gap, or both; the target interest rate falls when inflation is low or negative, or when the output gap is negative, or both. • Some central banks engage in inflation targeting, which is a forward-looking policy rule. • Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the preferred policy tool for stabilizing the economy.

18. MODULE 32Money, Output, and Prices in the Long Run

19. The effects of an inappropriate monetary policy • The concept of monetary neutrality and its relationship to the long-term economic effects of monetary policy

20. Money, Output, and Prices • Because of its expansionary and contractionary effects, monetary policy is generally the policy tool of choice to help stabilize the economy. • The economy is self-correcting in the long run: a demand shock has only a temporary effect on aggregate output.

21. AS 2 P . . . but the eventual rise in nominal wages leads to a fall in short-run aggregate supply and aggregate output falls back to potential output. 3 P E 2 2 AD 2 Y 2 The Short-Run and Long-Run Effects of an Increase in the Money Supply Aggregate price level An increase in the money supply reduces the interest rate and increases aggregate demand . . . L R AS S R S R AS 1 E 3 P 1 E 1 AD 1 Y Real GDP 1 Potential output

22. Monetary Neutrality • In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. • x% increase in money supply increases inflation by x%. • In fact, there is monetary neutrality: changes in the money supply have no real effect on the economy. So monetary policy is ineffectual in the long run. • Does this mean monetary policy is useless? • Monetary policy smoothens fluctuations in economy.

23. An increase in the money supply lowers the interest rate in the short run . . . MS 2 . . . but in the long run higher prices lead to greater money demand, raising the interest rate to its original level. E 2 r MD 2 2 M 2 The Long-Run Determination of the Interest Rate Interest rate, r MS 1 E E 1 r 3 1 MD 1 M Quantity of money 1

24. In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. • Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run.

25. MODULE 33Types of Inflation, Disinflation, and Deflation

26. The classic model of the price level • Why efforts to collect an inflation tax by printing money can lead to high rates of inflation and even hyper inflation • The types of inflation: cost-push and demand-pull

27. Money and Inflation • According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium level. • The real quantity of money is M/P. • A change in the nominal money supply, M, leads in the long run to a change in the aggregate price level, P.

28. AS 2 E 3 P E 2 2 AD 2 Y 1 Money and Prices Aggregate price level L R AS S R S R AS 1 P 3 E 1 P 1 AD 1 Y Real GDP Potential output P

29. Money Supply Growth and Inflation in Zimbabwe

30. The Inflation Tax • Inflation imposes a tax, called “inflation tax.” • The inflation tax is the reduction in the real value of money held by the public caused by inflation, • Inflation tax = inflation rate X money supply • A 5% inflation is like a 5% tax as 1 dollar will be worth only 95 cents.

31. The Logic of Hyperinflation • In order to avoid paying the inflation tax, people reduce their real money holdings and force the government to increase inflation. • Example: In the 1920s, hyperinflation made German currency worth so little that children made kites from banknotes. • In some cases, this leads to a vicious circle of a shrinking real money supply and a rising rate of inflation. • This leads to hyperinflation and a fiscal crisis.

32. The Logic of Hyperinflation • High inflation arises when the government must print a large quantity of money to cover a large budget deficit. Seigniorage = ∆M Real Seigniorage = ∆M P Real Seigniorage =∆M M M P Real Seigniorage = Rate of growth of the money supply x Real money supply x

33. Cost-push and Demand-pull Inflation • A decrease in aggregate supply because of an increase in the price of an input is cost-push inflation. • An increase in aggregate demand that increases the price level is demand-pull inflation. • In the short run, policies that produce a booming economy also tend to lead to higher inflation, and policies that reduce inflation tend to depress the economy. • This creates both temptations and dilemmas for governments.

34. The Output Gap and the Unemployment Rate • When actual aggregate output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment. • When the output gap is positive (an inflationary gap), the unemployment rate is below the natural rate. • When the output gap is negative (a recessionary gap), the unemployment rate is above the natural rate. • https://www.youtube.com/watch?v=wiWursKR9Ao

35. Cyclical Unemployment and the Output Gap

36. Cyclical Unemployment and the Output Gap

37. In analyzing high inflation, economists use the classical model of the price level, which says that changes in the money supply lead to proportional changes in the aggregate price level even in the short run. • Governments sometimes print money in order to finance budget deficits. When they do, they impose an inflation tax on those who hold money. • The output gap is the percentage difference between the actual level of real GDP and potential output.