Monetary Policy and Aggregate Demand: Understanding the Relationship

1. Chapter 10 Monetary Policy and Aggregate Demand

2. Preview • To understand the positive relationship between real interest rates and inflation, which is called the monetary policy (MP) curve • To develop the aggregate demand curve using the monetary policy curve and the IS curve

3. The Federal Reserve and Monetary Policy • The Fed of the United States conducts monetary policy by setting the federal funds rate—the interest rate at which banks lend to each other • Because the real interest rate is (Chapter 2), and if prices are sticky, changes in monetary policy does not immediately affect inflation and expected inflation • When the Federal Reserve lowers the federal funds rate, real interest rates fall; and when the Federal Reserve raises the federal funds rate, real interest rates rise.

4. The Monetary Policy Curve • The monetary policy (MP) curve shows how monetary policy, measured by the real interest rate, reacts to the inflation rate, : • The MP curve is upward sloping: real interest rates rise when the inflation rate rises

5. FIGURE 10.1 The Monetary Policy Curve

6. The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope • The key reason for an upward sloping MP curve is that central banks seek to keep inflation stable • Taylor principle: To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation, so that r rises when rises • Schematically, if a central bank allows r to fall when rises, then :

7. Shifts in the MP Curve • Two types of monetary policy actions that affect interest rates: • Automatic (Taylor principle) changes as reflected by movements along the MP curve • Autonomous changes that shift the MP curve • Autonomous tightening of monetary policy that shifts the MP curve upward (in order to reduce inflation) • Autonomous easing of monetary policy that shifts the MP curve downward (in order to stimulate the economy)

8. FIGURE 10.2 Shifts in the Monetary Policy Curve

9. Policy and Practice: Autonomous Monetary Easing at the Onset of the 2007-2009 Financial Crisis • When the financial crisis started in August 2007, inflation was rising and economic growth was quite strong • The MP curve would have suggested that the Fed would continue to keep raising the federal funds rate • Instead the Fed lowered the federal funds rate • This reflects that the Fed pursued autonomous monetary policy easing, thus shifting the MP curve down, because the Fed perceived the economy to weaken in the near future due to the financial crisis

10. FIGURE 10.3 The Inflation Rate and the Federal Funds Rate, 2007-2010

11. The Aggregate Demand Curve • The aggregate demandcurve represents the relationship between the inflation rate and aggregate demand when the goods market is in equilibrium

12. Deriving the Aggregate Demand Curve Graphically • The AD curve is derived from: • The MP curve • The IS curve • The AD curve has a downward slope: As inflation rises, the real interest rate rises, so that spending and equilibrium aggregate output fall

13. FIGURE 10.4 Deriving the AD Curve

14. Box: Deriving the Aggregate Demand Curve Algebraically • The numerical version of the AD curve can be derived from (1) the numerical IS curve from Chapter 9 , and (2) then substituting in for r from the numerical MP curve • Similarly, the general version of the AD curve can be derived by substituting in for r from the MP curve using the algebraic version of the IS curve in Chapter 9:

15. Factors that Shift the Aggregate Demand Curve • Shifts in the IS curve • Autonomous consumption expenditure • Autonomous investment spending • Government purchases • Taxes • Autonomous net exports • Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction

16. FIGURE 10.5 Shift in the AD Curve From Shifts in the IS Curve

17. Factors that Shift the Aggregate Demand Curve (cont’d) • Shifts in the MP curve • An autonomous tightening of monetary policy, that is a rise in real interest rate at any given inflation rate, shifts the aggregate demand curve to the left • Similarly, an autonomous easing of monetary policy shifts the aggregate demand curve to the right

18. FIGURE 10.6 Shift in the AD Curve From Autonomous Monetary Policy Tightening

19. The Money Market and Interest Rates • The liquidity preference framework determines the equilibrium nominal interest rate by equating the supply of and demand for money • John Maynard Keynes developed a theory of money demand that he described as liquidity preference theory • Real money balances—the quantity of money in real terms—reflect how much money people want to hold (demand)

20. Liquidity Preference and the Demand for Money • According to Keynes, the demand for money can be expressed in the form of the liquidity preference function:

21. Liquidity Preference and the Demand for Money (cont’d) • Why are real money balances negatively related to i? • i represents the opportunity cost of holding money

22. Liquidity Preference and the Demand for Money (cont’d) • Why are real money balances positively related to Y? • As income rises, households and firms conduct more transactions and so keep more money on hand to make purchases • Higher incomes make households and firms wealthier, and the wealthy tend to hold larger quantities of all financial assets, including money

23. Demand Curve for Money • In short-run analysis, prices are assumed to be sticky so the price level is fixed at • All else being equal, lower real interest rates mean the opportunity cost of holding money falls, so that firms and households desire to higher quantities of real money balances • As a result, the demand curve for money slopes downward

24. Supply Curve for Money • The Fed fixes the money supply by open market operations • When the Fed buys (sells) government securities in open market operations, it increases (decreases) deposits at banks, so that bank reserves and liquidity in the banking system increase (decrease)

25. Supply Curve for Money • An open market purchase leads to an increase in liquidity and the money supply • An open market sale of government securities leads to a decrease in liquidity and a decrease in the money supply

26. Supply Curve for Money (cont’d) • The supply curve for money (MS) shows the quantity of real money balances supplied at each price level • The line MS is a vertical line because: • The money supply is fixed by the Fed at • The price level in the short run is fixed at • Thus, the quantity of real money balances supplied is

27. FIGURE 10.7 Equilibrium in the Money Market

28. Equilibrium in the Money Market • Equilibrium in the money market occurs when the quantity of real money balances demanded equals the quantity of real money balances supplied: • Graphically, equilibrium occurs where MD and MS curves intersect at i* • An excess supply (demand) of money results in a decrease (an increase) in i

29. Changes in the Equilibrium Interest Rate • A shift in the MD (or MS) curve occurs when the quantity demanded (or supplied) changes at each given interest rate in response to a change in some other factor besides the interest rate

30. Changes in the Equilibrium Interest Rate (cont’d) • Examples of factors that shifts the MD or MS: • When income rises, MD shifts to the right and so interest rates will rise • When the money supply increases, MS shifts to the right and so interest rates will decline • When the price level rises, MS shifts to the right and so interest rates will rise

31. FIGURE 10.8 Response to Shift in the Demand Curve from a Rise in Income

32. FIGURE 10.9 Response to Shifts in the Supply Curve (a)

33. FIGURE 10.9 Response to Shifts in the Supply Curve (b)

34. Chapter 10Appendix The Demand for Money

35. Keynesian Theories of Money Demand • Three motives behind the demand for money in Keynes’ liquidity preference theory: • Transactions motive • People hold money to carry out everyday transactions • Affected by payment technology (e.g., credit cards) • Precautionary motive • Money holding as a cushion against unexpected needs • Proportional to income, Y • Speculative motive • Money as a store of wealth • As the interest rate i rises, the opportunity cost of money rises (it is more costly to hold money relative to bonds) and the quantity of money demanded falls

36. Putting the Three Motives Together • Keynes’ liquidity preference function that combines the 3 motives together: • An important implication is that velocity, V, is not a constant buy will fluctuate with changes in interest rates. This is because , so that (assuming Md=M):

37. Portfolio Theories of Money Demand • In Keynes’ portfolio theories of money demand, the main determinants of the demand for an asset: • Wealth—total resources owned by individuals, including all assets • Expected return—the return expected on the asset relative to other assets • Risk—the degree of uncertainty associated with the return on the asset relative to other assets. Most people do not like risk (risk averse) • Liquidity—the ease and speed with which an asset can be turned into cash relative to other assets

38. Portfolio Theory and Keynesian Liquidity Preference • Portfolio theory justifies Keynesian liquidity preference theory as the demand for real money balances in both theories is: • positively related to income • negatively related to the nominal interest rate

39. Other Factors That Affect the Demand for Money • Wealth • Portfolio theory posits that as wealth increases, investors have more resources to purchase assets, increasing the demand for money (such as M1, known as dominated assets because they are perceived as safe)

40. Other Factors That Affect the Demand for Money (cont’d) • Risk • When the stock market becomes more volatile, the demand for money, which is perceived as less risky, increases • An increase in the variability of the real return on money reduces its money as people shift into alternative assets as inflation hedges

41. Other Factors That Affect the Demand for Money (cont’d) • Liquidity of other assets • The development of new liquidity assets, e.g., money market mutual funds, reduces the relative liquidity of money, so that the demand for money falls

42. TABLE 10A1.1 Factors That Determine the Demand for Money

43. Empirical Evidence on the Demand for Money • Is the demand for money sensitive to changes in interest rates? • The liquidity trap is an extreme case of ultrasensitivity in the demand for money to interest rates, implying that a change in the money supply has no effect on interest rates • There is little evidence of a liquidity trap, except in recent years when interest rates fell to near zero

44. Empirical Evidence on the Demand for Money (cont’d) • Is the demand for money function stable? • By the early 1970s, evidence strongly supported the stability of the money demand function. • After 1973, there is evidence substantial instability in estimated money demand functions because of the rapid pace of financial innovation, which changed which items could be used for money.