Modern Macroeconomics and Monetary Policy

1. Modern Macroeconomics and Monetary Policy 3 14 3 14

2. The Impact of Monetary Policy on Output and Inflation

3. Impact of Monetary Policy • Evolution of the modern view: • 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 the1960s and 1970s. • Monetarists argued that changes in the money supply caused 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. The following slides present this modern view.

4. The Demand for Money Money interestrate Money Demand Quantity 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-earning assets like bonds.

5. The Supply of Money Money interestrate Money Supply Quantity of money • The supply of money is vertical because it is established by the Fed and, hence, determined independently of the interest rate.

6. Excess supplyat i2 At ie, people are willingto hold the money supply set by the Fed. Excess demandat i3 The Demand and Supply of Money Money interestrate Money Supply i2 ie i3 Money Demand Quantity of money • Equilibrium: The money interest rate gravitates toward the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the Fed has supplied.

7. S2 S2 Transmission of Monetary Policy • When the Fed shifts to a more expansionary monetary policy, it usually buys additional bonds, expanding the money supply. • This increase in the money supply (shift from S1 to S2 in the market for money) provides banks with additional reserves. • The Fed’s bond purchases and the bank’s use of new reserves to extend new loans increases the supply of loanable funds (shifting S1 to S2 in the loanable funds market) … and puts downward pressure on real interest rates (a reduction to r2). Moneyinterestrate S1 Realinterestrate S1 i1 r1 r2 i2 D1 D Qty of loanable funds Quantityof money Qs Qb Q1 Q2

8. AS1 AD2 Transmission of Monetary Policy • As the real interest rate falls, AD increases (to AD2). • As the monetary expansion was unanticipated, the expansion in AD leads to a short-run increase in output (from Y1 to Y2) and an increase in the price level (from P1 to P2) – inflation. • The impact of a shift in monetary policy is transmitted through interest rates, exchange rates, and asset prices. S1 Realinterestrate PriceLevel S2 r1 P2 P1 r2 D AD1 Qty of loanable funds Goods & Services (real GDP) Y1 Y2 Q1 Q2

9. Unanticipated Expansionary Monetary Policy Fed buys bonds Increases in investment & consumption Net exports rise This increases money supply and bank reserves Real interest rates fall Increase in aggregate demand Depreciation of the dollar Increases in investment & consumption Increase in asset prices Transmission of Monetary Policy • Here, a shift to an expansionary monetary policy is shown. • Assume the Fed expands the supply of money by buying bonds… which will increase bank reserves … which leads to increased investment and consumption … pushing real interest rates down … a depreciation of the dollar (leading to increased net exports) and … an increase in the general level of asset prices (and with the increased personal wealth, increased investment and consumption). • So, an unanticipated shift to a more expansionary monetary policy will stimulate aggregate demand and, thereby, increase both output and employment.

10. E2 AD2 Expansionary Monetary Policy LRAS PriceLevel SRAS1 P2 e1 P1 AD1 Goods & Services(real GDP) Y1 YF • If expansionary monetary policy leads to an in increase in AD when the economy is below capacity, the policy will help direct the economy toward LR full-employment output (YF). • Here, the increase in output from Y1 to YF will be long term.

11. e2 AD2 AD Increase Disrupts Equilibrium LRAS PriceLevel SRAS1 P2 P1 E1 AD1 Goods & Services(real GDP) Y2 YF • Alternatively, 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).

12. SRAS2 E3 AD Increase: Long Run LRAS PriceLevel SRAS1 P3 P2 e2 P1 E1 AD2 AD1 Goods & Services(real GDP) Y2 YF • In the long-run, the strong demand pushes up resource prices, shifting short run aggregate supply (from SRAS1 to SRAS2). • The price level rises (from P2 to P3) and output falls back to full-employment output again (YF from its temp high,Y2).

13. A Shift to More Restrictive Monetary Policy • Suppose the Fed shifts to a more restrictive monetary policy. Typically it will do so by selling bonds which will: • depress bond prices and • drain reserves from the banking system, • which places upward pressure on real interest rates. • As a result, an unanticipated shift to a more restrictive monetary policy reduces aggregate demand and thereby decreases both output and employment.

14. AS1 S2 PriceLevel AD2 Goods & Services (real GDP) Short-run Effects of More Restrictive Monetary Policy • A shift to a more restrictive monetary policy, will increase real interest rates. • Higher interest rates decrease aggregate demand (to AD2). • When the reduction in AD is unanticipated, real output will decline (to Y2) and downward pressure on prices will result. Realinterestrate S1 r2 P1 P2 r1 AD1 D Qty of loanable funds Y2 Y1 Q2 Q1

15. PriceLevel E2 AD2 Goods & Services(real GDP) Restrictive Monetary Policy LRAS SRAS1 P1 e1 P2 AD1 Y1 YF • The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its impact. • Restrictive monetary policy will reduce aggregate demand. If the demand restraint occurs during a period of strong demand and an overheated economy, then it may limit or prevent an inflationary boom.

16. PriceLevel e2 AD2 Goods & Services(real GDP) AD Decrease Disrupts Equilibrium LRAS SRAS1 P1 E1 P2 AD1 Y2 YF • 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.

17. Proper Timing • If a change in monetary policy is timed poorly, it can be a source of instability. • It can cause either recession or inflation. • Proper timing of monetary policy is not easy: • While the Fed can institute policy changes rapidly, there will be a time lag before the change exerts much impact on output & prices. • This time lag is estimated to be 6 to 18 months in the case of output and perhaps as much as 36 months before there is a significant impact on the price level. • Given our limited ability to forecast the future, these lengthy time lags clearly reduce the effectiveness of discretionary monetary policy as a stabilization tool.

18. Questions for Thought: 1. What are the determinants of the demand for money? The supply of money? • 2. If the Fed shifts to more restrictive monetarypolicy, it typically sells bonds. How will this action influence 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 price of stocks and real assets like apartments or office buildings • g. real GDP

19. Questions for Thought: • 3. Timing a change in monetary policy correctly is difficult because • a. monetary policy makers cannot act without congressional approval. • b. it is often 6 to 18 months in the future before the primary effects of the policy change will be felt. 4. When the Fed shifts to a more expansionary monetary policy, it often announces that it is reducing its target federal funds rate. What does the Fed generally do to reduce the federal funds rate?

20. Questions for Thought: 5. The demand curve for money: a. shows the amount of money balances that individuals and business wish to hold at various interest rates. b. reflects the open market operations policy of the Federal Reserve.

21. Monetary Policy in the Long Run

22. x x = Y= Income Money Velocity Price The Quantity Theory of Money • The quantity theory of money: Y P M V • If V and Y are constant, then an increase in M will lead to a proportional increase in P.

23. Long-run Impact of Monetary Policy -- The modern View • Long-run implications of expansionary policy: • 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 real output will return to their long-run normal levels. • Thus, in the long run, money supply growth will lead primarily to higher prices (inflation) just as the quantity theory of money implies.

24. LRAS SRAS1 (a) Growth rate of the money supply. E1 AD2 AD1 YF (b) Impact in the goods & services market. Long-run Effects of a Rapid Expansion in the Money Supply • Here we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3 to 8 percent. • Initially, prices are stable (P100) when the money supply is expanding by 3% annually. • The acceleration in the growth rate of the money supply increases aggregate demand(shift to AD2). Money supply growth rate Price level(ratio scale) 9 8% growth 6 P100 3 3% growth Timeperiods RealGDP 4 1 2 3

25. SRAS2 E2 (a) Growth rate of the money supply. (b) Impact in the goods & services market. Long-run Effects of a Rapid Expansion in the Money Supply • 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 SRAS1 to SRAS2. • Output returns to its long-run potential YF, and the price level increases to P105 (E2). Money supply growth rate Price level(ratio scale) LRAS 9 8% growth SRAS1 P105 6 E1 P100 3 3% growth AD2 AD1 Timeperiods RealGDP Y1 YF 4 1 2 3

26. SRAS3 E3 (a) Growth rate of the money supply. AD3 (b) Impact in the goods & services market. Long-run Effects of a Rapid Expansion in the Money Supply • If the more rapid monetary growth continues, then ADand SRASwill continue to shift upward, leading to still higher prices (E3 and points beyond). • The net result of this process is sustained inflation. Money supply growth rate Price level(ratio scale) LRAS SRAS2 P110 9 8% growth SRAS1 P105 E2 6 E1 P100 3 3% growth AD2 AD1 Timeperiods RealGDP YF 4 1 2 3

27. (expected rate S2 of inflation = 5 %) Recall: the nominal interest rate is the real rate plus theinflationary premium. D2 (expected rate of inflation = 5 %) Expansionary Monetary Policy Loanable FundsMarket Interestrate (expected rate S1 of inflation = 0 %) i.09 r.04 (expected rate D1 of inflation = 0 %) Quantity of loanable funds Q • With stable prices, supply and demand in the loanable funds market are in balance at a real & nominal interest rate of 4%. • If 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%.

28. Money and Inflation • The impact of monetary policy differs between the short and long-run. • In the short-run, shifts in monetary policy will affect real output and employment. A shift toward monetary expansion will temporarily increase output, while a shift toward monetary restriction will reduce output. • But in the long-run, monetary expansion will only lead to inflation. The long-run impact of monetary policy is consistent with the quantity theory of money.

29. Congo, DR Nicaragua Brazil Paraguay Ghana Sierra Leone Venezuela Columbia Nigeria Mexico Chile Indonesia Hungary India Japan South Korea Belgium Central Africa Republic United States Switzerland Money and Inflation – An International Comparison 1985 - 2005 • The relationship between the avg. annual growth rate of the money supply and the rate of inflation is shown here for the 1985-2005 period. 1000 100 • The relationship between the two is clear: higher rates of money growth lead to higher rates of inflation. Rate of inflation (%, log scale) 10 Note: The money supply data are the actual growth rate of the money supply minus the growth rate of real GDP. 1 1 10 100 1,000 Rate of money supply growth (%, log scale)

30. Time Lags, Monetary Shifts, and Economic Stability

31. Time Lags, Monetary Shifts, and Economic Stability • Shifts in monetary policy will influence the general level of prices and real output only after time lags that are long and variable. • Given our limited forecasting ability, these time lags will make it difficult for policy-makers to institute changes in monetary policy that will promote economic stability. • Constant shifts in monetary policy are likely to generate instability rather than stability. • Historically, erratic monetary policy has been a source of economic instability.

32. Measurement of Monetary Policy • How can you tell whether monetary policy is expansionary or restrictive? • During the 1960s and 1970s the growth rate of the money supply was a reasonably good indicator of the direction of monetary policy. Rapid growth of the money supply signaled expansion, while slow growth or decline was indicative of restriction. • But innovations and dynamic change reduced the reliability of the money growth data.

33. Measurement of Monetary Policy • Since the mid-1980s, the Fed has used its control over short-term interest rates more extensively in its conduct of monetary policy. • When the Fed shifted toward expansion, it pushed short-term interest rates downward. • When it shifted toward restriction, it pushed short-term interest rates upward. • Thus, movements of short-term interest rates have emerged as a reliable monetary policy indicator.

34. What is the Taylor Rule? • Developed by John Taylor of Stanford, the Taylor rule provides an estimate of the federal funds interest rate that would be consistent with both price stability and full employment. • The Taylor rule equation for the target federal funds rate is: (p-p*) + r .5 * .5 * (y-yp) + p + f = f - the target fed funds rate r - equilibrium real interest rate (assumed to be 2.5%) p - actual inflation rate p* - the desired inflation rate (assumed to be 2%) y - output yp - potential output

35. What is the Taylor Rule? • Most economists believe that price indexes slightly overstate the rate of inflation. Thus, the 2% desired rate of inflation might be thought of as approximate price stability.

36. What is the Taylor Rule? • The general idea of the Taylor Rule is straightforward: • When the rate of inflation is high and current output is large relative to the potential, more restrictive monetary policy and a higher target fed funds rate would be appropriate. • In contrast, when inflation is low and current output well below its potential, more expansionary monetary policy and a lower fed funds rate would be called for.

37. Why is the Taylor Rule Important? • The Taylor rule is important because it provides both a guide for the conduct of monetary policy and a tool for the evaluation of how well it is being conducted. • If the actual fed funds rate is below the target rate implied by the Taylor rule, this indicates monetary policy is overly expansionary. • On the other hand, when the actual federal funds rate is above the target rate, this signals monetary policy is too restrictive. • When the actual and target rates are equal, this indicates monetary policy is on target.

38. The Taylor Rule and Monetary Policy, 1960-2009 • The actual fed funds rate tracked the target rate quite closely during most of the 1960s and the 1986-1999 period, indicating that monetary policy was appropriate for the maintenance of full employment and low inflation. Actual Fed Funds Rate Taylor Rule Target

39. The Taylor Rule and Monetary Policy, 1960-2009 • In contrast, the actual fed funds rate was substantially less than the target rate in the inflationary 1970s and during 2002-mid-year 2005. • This indicates that monetary policy was too expansionary during these periods. Actual Fed Funds Rate Taylor Rule Target

40. Did Monetary Policy Cause the Crisis of 2008? • Between January 2002 and mid-year 2006, housing prices increased by 87%. • This boom in housing prices was fueled by several factors including: • government regulations that eroded lending standards and promoted the purchase of housing with little or no down payment • heavily leveraged borrowing for the financing of mortgage-backed securities • But, the expansionary Fed policy of 2002-2004, followed by the shift to a more restrictive monetary policy in 2005-2006 also contributed to the housing boom and subsequent bust.

41. Short-Term Interest Rates, 1998-2009 • Rising short-term interest rates are indicative of monetary restriction, while falling rates imply expansion. • Note, how the Fed pushed short-term interest rates to historic lows during 2002-2004, and housing prices soared. Federal Funds 1-Year T-Bill

42. Inflation, 1998-2009 • As inflation rose in 2005-2006, the Fed shifted toward restriction and pushed short-term interest rates upward. • The Fed’s low interest rate policy (2002-2004), followed by its more restrictive policy (2005-2006), contributed to the boom and bust in housing prices, and the Crisis of 2008.

43. Current Fed Policy and the Future • As the recession worsened during the second half of 2008, the Fed shifted toward a highly expansionary monetary policy. • Vast amounts of reserves were injected into the banking system, short-term interest rates were pushed to near zero, and the monetary base was approximately doubled. • Monetary policy works with a lag. It will take some time for the expansionary monetary policy to stimulate demand and economic recovery.

44. Current Fed Policy and the Future • The Fed now faces a dilemma: If it shifts toward restriction too quickly, the recovery may falter. But, if the Fed continues with the expansionary monetary policy for too long, it will lead to serious future inflation. • The problem is not the Fed’s ability to control the money supply, but its ability to time shifts properly. Given the long and variable lags, it is hard for monetary policy-makers to institute stop-go policy in a stabilizing manner. • We are in the middle of another great monetary policy experiment.

45. Questions for Thought: 1. When the actual interest rate is less than the rate implied by the Taylor rule, monetary policy is too expansionary. (True or False?) 2. Will stop-go monetary policy help stabilize real output and employment? Why or why not? 3. Did Fed policy contribute to the Crisis of 2008? Why or why not? 4. Did the change in Fed policy during the latter half of 2008 help promote economic recovery? Did this policy change lead to long-term stability?

46. EndChapter 14