Transcript Macroeconomics Module 8

Macroeconomics
Unit 15
Monetary Policy and Theory
The Top Five Concepts
Introduction
This unit discusses another economic policy tool called
monetary theory. Similar to fiscal policy or Keynesian theory it
focuses on demand. However, its main emphasis is controlling
the demand for money by consumers and businesses.
In the United States, monetary policy and the tools used to
control the supply of money are controlled and implemented by
the Federal Reserve.
Concept 1: The Money Market
Money is confronted with its own demand and supply curve.
The demand and supply of money is controlled through the
interest rate.
The interest rate in this case is the price paid for the use of
money. The amount of money demanded is based upon the
interest rate. Think of the interest rate as the cost of money.
When interest rates are low, borrowing money to buy a home or
car is less expensive. When interest rates are higher, your cost
(and monthly payment) increases.
There are three types of demand for money: transactions,
precautionary, and speculative.
Concept 1: Money Demand
Transactions demand – This is money that is being held for
the purpose of making everyday market purchases.
Examples of routine market purchases include paying for gas,
buying lunch, shopping for clothes, buying a home.
Payments are made using cash, check, debit card, credit card,
and loans.
Think about the money that you have in your wallet or purse,
and in your checking account. Chances are this money is for
your routine transactions that occur every day.
Concept 1: Money Demand
Precautionary demand – This is money held in “reserve” for
unexpected needs or purchases, and emergencies.
Examples include money held in certificates of deposit, extra
cash kept in a checking account, and extra cash kept in a
money market account or a savings account.
Uses of money for precautionary demand included unexpected
illnesses, a great deal on some new electronic equipment, or
the unexpected loss of a car or home not adequately covered
by insurance. Most people think of this money as their
emergency money although it can also be used to take
advantage of a great bargain.
Concept 1: Money Demand
Speculative demand – This is the
money you keep in reserve for later
financial opportunities or speculation.
For example, extra cash in the bank
reserved for when stocks fall to a
certain price. It’s also the extra cash
being held to buy some property when
the price falls enough. Or, it could be
the extra cash you use to invest in a
friend’s business.
Concept 1: Money Demand
The three different types of demand affect the market demand
for money.
The market demand curve for money indicates that as the
price of money falls (the cost in terms of the interest rate), the
demand for money will increase.
The supply of money is fixed by current monetary policy
initiated and controlled by the Federal Reserve. So in regards
to the money supply, the supply curve is vertical, while the
demand for money is a downward sloping curve.
Interest Rate (percent per year)
The Demand For Money
Money supply
The amount of money
demanded (held) depends
on interest rates
Equilibrium
0
Quantity Of Money (billions of dollars)
Money
demand
Concept 2: Money Equilibrium
At the equilibrium point the demand and supply of money
intersect indicating that people are willing to hold as much
money as is available.
If interest rates increase, then money will be transferred to
other markets, like the bond market. The demand for money
falls.
The equilibrium point represents the equilibrium rate of
interest indicating the interest rate at which the demand and
supply of money are equal.
Concept 2: Changes to Equilibrium
Federal Reserve policy can have an impact on the equilibrium
rate of interest.
The Federal Reserve can increase the supply of money by:
• lowering the reserve requirement
• lowering the discount rate
• buying bonds in the open market
The increase in the supply of money causes the equilibrium
rate of interest to fall.
Changing Interest Rates
Interest Rate(percent per year)
When rates drop from 7% to 6%, there is movement along the
demand curve to the right. The demand for money increases.
7
6
E1
E2
Demand for
money
0
Quantity Of Money (billions of dollars)
Economic Effects
Federal Reserve policy changes have an effect on aggregate
demand.
Monetary stimulus is achieved by the Federal Reserve
through:
Increasing the supply of money.
Reducing interest rates.
Buying bonds in the market.
As a rule, a 1/10 point reduction in long-term interest rates can
produce $10 billion dollars in fiscal stimulus according to Alan
Greenspan, former chair of the Federal Reserve.
Economic Effects
Federal Reserve policy can also be used to restrain the
economy.
To reduce aggregate demand, the Federal Reserve can:
Decrease the money supply.
Increase interest rates.
Sell more bonds at attractive prices.
All three policy changes will cause a leftward shift in aggregate
demand.
Concept 3: Policy Constraints
Changes in short-term interest rates (federal funds rates, 6
month Treasury bonds) need to produce changes in long-term
interest rates. Long-term interest rates are the rates on home
mortgages, installment loans, 10 year Treasury bonds, etc.
Most Federal Reserve Open Market operations focus on shortterm rates.
In order to have a lasting effect on the economy, long-term
rates need to change as well as short-term rates. The success
of Federal Reserve policy changes is often measured by
changes in long-term interest rates.
Concept 3: Policy Constraints
Long-term rates may not change as fast or as much due to the
following:
Reluctant Lenders – Private banks may not be willing to
increase their lending activity. They may be concerned about
consumer or business credit quality and/or general economic
conditions.
Liquidity Trap – If interest rates are already low, people may
continue to hold money waiting for better investment options,
and not seek loans or conduct additional spending. At this
point the demand curve is horizontal and increases in the
supply of money do not push rates lower.
Concept 3: Policy Constraints
Long-term rates also may not change due to low expectations.
If businesses do not believe that the demand for goods and
services will increase, they may curtail investment spending
until economic conditions improve.
Any further interest rate reductions may not produce an
increase in demand – at this point demand is inelastic until
expectations change. The U.S. economy during 2002 – 2003
had some of the lowest interest rates in the last 40 years.
Expectations of future growth remained pessimistic until
consumer and business spending increased significantly during
the third and fourth quarters of 2003.
Concept 4: Monetarists
Keynes believed changes in the money supply can affect
aggregate demand. Changes in the supply of money occur
when interest rates change.
Monetarists believe that changes in short-term interest rates
(like the discount rate and federal funds rate) do not have a
significant effect on the supply of money. They believe the
changes in these rates affect the price of money.
Monetarists believe that monetary policy is not effective for
recessionary problems, but is effective against inflation.
Concept 4: Monetarists
Monetary policy can be viewed as a relationship between four
variables according to Monetarists. The relationship is
expressed by the equation of exchange.
The equation of exchange shows the relationship between
four variables that affect monetary policy.
MV = PQ is the equation of exchange.
M = quantity of money in circulation
V = the velocity of money in circulation
P = average price of goods
Q = quantity of goods purchased
Concept 4: Equation of Exchange
V indicates the number of times per year, on average, a dollar
is used to purchase final goods and services.
Monetarists believe that V is stable and does not change over
the long run.
MXV=PXQ
Any change that occurs in M indicates a change will also occur
in P and/or Q. The equation must remain in balance.
Monetarists believe that any change in the supply of money (M)
will alter total spending (PQ), even if interest rates change.
Concept 5: Monetary Theory
Monetarists believe that Federal Reserve policy should be
directed at increasing/decreasing the supply of money, not at
changing interest rates.
Expanding upon the basic theories of monetarists, some
believe that Q is stable too. Under this theory, a natural rate of
unemployment exists within the economy that is not affected by
short term monetary policy changes.
If this is true, then some monetarists believe that changes in M
will lead to changes only in P.
Concept 5: Monetary Theory
In regards to interest rates, the real rate of interest is important
to Monetarists. The real interest rate is the nominal interest
rate minus anticipated inflation.
For example, if the nominal or current rate of interest is 4% and
the anticipated inflation rate is 2%, the real rate of interest = 4%
- 2% = 2%.
The real rate of interest tells you if, after a year, you actually
gained or lost money. For example, if a bank wishes to receive
a 5% return (profit) on a loan when the inflation rate is 3%, then
the bank should charge an interest rate of 8%. This nominal
rate of 8% has a real rate of interest of 5% after inflation.
Concept 5: Monetary Theory
Monetarists believe that the real rate of interest is stable and
that changes in nominal interest rates are caused by changes
in the anticipated rate of inflation.
If inflation exists, monetarists believe that a reduction in the
supply of money will lessen inflation. As the supply of money is
gradually reduced by the Federal Reserve through open market
operations and/or changes in the reserve ratio, nominal interest
rates will fall.
Keynesians believe that increasing interest rates (discount and
federal funds rate) is an effective method to lessen inflation.
Concept 5: Monetary Policy
For recessionary problems, monetarists believe that increasing
the supply of money or reducing interest rates is not an
effective way to end recessions.
Keynesians believe that lowering rates and increasing the
supply of money (M) can help eliminate a recession, along with
fiscal policy changes.
Monetarists believe that increasing the supply of money (M)
could cause an increase in prices (P). Rising prices and
interest rates would stall any economic recovery.
Monetarists – Keynesians
Comparison
Monetarists – Changes in interest rates do not affect the
supply of money. To change the money supply, you need to
change bond prices through the buying and selling of bonds by
the Federal Reserve, or change the bank reserve requirements
(reserve ratio).
Keynesians – Changes in interest rates do affect the supply
and demand for money. They prefer interest rate changes but
will also support selling/buying of bonds to change the supply of
money. Interest rate changes are used to supplement fiscal
policy tools (government spending, taxes, transfer payments).
Further Analysis
When interest rates fall, borrowers are very happy. Interest
rates on mortgages and car loans fall which increases lending
activity and new purchases.
Banks and other lenders receive lower income from lending
activity as interest rates fall. However it is important to examine
the real rate of interest again. During a period of higher rates, a
bank may have been loaning money for mortgages at 9% when
inflation was at 6%; the real rate of interest is 3%. If both
nominal interest rates and the inflation rate falls, the bank may
be loaning money for mortgages at 5%, but if the rate of
inflation is only 2%, then the real rate of interest remains at 3%.
Further Analysis
So is anyone not happy about lower interest rates? Well the
banks and other lenders may not be if the real interest rate has
fallen. Their profits are likely to be lower.
Individuals who have investments in savings account, CDs,
money market accounts, and Treasury bills will receive lower
rates of interest on their savings and investments. Their
incomes will be lower as a result.
Summary
•
•
•
•
•
•
•
Demand for money (3).
Equilibrium rate of interest.
Monetary stimulus and constraints.
Real interest rate.
Equation of Exchange.
Keynesian view of monetary policy.
Monetarist view of monetary policy.