049f7ee71c27e187f6716cc71056c0fb_EC103 Week 09 and 10 S14.ppt

8/9/2019 049f7ee71c27e187f6716cc71056c0fb_EC103 Week 09 and 10 S14.ppt

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1

Next: Monetary theory and

policyEvery major contraction in thiscountry has been either produced by monetary disorderor greatly exacerbated bymonetary disorder. Everymajor inflation has been

produced by monetaryexpansion.

--the late Milton Friedman (1967)

So monetary policy has greatcapacity to do harm. Why?

And can it do good, as ell?


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The Federal Reserves Goals

What the Fed wants monetary policy to do!1. "rice sta#ility$. %igh employment&. Sta#ility o' 'inancial mar ets and instit tions*.+conomic gro th And a'ter the in'lationary 7-s ( e ere all/eynesians0), it seemed pretty s ccess' l

e called this the 2reat Moderation3 tilthe 2reat 4ecession o' $--75-9 hitWhat went wrong (or right !

2


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Nominal GDP growth rates

since 1960

3


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The Monetary TransmissionMechanism

As e said (in h. 1*), the Fed can controlmoney gro th ia (1) 8pen M t 8ps, ($)isco nt 4ate, (&) 4e:;d 4eser e 4atio

AS, and there'oreprices, o tp t, and employment

4


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Fig re 1 .$ @he emand 'or Money

@he money demand c r e slopes do n ard #eca se lo er interest rates ca se ho seholdsand 'irms to s itch 'rom 'inancial assets, s ch as .S. @reas ry #ills, to money.

All other things #eing e: al, a 'all in the interest rate 'rom * percent to & percent ill increasethe : antity o' money demanded 'rom B9-- #illion to B9 - #illion.

An increase in the interest rate ill decrease the : antity o' money demanded.

@he interest rate is the opportunity cost , or hat yo 'orgo, to hold money.


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Fig re 1 .& Shi'ts in the Money emand r e

Changes in real GDP or the price level cause the money demand curve to shift.1.An increase in real 2 " or an increase in the price le el ill ca se the money demandc r e to shi't 'rom "# 1 to "# $.$.A decrease in real 2 " or a decrease in the price le el ill ca se the money demandc r e to shi't 'rom "# 1 to "# &.


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Fig re 1 .*

@he +''ect on the Cnterest 4ateWhen the Fed Cncreases theMoney S pplyWhen the Fed increases themoney s pply, ho seholds and'irms ill initially hold moremoney than they ant, relati eto other 'inancial assets.%o seholds and 'irms se the

money they don;t ant to holdto # y @reas ry #ills and ma edeposits in interest5paying#an acco nts.@his increase in demand allo s#an s and sellers o' @reas ry#ills and similar sec rities too''er lo er interest rates.+ ent ally, interest rates ill 'all eno gh that ho seholds and 'irms ill #e illing to hold theadditional money the Fed has created.Cn the 'ig re, an increase in the money s pply 'rom B9-- #illion to B9 - #illion ca ses themoney s pply c r e to shi't to the right, 'rom "$ 1 to "$ $, and ca ses the e: ili#ri m interest rate to 'all 'rom * percent to & percent.


8/44

Fig re 1 .

@he +''ect on Cnterest 4ates Whenthe Fed ecreases Money S pplyWhen the Fed decreases themoney s pply, ho seholds and'irms ill initially hold lessmoney than they ant, relati eto other 'inancial assets.%o seholds and 'irms ill sell@reas ry #ills and other

'inancial assets and ithdramoney 'rom interest5paying#an acco nts.@hese actions ill increaseinterest rates.+ ent ally, interest rates illrise to the point at hichho seholds and 'irms ill #e

illing to hold the smalleramo nt o' money that res lts'rom the Fed;s actions.Cn the 'ig re, a red ction in the money s pply 'rom B9-- #illion to BD - #illion ca ses themoney s pply c r e to shi't to the le't, 'rom "$ 1 to "$ $,

and ca ses the e: ili#ri m interest rate to rise 'rom * percent to percent.


9/44

A tale o t!o interest rates " i and r #Cn the loana#le ' nds mar et, lenders and #orro ers are concerned

ith the long-term real rate of interest (call it r )as the rele ant price0o' the good (credit) they are eEchanging hile in the(a'orementioned) money mar et transactors are concerned ith theshort-term nominal rate of interest (call it i )

t there;s o'ten a close connection #et een their mo ements (see'ollo ing graphics).

@he long5term real rate o' interest r is the interest rate that is mostrele ant hen!

G Sa ers consider p rchasing a long5term 'inancial in estmentG Firms #orro to 'inance long5term in estment proHectsG %o seholds ta e o t mortgage loans

When cond cting monetary policy, ho e er, the short5term nominalinterest rate i is most rele ant #eca se it is the interest rate mosta''ected #y increases and decreases in the money s pply.


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D 1

Moneyinterestrate S 1

D

S 1

i 1

Q s

r 1

Q 1

i 2

Q b

r 2

Q 2

S 2 S 2

Realinterestrate

Quantity

of money

Qty ofloanable

funds

Tracin$ e%ects o &M "'rst( expansion#

S ppose the Fed # ys #onds in open m t, so MI. Cn the moneym t, this shi'ts S 1 to S 2 , i J, and #an s; reser es I.Cn the loana#le ' nds m t, #an s se their ne reser es to o''er neloans to ho seholds and # sinesses, so the s pply o' loana#le ' ndsI (shi'ting S 1 to S 2 ), and r J.


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PriceLevel

Goods &Services(real GDP)

D

S 1

r 1

Q 1

r 2

Q 2

S 2

Realinterestrate

P 1

Y 1 Y 2

AS 1

AD 1

P 2

AD 2

Monetary expansion "cont)# As i and r J, AD I (to AD 2 ). And since the M eEpansion asun anticipated, the AD I leads to a short5r n I in o tp t ('rom Y 1 to Y 2 )and I in the price le el inflation .

So! monetary policy is transmitted mostly thro gh interest rates(# t also thro gh eEchange rates and asset prices).

Qty ofloanable

funds


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But notice

Cn the pre io s A 5AS pict re, e didn;t drathe K4AS c r e

idn;t say hether e ere starting at ' llemployment, #elo it, or a#o e it i.e., didn;tsay hether L 1 or L $ L ' @hat;s a ey : estion! C' e start stim lating

A hen there;s slac , e;re doing good= i' estart hen there;s none, e;re desta#iliNingthe economy and in'lating O

%Why on earth would we ever do that!

12


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13

AD 1

C' the increase in AD accompanying eEpansionary monetary policy is'elt hen the economy is operating #elo capacity, the policy mayhelp direct the economy to ard long5r n ' ll5employment e: ili#ri mY F if the timing&s right (i.e.' before $ )$ shifts .

Monetar y

expansionwith

slack

PriceLevel

LRAS

Y F Y 1

AD 2

Goods & Services(real GDP)

P 2

SRAS 1

P 1

E 2e1


14/44

14

AD 1

t i' the demand5stim l s e''ects are imposed on aneconomy already at ' ll5employment Y F , they ill lead toeEcess demand, higher prod ct prices, and temporarily highero tp t Y 2 .

PriceLevel

LRAS

Y F

P 2


P 1

SRAS 1

E 1

Y 2

Monetar y

expansionat Y f

AD 2

e2


15/44

1*

AD 1

PriceLevel

LRAS

Y F

P 2


P 1

SRAS 1

AD 2

E 1

e2

Y 2

Cn the long5r n, the strong demand p shes p reso rce prices, shi'tingSRAS 1 to SRAS 2 .

P 3

And inthe

+on$R,n

SRAS 2

P rises to P 3 and o tp t 'alls #ac to ' ll5employment o tp t again ( Y F 'rom its temporary high, Y 2 ).

E 3


16/44

Timin$ is everythin$

"roper diagnosis and timing o' monetarypolicy ain;t easy.While the Fed can change monetary policyrapidly, there may #e a non5tri ial time lag#e'ore the change ill impact AD .So, e en i' the Fed is starting ith slac 0 inthe economy, i' SRAS has #eg n to shi't#e'ore AD , then3 tro #le happens .

*or you to do+ wor, through effects of contractionary monetary policyin money' loanable funds' and final goods mar,ets.


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Fig re 1 .D @he +''ect o' a "oorly @imed Monetary "olicy on the +conomy

@he p ard5sloping straight line represents the long5r n gro th trend in real 2 ".@he c r ed red line represents the path real 2 " ta es #eca se o' the # siness cycle.C' the Fed is too late in implementing a change in monetary policy,real 2 " ill 'ollo the c r ed #l e line.@he Fed;s eEpansionary monetary policy res lts in too great an increase in aggregatedemand d ring the neEt eEpansion, hich ca ses an increase in the in'lation rate.


18/44

@rying to %it a Mo ing @arget! Ma ing "olicy ith 4eal5@ime ata0

Ma ingthe

onnection

Lo r @ rn! @est yo r nderstanding #y doing related pro#lems &.1& and &.1* at the end o' this chapter.My+con Ka#

Cn addition to the other pro#lems the Federal 4eser e enco nters in s ccess' lly cond ctingmonetary policy, it m st ma e decisions sing data that may #e s #Hect to s #stantialre isions.


19/44

Notice also: o,r t!ointerest rates"i and r # may not move inloc-stepWhen the 'ed increases M, that p ts S4do n ard press re on nominal interest rate i

t remem#er!i r P eEpected in'lation

8 er time, increases in M (or M gro th)

in'lation that is built into expectationsSo! MI iJ in S4, # t "I and e ent al iI*ed has to be careful not to over-expand "


20/44

Money $ro!th( i( and r in .Rand +R

2/


21/44

.,mmary: 0nterest rates and monetary policy

While the Fed can a''ect real interest rate r in the shortterm , its impact on long5term rates is limited to nominal rate i and not necessarily in a good ayQC.e., it;s nai e to ad ocate, e.g., that the Fed sho ld c tinterest rates so C can a''ord a ho se in a 'e yearsQ0

Cn the long r n, expansionary monetary policy leadsto in'lation and high nominal interest rates, rather thanlow interest rates.Similarly, restri ti!e monetary policy, hen p rs edo er a lengthy time period, leads to low in'lation andlow nominal interest rates.

".e., monetary poli y ten#s to $e %neutral& in the longrun with respe t to real !aria$les 'li(e r)


22/44

A S mmary o' %o Monetary "olicy Wor s ( at least in the $ )

@a#le 1 .1 +Epansionary and ontractionary Monetary "olicies

@he arro s point to the steps in ol ed in the policy that occ r relati e to hato ld ha e happened itho t the policy.


23/44

Why oesn;t the Fed @arget oth the Money S pply and the Cnterest4ate?

Fig re 1 .11

@he Fed an;t @arget oththe Money S pply andthe Cnterest 4ate@he Fed is 'orced tochoose #et een sing

either an interest rate orthe money s pply as itsmonetary policy target.Cn this 'ig re, the Fed canset a target o' B9-- #illion'or the money s pplyor a target o' percent

'or the interest rate,# t the Fed can;t hit #othtargets #eca se it canachie e only com#inationso' the interest rate and the money s pply that represent e: ili#ri m in the money mar et.


24/44

24

A case stud : The Greatepression and

the ,antity Theory o Money"op lar isdom0 on the epression!@he 4oaring ;$-s # ##le0 # rst=Social ine: ality economic insta#ility

A tonomo s decline in , CMaintenance o' gold standard crisis in 'oreigneEchange mar ets

Ris als! ommanding %eights, hs. * >
http://www.pbs.org/wgbh/commandingheights/lo/story/ch_menu.htmlhttp://www.pbs.org/wgbh/commandingheights/lo/story/ch_menu.html


25/44

2*

Monetary ri$ins o theepression

antity +: ation (T change 'orm)! UMVM P URVR U"V" P ULVL

19$&5$D al es!P*.*T P -.1T P-.&T P *.$T

t Fed sa eEcessi e spec lation0 as apro#lem it decided to sol e ith a contractiono' M starting in April, 19$D


26/44

2

The Great 5ontraction

Money gro th rates!4/28 *V$9! 51.- T*V$9 *V&-!5-.9 T*V&- *V&1!*+.3*V&1 *V&$!*1-. ///

*V&$ *V&&!*10.-


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26

7o! does monetary contractiont,rn to epression8

+''ects on #an lending3S4 e''ects on nominalVreal interest rates3+''ects on A , real 2 ", corporate pro'its,and stoc prices3+''ects on con'idence and reliance on the#an ing system ' he reat Pani ) and

Fed;s 'ail re to act as lender o' last resort0


28/44

29

The Great epression

antity +: ation (T change 'orm)! UMVM P URVR U"V" P ULVL

19$D5&& al es!

5D.$T 5 $.9T 5 .1T 5 6.-T


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