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Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Chapter 17
Domestic and International Dimensions of Monetary Policy
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
17-2
Effects of an Increase in The Money Supply
• What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter?
• People pick up the money and put it in their pockets, but how do they dispose of the new money?
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
17-3
Effects of an Increase in The Money Supply (cont'd)
• Direct effect
– Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services.
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17-4
Effects of an Increase in The Money Supply (cont'd)
• Indirect effect
– Not everybody will necessarily spend the newfound money on goods and services.
– Some of the money gets deposited, so banks have higher reserves (and they lend the excess out).
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17-5
Effects of an Increase in The Money Supply (cont'd)
• Indirect effect
– Banks lower rates to induce borrowing. • Businesses engage in investment.• Individuals consume durable goods (like housing and
autos).
– Increased loans generate an increase in aggregate demand.
• More people are involved in more spending (even those who didn’t get money from the helicopter!).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
17-6
Effects of an Increase in The Money Supply (cont'd)
Graphing the Effects of an Expansionary Monetary Policy
• Assume the economy is operating at less than full employment
– Expansionary monetary policy can close the recessionary gap.
– Direct and indirect effects cause the aggregate demand curve to shift outward.
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17-7
Figure 17-1 Expansionary Monetary Policy with Underutilized Resources
• The recessionary gap isdue to insufficient AD
• To increase AD, use expansionary monetary policy
• AD increases and real GDP increases to full employment
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17-8
Effects of an Increase in The Money Supply (cont'd)
Graphing the Effects of Contractionary Monetary Policy
• Assume there is an inflationary gap
– Contractionary monetary policy can eliminate this inflationary gap.
– Direct and indirect effects cause the aggregate demand curve to shift inward.
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17-9
• The inflationary gap is shown
• To decrease AD, use contractionary monetary policy
• AD decreases and real GDP decreases
Figure 17-2 Contractionary Monetary Policy with Overutilized Resources
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17-10
Open Economy Transmission of Monetary Policy
• So far we have discussed monetary policy in a closed economy.
• When we move to an open economy, monetary policy becomes more complex.
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17-11
Open Economy Transmission of Monetary Policy (cont'd)
• The net export effect of contractionary monetary policy
• Boosts the market interest rate
• Higher rates attract foreign investment
• International price of dollar rises
• Appreciation of dollar reduces net exports
• Negative net export effect
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
17-12
Open Economy Transmission of Monetary Policy (cont'd)
• The net export effect of expansionary monetary policy
• Lower interest rates
• Financial capital flows out of the United States
• Demand for dollars will decrease
• International price of dollar goes down
• Foreign goods look more expensive in United States
• Net exports increase (imports fall)
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
17-13
Monetary Policy in Action: The Transmission Mechanism
• Recall we talked about the direct and indirect effects of monetary policy
– Direct effect: implies increase in money supply causes people to have excess money balances.
– Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.
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17-14
Figure 17-4 The Interest-Rate-Based Money Transmission Mechanism
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17-15
Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a and b)
At lower rates, a larger quantity of money will be demanded
The decrease in the interest rate stimulates investment