Chapter 15:Monetary Policy

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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Monetary Policy

• Control over the money supply is a critical policy tool for altering macroeconomic outcomes.– The quantity of money in circulation influences

its value in the marketplace.– Interest rates and access to credit are basic

determinants of spending behavior.

• Therefore, the effectiveness of monetary policy is of significance.

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Learning Objectives

• 15-01. Explain how interest rates are set in the money market.

• 15-02. Describe how monetary policy affects macro outcomes.

• 15-03. Summarize the constraints on monetary policy impact.

• 15-04. Identify the differences between Keynesian and monetarist monetary theories.

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The Money Market• Money is like any other commodity. It is traded

in the marketplace.– There is a money supply (controlled by the Fed)

and a money demand by the people. – They determine the “price” of money: the interest

rate.• At high interest rates, money is expensive to

acquire.• At low interest rates, money is cheap to

acquire.

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The Money Market• If people hold cash as M1, they suffer an

opportunity cost: the forgone interest they could have earned.

• Money demand: the quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus. – At low interest rates, the opportunity cost of

holding money is low, so people will hold more of it, and vice versa.

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The Demand for Money• Why would people want to hold money – that

is, have a demand for money?– Transactions demand: people need to hold money

for the purpose of making everyday market purchases.

– Precautionary demand: people also hold money for unexpected market transactions or for emergencies.

– Speculative demand: some people also hold money to be able to take advantage of an investment opportunity in the near future.

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Money Market Equilibrium

• Money demand: the quantity of money people are willing and able to hold (demand) increases as interest rates fall, and vice versa.

• Money supply: since the Fed controls the money supply, it is represented by a vertical line.

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Money Market Equilibrium

• The intersection of money demand and money supply (E1) establishes the equilibrium rate of interest.

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Money Market Equilibrium• If interest rates are

higher than equilibrium, there is a money surplus.– People must hold more

money as M1 than they wish.

– They will move money out of M1 into M2 or other assets (such as bonds).

– The interest rate will then fall to E1.

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Money Market Equilibrium• If interest rates are

lower than equilibrium, there is a money shortage.– People must hold less

money as M1 than they wish.

– They will move money into M1 from M2 or other assets (such as bonds).

– The interest rate will then rise to E1.

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Changing Interest Rates

• The Fed controls the money supply.• By using the Fed policy tools, it can alter the

equilibrium rate of interest.– By increasing the money supply (causing a

surplus), the Fed tends to lower the equilibrium rate of interest.

– By decreasing the money supply (causing a shortage), the Fed tends to raise the equilibrium rate of interest.

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Interest Rates and Spending• Lowering interest rates is a tactic of monetary

stimulus, the purpose of which is to increase aggregate demand (AD).– Lower interest rates reduce the cost of investment

spending (most of which is done with borrowed funds) and the cost of holding inventory. Investment spending will increase.

– An investment spending increase is an injection into the circular flow, and will kick off the multiplier effect. AD will shift right because of this.

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Interest Rates and Spending• Raising interest rates is a tactic of monetary

restraint, the purpose of which is to decrease aggregate demand (AD).– Higher interest rates increase the cost of

investment spending (most of which is done with borrowed funds) and the cost of holding inventory. Investment spending will decrease.

– An investment spending decrease will kick off a negative multiplier effect. AD will shift left because of this.

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Policy Constraints

• Short- vs. long-term rates. – The Fed has greater influence on short-term

rates (that is, the Fed funds rate) than long-term rates (mortgages and installment loans).

– The Fed’s monetary stimulus will be most effective is long-term interest rate changes mirror short-term rate changes.

– If not, the AD increase will be less than hoped for.

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Policy Constraints

• Reluctant lenders.– The banking system must be willing to increase

lending activity.– Banks may pile up excess reserves instead of

making loans.– They might have concerns about their financial

well-being and about making loans to those who might not pay back the money.

– They might be uncertain about how new bank regulations may affect profitability.

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Policy Constraints

• Liquidity trap.– When interest rates are low, the opportunity cost of

holding money is also low.– Lowering interest rates further might not elicit the

response desired by the Fed because people and firms simply hold the money instead of investing.

– This is the liquidity trap:• People are willing to hold unlimited amounts of money at

some low interest rate.• The money demand curve becomes horizontal.

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Policy Constraints• Low expectations:– Investment decisions are influenced by

expectations.• In a recession, firms have little incentive to expand

production capability. • There would be little expectation of future profit, or

“payoff,” from new investment.

– Consumers may be reluctant to take on added debt when future income prospects are uncertain.

• Thus AD does not increase when interest rates are reduced.

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Policy Constraints

• Time lags:– It takes time to develop and implement new

investments in response to lower interest rates.– Consumers also may take time to decide to

increase their borrowing.– It may take 6 to 12 months before market

behavior responds to monetary policy.

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The Monetarist Perspective• The Keynesian view of monetary policy says

that changes in the money supply affect macro outcomes primarily through changes in interest rates.

• The monetarist view is different. They believe that only the price level is affected by Fed policy … and then only by changes in the money supply.– They say monetary policy is not effective for

fighting recession, but is a powerful tool for managing inflation.

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The Equation of Exchange• The equation of exchange is

• In this equation, total spending is price (P) times quantity (Q). This spending is financed by the money supply (M) times the velocity of its circulation (V).– Velocity (V): the number of times per year, on

average, that a dollar is used to purchase final goods and services.

MV = PQwhere M is the money supply, V is its velocity in circulation,P is the average price, and Q is the quantity of goods sold.

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The Equation of Exchange

• PQ is the same as nominal GDP.• The quantity of money in circulation and the

velocity with which it exchanges hands will always be equal to the value of nominal GDP.

• Monetarist view: If M increases, P or Q must rise, or V must fall.

MV = PQ

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The Equation of Exchange

• Assume V is stable – that is, does not change.• V is a function of how people handle their

money and the institutions they use to do so. Neither should change much in the short run.

• Thus total spending (PQ) must rise if money supply (M) grows and velocity (V) is stable, regardless of interest rates.

MV = PQ

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Money Supply Focus

• If spending increases when the money supply grows, then the Fed should focus on the money supply, not interest rates.– Fed policy should not be to manipulate interest

rates.– Fed policy should focus on the size and growth

of the money supply.

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“Natural” Unemployment

• Monetarists insert another perspective: – Q is stable also. It is a function of productive capacity, labor

efficiency, and other “structural” forces.– This leads to a “natural” rate of unemployment that is fairly

immune to short-run policy intervention.• Natural rate of unemployment: the long-term rate of

unemployment determined by structural forces.• Thus if both V and Q are stable, any increase in M in the

long run only increases P.

MV = PQ

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“Natural” Unemployment

• If both V and Q are stable, any increase in M in the long-run only increases P.– If prices rise, costs of production will rise also,

so there is no profit incentive to increase Q.– In the long run, the aggregate supply is vertical.– Any increase in AD directly increases the price

level.

MV = PQ

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Monetarist: Fighting Inflation

• The policy goal is to reduce aggregate demand.– Keynesians: shrink the money supply and drive

up interest rates.– Monetarists: interest rates are likely to be high

already. A decrease in the money supply will lower nominal interest rates, not raise them.

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Monetarist: Fighting Inflation• Interest rates are likely to be high already. A

decrease in the money supply will lower nominal interest rates, not raise them.– Nominal interest rate: the interest rate we

actually see and pay.– Real interest rate: the nominal rate minus the

anticipated inflation rate.• As the money supply shrinks, the price level

falls and anticipated inflation decreases, so nominal interest rates fall, not rise.

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Monetarist: Fighting Inflation• To close an inflationary GDP gap using monetary

policy, reduce the money supply.– Keynesians: interest rates rise, reducing spending.– Monetarists: once the people are convinced the Fed is reducing

money supply, anticipated inflation falls and nominal interest rates will fall. Short-term rates will rise in response to the Fed action, but long-term rates will react more slowly.

• Monetarists advise steady and predictable changes in the money supply, to reduce uncertainty and thus stabilize both long-term interest rates and GDP growth.

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Monetarist: Fighting Unemployment

• The policy goal is to increase aggregate demand.– Keynesians: expand the money supply and drive down

interest rates.– Monetarists: increased money supply leads to higher prices,

immediately raising people’s inflationary expectations. Long-term interest rates might actually rise, defeating the purpose of monetary stimulus.

• Monetarists conclude that expansionary monetary policy can’t lead us out of recession.