KRUGMAN_WELLS_MACRO_CHAPTER14

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Unformatted text preview: chapter 4 >> Monetary Policy EIGHT TIMES A YEAR w HEN THE FOMC TALKS, PEOPLE clues to the future stance of monetary policy. A careful reading of FOMC statements, where seemingly minor changes in wording can be highly significant, can help predict whether monetary policy will be relatively expansionary (or loose), leading to a fall in interest rates, or relatively contractionary (or tight), leading to a rise in interest rates. For example, the FOMC statement in December 2003 said, as it had after the past several meetings, that “policy accommodation can be maintained for a considerable period.” The phrase “policy accommodation” means “keeping interest rates low.” But in January 2004 these words were replaced with slightly different wording: “The Committee believes that it can be patient in removing its policy accommodation.” The new wording suggested that the FOMC would soon begin raising the federal funds rate, and stocks and bonds plunged at this news. listen. Eight times a year, econo- mists and investors around the world wait anxiously for word from the dozen men and women who make up the Federal Open Market Committee of the Federal Reserve. The FOMC controls the federal funds rate, the interest rate on reserves that banks lend each other to meet reserve requirements. What the world wants to know is the FOMC’s decision—whether it has decided to increase the federal funds rate, reduce it, or leave it unchanged. Financial market analysts also carefully read the committee’s accompanying statement and wait anxiously for the official minutes of the meeting, released three weeks later. Why such a high degree of scrutiny? Because the statements of the FOMC, although usually written in jargon, offer What you will learn in this chapter: ® What the money demand curve is Why the liquidity preference model determines the interest rate in the short run How the Federal Reserve can move interest rates How monetary policy affects aggregate output in the short run A deeper understanding of the adjustment process behind the savings–investment spending identity Denni Brack/Bloomberg News/Landov ® ® ® ® ® 342 The FOMC’s decision about interest rates is anxiously watched by traders like these, and by investors around the world. John Gress/Reuters/Landov Why economists believe in monetary neutrality—that monetary policy affects only the price level, not aggregate output, in the long run In Chapter 13 we learned about the structure of the Federal Reserve system and about how its open-market operations affect the money supply. In this chapter, we’ll look at how monetary policy works—how actions by the FOMC can turn recession into expansion, and vice versa. We’ll start by looking at the demand for money by households and firms. Then we’ll see how the Fed’s ability to change the money supply allows it to increase or reduce interest rates in the short run and, in doing so, shift the aggregate demand curve. Finally, we’ll see why monetary policy affects the aggregate price level but doesn’t affect aggregate output in the long run. The Demand for Money In Chapter 13 we saw that M1, the most commonly used definition of the money supply, consists of currency in circulation (cash) plus checkable bank deposits plus traveler’s checks. M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. We also saw why people hold money—to make it easier to purchase goods and services. Now we’ll go deeper, examining what determines how much money individuals and firms want to hold at any given time. The Opportunity Cost of Holding Money Individuals and firms hold some of their assets in the form of money because only money can be used to make purchases directly. But there is a price to be paid for holding money: it normally yields a lower rate of return than nonmonetary assets. For most individuals and firms, the relevant choice is between money and less liquid assets, such as certificates of deposit, that can be converted fairly quickly into money but yield higher interest rates than money. The rate-of-return disadvantage of money is obvious in the case of currency, which pays no interest. Most checkable bank deposits pay interest, but the rate is lower than that on other, less convenient assets. Table 14-1 shows a selection of average interest rates prevailing in two months, May 2004 and March 2005. The top row shows the federal funds rate. The next row shows the rate on one-month Treasury bills, a bond issued by the U.S. government that is paid off in one month. The next row shows the interest rate on zero-maturity deposits. These are deposits, including checking account deposits, from which funds can be withdrawn at any time without penalty. The fourth row shows the interest rate on currency, which is, of course, zero. TABLE 14-1 May 2004 March 2005 2.63% 2.36 1.05 0.00 1.28 2.36 Selected Interest Rates Federal funds rate One-month Treasury bill Interest-bearing deposits* Currency Treasury bill rate minus rate on deposits Treasury bill rate minus rate on currency 1.00% 0.91 0.54 0.00 0.37 0.91 *Average on all zero-maturity deposits, that is, deposits that can be withdrawn at any time Source: Federal Reserve Bank of St. Louis. 344 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Short-term interest rates are the interest rates on financial assets that mature within six months or less. Long-term interest rates are interest rates on financial assets that mature a number of years in the future. As you can see, in both months people received a higher rate of interest on onemonth U.S. Treasury bills than they did on either currency or zero-maturity deposits. There is an opportunity cost to holding money, which we can measure by the difference between the interest rate on assets that aren’t money and the interest rate on assets that are money. The next-to-last row in Table 14-1 shows the difference between the interest rate on one-month Treasury bills and the interest rate on zero-maturity deposits. The last row shows the difference between the interest rate on one-month Treasury bills and the interest rate on currency. In May 2004 zero-maturity deposits yielded 0.37 percentage points less at an annual rate than Treasury bills; by March 2005 that difference had risen to 1.31 percentage points. The comparison between one-month Treasury bills and currency is even worse: in May 2004 holding currency meant forgoing 0.91 percentage points at an annual rate; by March 2005 that difference had widened to 2.36 percentage points. As this example shows, people pay a cost for holding wealth in the form of money as opposed to nonmonetary assets such as Treasury bills. Why, then, does the public hold money? Money provides convenience and reduces the costs of transactions because it can be used immediately for spending, which other assets can’t. As an example of how convenience makes it worth incurring some opportunity costs, consider the fact that even today—with the prevalence of credit cards, debit cards, and ATMs—people continue to keep cash in their wallets rather than leave the funds in an interest-bearing account. They don’t want to have to go to the bank to withdraw money every time they want to buy lunch from a place that doesn’t accept credit cards at all or won’t accept them for small amounts because of the processing fee. The convenience of keeping some cash in your wallet is more valuable than the interest you would earn by keeping that money in the bank. So how much of your wealth should you hold in the form of money on any given day? Choosing the optimal quantity of money to hold requires a trade-off between the extra convenience of an additional dollar in your wallet against the higher return from keeping it in other financial assets. The terms of this trade-off change when interest rates change. Look again at Table 14-1. Between May 2004 and March 2005, the federal funds rate rose by about 1.5 percentage points. The interest rate on onemonth Treasury bills rose by about the same amount. That’s not an accident: all short-term interest rates—rates on financial assets that come due, or mature, within six months or less—tend to move together. This occurs because Treasury bills, one-month bonds, three-month bonds, and so on are in effect competing for the same business. Why? Investors will move their wealth out of any short-term financial asset that offers a lower-than-average interest rate. The selling of the asset forces the interest rate on that asset up because new buyers must be rewarded with a higher rate in order to induce them to buy it. Conversely, investors will move their wealth into any short-term financial asset that offers an above-average interest rate. The purchase of the asset drives its interest rate down when sellers find they can lower the rate of return on the asset and still find willing buyers. So interest rates on short-term financial assets tend to be roughly the same because no asset will consistently offer a higher-than-average or a lower-than-average interest rate. But the interest rates on money don’t rise by the same amount. The interest rate on currency remains at zero. The interest rate on zero-maturity bank deposits rises, but by much less than short-term interest rates. As a result, the opportunity cost of holding money increases. This reflects a general result: the higher the short-term interest rate, the higher the opportunity cost of holding money. So the quantity of money the public wants to hold—the quantity of money demanded—depends negatively on the interest rate. Table 14-1 contains only short-term interest rates. At any given moment, longterm interest rates—rates of interest on financial assets that mature, or come due, a number of years into the future—may be different from short-term interest rates. The difference between short-term and long-term interest rates is sometimes important UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 345 as a practical matter. For our current purposes, however, it’s useful to ignore the distinction between short-term and long-term rates and assume that there is only one interest rate. The Money Demand Curve The relationship between the interest rate and the quantity of money demanded by the public is illustrated by the money demand curve, MD, in Figure 14-1. This curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money, leading the public to reduce the quantity of money it demands. For example, if the interest rate is very low—say, 1%—the interest forgone by holding money is relatively small. As a result, people will tend to hold relatively large amounts of money to avoid the cost and nuisance of converting other assets into money when making purchases. By contrast, if the interest rate is relatively high—say, 15%, a value it reached in the United States in the early 1980s—the opportunity cost of holding money is high. People will respond by keeping only small amounts in cash and deposits, converting funds into money only when needed. The money demand curve shows the relationship between the quantity of money demanded and the interest rate. Figure 14-1 Interest rate, r The Liquidity Preference Model of the Interest Rate The money demand curve illustrates the relationship between the interest rate and the nominal quantity of money demanded. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. Money demand curve, MD Nominal quantity of money, M You might ask why we draw the money demand curve with the interest rate—as opposed to rates of return on other assets, such as stocks or real estate—on the vertical axis. As we noted earlier, for most people the relevant question in deciding how much money to hold is whether to put the funds in the form of other assets that can be turned fairly quickly into money, such as Treasury bills. And the rates of return on assets that are “close to” money—fairly liquid assets like Treasury bills that are relatively good substitutes for money—move closely with the short-term interest rate. Prices and the Demand for Money Because the horizontal axis in Figure 14-1 measures the nominal quantity of money, the money demand curve shows the number of dollars demanded unadjusted for the purchasing power of a dollar. However, economists sometimes focus instead on the real quantity of money: the nominal quantity of money divided by the aggregate The real quantity of money is the nominal quantity of money divided by the aggregate price level. 346 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition price level. Using M for the nominal quantity of money and P for the aggregate price level, the real quantity of money is M/P. The real quantity of money, M/P, measures the purchasing power of the nominal quantity of money, M. To see why economists sometimes focus on the real quantity of money, consider the effects of a doubling of the aggregate price level on the nominal quantity of money demanded, as shown in Figure 14-2. An increase in the aggregate price level means consumers must spend more money to buy a given basket of goods and services, which translates into holding more money at any given interest rate. So a rise in the aggregate price level from P1 to P2 shifts the money demand curve rightward from MD1 to MD2. But we can be more specific about the effect of the aggregate price level on money demand: other things equal, the nominal quantity of money demanded is proportional to the aggregate price level. That is, a 50% rise in the aggregate price level leads to a 50% rise in the nominal quantity of money demanded. We can get a better intuitive understanding of this property with a little algebra. Suppose that the interest rate is constant at r1 in Figure 14-2 and that the aggregate price level rises from P1 to P2 by a factor k, so that we can express the rise in the aggregate price level as P2 = k × P1. Then the fact that nominal money demand is proportional to the aggregate price level means that the nominal quantity of money demanded after the aggregate price change (M2), and before the price change (M1) have the following relationship: M2 = k × M1. As a result, the ratio of M2 to M1 is equal to the ratio of P2 to P1: (14-1) M2 P2 = M1 P1 Equation 14-1 can be rearranged by dividing both sides by P2 and multiplying both sides by M1. This gives us the following result: (14-2) M2 M1 = P2 P1 The real money demand curve shows the relationship between the real quantity of money demanded and the interest rate. Equation 14-2 tells us that the real quantity of money demanded after a change in the aggregate price level, M2/P2, other things equal, is the same as the real quantity of money demanded before the aggregate price level change, M1/P1. One way to take this result into account is to draw the real money demand curve, RMD, shown in Figure 14-3. This Figure 14-2 Interest rate, r A rise in the aggregate price level shifts the money demand curve rightward. The Aggregate Price Level and Money Demand Other things equal, an increase in the aggregate price level leads to an equal percent increase in the nominal quantity of money demanded. In this case, an increase in the aggregate price level causes a rightward shift in the money demand curve from MD1 to MD2. The nominal quantity of money demanded at the interest rate r1 rises from M1 to M2, an increase that is proportional to the increase in the aggregate price level. r1 MD1 M1 M2 MD2 Nominal quantity of money, M UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 347 Figure 14-3 Interest rate, r The Real Demand for Money Since money demand is proportional to the aggregate price level, money demand can also be expressed as a demand for a real quantity of money. A rise in the aggregate price level does not shift the real money demand curve. At an interest rate r1, the real quantity of money demanded when the aggregate price level is P2, M2 /P2, is the same as it is when the aggregate price level is P1, M1 /P1. r1 Real money demand, RMD M1/P1 = M2/P2 Real quantity of money, M/P curve shows the relationship between the real quantity of money demanded and the interest rate. Unlike the nominal money demand curve, the real money demand curve automatically takes into account the effect of changes in the aggregate price level on the nominal quantity of money demanded. So, for example, at an interest rate r1, the real quantity of money demanded is equal to both M1/P1 and M2/P2, shown as the same point on the real money demand curve. Shifts of the Real Money Demand Curve By expressing the demand for money in real terms, we take account of the effects of changes in the aggregate price level on the nominal demand for money. A number of factors can shift the real money demand curve. The most important of these are changes in the level of real aggregate spending, changes in banking technology, and changes in banking institutions. Changes in Real Aggregate Spending Households and firms hold money as a way to facilitate purchases of goods and services. The larger the quantity of goods and services they plan to buy, the larger the real quantity of money they will want to hold at any given interest rate. So an increase in real aggregate spending will shift the real money demand curve rightward; a fall in real aggregate spending will shift the real money demand curve leftward. Some economists have argued that the real quantity of money demanded, other things equal, is proportional to real aggregate spending. That is, a 20% rise in real aggregate spending leads to a 20% rise in the real quantity of money demanded. This view leads to a concept known as the velocity of money, which we’ll turn to shortly. Changes in Technology There was a time, not so long ago, when withdrawing cash from a bank account required a visit during the bank’s hours of operation. And since most people found themselves trying to do their banking during lunch hour, this often meant standing in line. So people limited the number of times they needed to withdraw funds by keeping substantial amounts of cash on hand. Not surprisingly, this tendency diminished greatly with the advent of ATMs in the 1970s. These events illustrate how changes in technology can affect the real demand for money. In general, advances in information technology have tended to reduce the 348 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition real demand for money by making it easier for the public to make purchases without holding significant sums of money. ATM machines are only one example of how changes in technology have altered the demand for money. The ability of stores to process credit card transactions via the Internet has widened the acceptance of credit cards and similarly reduced the need for cash. Changes in Institutions Changes in institutions can increase or decrease the demand for money. For example, until the beginning of the 1980s, U.S. banks weren’t allowed to offer interest on checking accounts. As a result, the opportunity cost of holding funds in checking accounts was very high. That disincentive was greatly reduced when a change in banking regulations made interest on checking accounts legal, leading to a rise in the real demand for money. The Velocity Approach to Money Demand We have discussed the demand for money using the same framework we use for discussing any demand curve: first we describe the reasons the curve slopes downward, and then we discuss the factors that shift the curve rightward or leftward. In some discussions about money demand and monetary policy, however, economists use a different approach, emphasizing a concept known as the velocity of money. The velocity of money is defined as nominal GDP divided by the nominal quantity of money. That is, (14-3) V = P×Y M The velocity of money is nominal GDP divided by the nominal quantity of money. According to the quantity equation, the nominal quantity of money multiplied by the velocity of money is equal to nominal GDP. where V is the velocity of money, P is the aggregate price level, Y is aggregate output measured by real GDP (so that P × Y equals nominal GDP), and M is the nominal quantity of money. This definition is often restated by multiplying both sides of the equation by the quantity of money to yield the quantity equation: (14-4) M × V = P × Y It says that the nominal quantity of money multiplied by the velocity of money is equal to nominal GDP. The intuition behind the concept of velocity is that each unit of money in the economy can be spent several times over the course of a year. For example, someone may use a dollar bill to pay for a cup of coffee at a restaurant; the restaurant may give that dollar bill as change to someone else who buys a sandwich; that person may use the dollar bill to buy a newspaper; and so on. The value of spending that takes place using a particular dollar bill in a given year depends on the number of times that dollar bill “turns over” during the year. For example, if the dollar bill is spent three times in a year, it is used for $3 worth of spending. By analogy, aggregate spending in the economy as a whole during a year is equal to the nominal quantity of money in the economy, M, multiplied by the number of times the average unit of money is spent—the velocity of money, V. And nominal GDP, P × Y, is equal to aggregate spending. One way to think about the velocity approach is that it is a special case of the real money demand curve. To see that, let’s rewrite the velocity equation, putting the real quantity of money on the left-hand side: (14-5) M l = ×Y P V Equation 14-5 says that the real demand for money, M/P, is proportional to real GDP, Y, where the constant of proportionality is 1/V. But real GDP is, in equilibrium, equal to real aggregate spending. And we already know that the real quantity of money demanded depends positively on real aggregate spending. UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 349 Equation 14-5 says that, more than being positive, the relationship is also proportional. This is why we noted earlier that some economists believe that the real quantity of money demanded is proportional to real aggregate spending. If this is indeed true, then the effect of changes in the interest rate on real money demand is reflected in changes in the velocity of money, V. For example, a rise in the interest rate, which reduces real money demand, will lead to a fall in 1/V—or a rise in V—other things equal. Intuitively, a smaller amount of real money holdings, M/P, will now account for the same amount of real aggregate spending, Y, because velocity has increased. We won’t pursue the velocity approach to money demand any further in this chapter. As we’ll see in Chapter 17, however, the concept of monetary velocity has played an important role in some debates about macroeconomic policy. economics in action A Yen for Cash Japan, say financial experts, is still a “cash society.” Visitors from the United States or Europe are surprised at how little use the Japanese make of credit cards and how much cash they carry around in their wallets. Yet Japan is an economically and technologically advanced country and, according to some measures, ahead of the United States in the use of telecommunications and information technology. So why do the citizens of this economic powerhouse still do business the way Americans and Europeans did a generation ago? The answer highlights the factors affecting the demand for money. Whatever they are shopping for, Japanese consumers tend to One reason the Japanese use pay with cash rather than plastic. cash so much is that their institutions never made the switch to heavy reliance on plastic. For complex reasons, Japan’s retail sector is still dominated by small mom-and-pop stores, which are reluctant to invest in credit card technology. Japan’s banks have also been slow about pushing transaction technology; visitors are often surprised to find that ATMs close early in the evening rather than stay open all night. But there’s another reason the Japanese hold so much cash: there’s little opportunity cost to doing so. Short-term interest rates in Japan have been below 1% since the mid-1990s. It also helps that the Japanese crime rate is quite low, so you are unlikely to have your wallet full of cash stolen. So why not hold cash? I Issei Kato/Reuters/Landov ®® ® QUICK REVIEW ® >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 14-1 1. Explain how each of the following would affect the real and nominal quantity of money demanded: a. Short-term interest rates rise to 30%. b. All prices fall by 10%. c. New wireless technology automatically charges supermarket purchases to credit cards, eliminating the need to stop at the cash register. d. For some reason, firms return to the old practice of paying employees in cash rather than with checks. Solutions appear at back of book. ® ® ® Money offers a lower rate of return than other financial assets. We usually compare the rate of return on money with short-term, not longterm, interest rates. Holding money provides liquidity but has an opportunity cost, leading to the downward slope of the money demand curve. Because the nominal demand for money is proportional to the aggregate price level, the money demand can also be represented by the real money demand curve. Changes in aggregate spending, institutions, and technology shift the real money demand curve. A widely used approach to money demand focuses on the velocity of money. 350 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Money and Interest Rates “The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 23⁄4 percent.” So reads the first sentence of the press release from the FOMC after its meeting of March 22, 2005. (A basis point is equal to 0.01 percentage point. So the statement says that the Fed raised the target from 2.50% to 2.75%.) We learned about the federal funds rate in Chapter 13: it’s the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight-times-a-year meetings, the Federal Open Market Committee sets a target value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells Treasury bills to achieve that target. Other short-term interest rates, such as the rates on bank loans to businesses, move with the federal funds rate. So when the Fed raised its target for the federal funds rate from 2.50% to 2.75% in March 2005, all short-term interest rates rose as well by about a quarter of a percentage point. How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all? The Equilibrium Interest Rate According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money. The money supply curve shows how the nominal quantity of money supplied varies with the interest rate. We’ll start by assuming for simplicity that there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 14-4, which illustrates the liquidity preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 14-4 combines the (nominal) money demand curve, MD, with the money supply curve, which shows how the nominal quantity of money supplied by the Federal Reserve varies with the interest rate. So what we are considering is the nominal version of the liquidity preference model, in which the nominal interest rate is determined by the nominal demand and supply of money. Equivalently, we could use the real version of the liquidity preference model, in which the real interest rate is determined by the real demand and supply Figure 14-4 Interest rate, r Money supply curve, MS Equilibrium in the Money Market The money supply curve, MS, is vertical at the money supply chosen by the Federal Reserve, M. The money market is in equilibrium when the quantity of money demanded by the public is equal to M, the quantity of money supplied—that is, when the interest rate is equal to rE. At a point such as L, the interest rate, rL, is below rE and the quantity of money demanded, ML, exceeds the money supply, M. In an attempt to shift their wealth out of nonmonetary interestbearing financial assets and raise their money holdings, investors drive the interest rate up to rE. At a point such as H, the interest rate rH is above rE and the quantity of money demanded, MH, exceeds the money supply M. In an attempt to shift out of money holdings into nonmonetary interest-bearing financial assets, investors drive the interest rate up to rE. rH Equilibrium interest rate H E Equilibrium rE rL MH L MD M Money supply chosen by the Fed ML Nominal quantity of money, M UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 351 of money. From now on we will drop the word nominal with the understanding that it still applies. In Chapter 13 we learned how the Federal Reserve can increase or decrease the money supply by buying or selling Treasury bills. Let’s assume for simplicity that the Fed simply chooses the level of the money supply. Then the money supply curve is a vertical line, MS in Figure 14-4, with a horizontal intercept corresponding to the money supply chosen by the Fed, M. The equilibrium is at E, where MS and MD cross. At this point the quantity of money demanded equals the money supply, M, leading to an equilibrium interest rate of rE. To understand why rE is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, rL , is below rE. At rL the public wants to hold the quantity of money ML , an amount larger than the actual money supply, M. This means that at point L, the public wants to shift some of its wealth out of nonmonetary interest-bearing financial assets such as Treasury bills into money. This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of non-monetary interest-bearing financial assets demanded is less than the quantity supplied. So those trying to sell interest-bearing assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from rL until the public wants to hold the quantity of money that is actually available, M. That is, the interest rate will rise until it is equal to rE. Now consider what happens if the money market is at a point such as H in Figure 14-4, where the interest rate rH is above rE. In that case the quantity of money demanded, MH, is less than the quantity of money supplied, M . Correspondingly, the quantity of non-monetary interest-bearing financial assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing financial assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from rH; it falls until the public wants to hold the quantity of money that is actually available, M . Again, the interest rate will end up at rE. PITFALLS the target versus the market Over the years, the Federal Reserve has changed the details of how it makes monetary policy. At one point, in the late 1970s and early 1980s, it set a target level for the money supply and altered the monetary base to achieve that target. Under this policy, the federal funds rate fluctuated freely. Today the Fed does the reverse, setting a target for the federal funds rate and allowing the money supply to fluctuate as it pursues that target. A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works. That is, you’ll sometimes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate. In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money. The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate. It’s important not to confuse a change in the Fed’s operating procedure with a change in the way the economy works. Two Models of Interest Rates? At this point you may be a bit puzzled. This is the second time we have discussed the determination of the interest rate. In Chapter 9 we studied the loanable funds model of the interest rate; according to it, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market. Which of these models is correct? The answer is both. But that will take a little time to explain, something we will do later in this chapter. For now, let’s put the loanable funds model to one side and concentrate on the liquidity preference model of the interest rate. The most important insight from this model is that it shows us how monetary policy—actions by the Federal Reserve and other central banks—works. Monetary Policy and the Interest Rate Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 14-5 on page 352 shows what happens when the Fed increases the money supply from M 1 to M 2. The economy is originally in equilibrium at E1, with an equilibrium interest rate of r1 and money supply M 1. An increase in the money supply by the Fed to M 2 shifts the money supply curve to the right, from MS1 to MS2, and leads to a fall in the equilibrium interest rate to r2. Why? Because r2 is the only interest rate at which the public is willing to hold the quantity of money actually supplied, M 2. So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate. 352 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Figure 14-5 Interest rate, r The Effect of an Increase in the Money Supply on the Interest Rate The Federal Reserve can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r1 to r2 in response to an increase in the money supply from M1 to M2. In order to induce people to hold a larger quantity of money, the interest rate must fall from r1 to r2. An increase in the money supply . . . MS1 MS2 . . . leads to a fall in the interest rate. r1 r2 E1 E2 MD M1 M2 Nominal quantity of money, M The target federal funds rate is the Federal Reserve’s desired federal funds rate. In practice, at each meeting the FOMC decides on the interest rate to prevail for the next six weeks, until its next meeting. Recall from Chapter 13 that the federal funds rate is the interest rate at which banks lend reserves to each other. The Fed sets a target federal funds rate, a desired level for the federal funds rate. The Open Market Desk of the Federal Reserve Bank of New York adjusts the money supply through the purchase and sale of Treasury bills until the actual federal funds rate equals the target rate. Figure 14-6 shows how this works. In both panels, rT is the target federal funds rate. In panel (a), the initial money supply curve is MS1 with money supply M 1, and Figure 14-6 Setting the Federal Funds Rate (a) Pushing the Interest Rate Down to the Target Rate (b) Pushing the Interest Rate Up to the Target Rate Interest rate, r An open-market purchase . . . Interest rate, r An open-market sale . . . MS1 MS2 MS2 MS1 . . . drives the interest rate down. r1 rT E1 E2 MD M1 M2 Nominal quantity of money, M . . . drives the interest rate up. rT r1 E2 E1 MD M2 M1 Nominal quantity of money, M The Federal Reserve sets a target for the federal funds rate and uses open-market operations to achieve that target. In both panels the target rate is rT . In panel (a) the initial equilibrium rate, r1, is above the target rate. The Fed increases the money supply by making an open-market purchase of Treasury bills, pushing the money supply curve rightward from MS1 to MS2 and driving the interest rate down to rT . In panel (b) the initial equilibrium rate, r1, is below the target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward from MS1 to MS2 and driving the interest rate up to rT . UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 353 FOR INQUIRING MINDS L O N G - T E R M I N T E R E S T R AT E S Earlier in this chapter we mentioned that longterm interest rates—rates on bonds or loans that mature in several years—don’t necessarily move with short-term interest rates. How is that possible? Consider the case of Millie, who has already decided to place $1,000 in certificates of deposit (CDs) for the next two years. However, she hasn’t decided whether to put the money in a one-year CD, at a 4% rate of interest, or a two-year CD, at a 5% rate of interest. You might think that the two-year CD is a clearly better deal—but it may not be. Suppose that Millie expects the rate of interest on oneyear CDs to rise sharply next year. If she puts her funds in a one-year CD this year, she will be able to reinvest the money at a much higher rate next year. And this could give her a twoyear rate of return that is higher than if she put her funds into the two-year CD. For example, if the rate of interest on one-year CDs rises from 4% this year to 8% next year, putting her funds in a one-year CD will give her a rate of return over the next two years of about 6%, better than the rate on two-year CDs. The same considerations apply to an investor deciding between short-term and long-term bonds. If they expect short-term interest rates to rise, investors may buy short-term bonds even if long-term bonds offer a higher interest rate. If they expect short-term interest rates to fall, investors may buy long-term bonds even if short-term bonds offer a higher interest rate. In practice, long-term interest rates reflect the average expectations in the market about what’s going to happen to short-term rates. When long-term rates are much higher than short-term rates, as they were in 2003, the market is signaling that it expects short-term rates to rise in the future. the equilibrium interest rate, r1, is above the target rate. To lower the interest rate to rT, the Fed makes an open-market purchase of Treasury bills. As we learned in Chapter 13, an open-market purchase of Treasury bills leads to an increase in the money supply. This is illustrated in panel (a) by the rightward shift of the money supply curve from MS1 to MS2 and an increase in the money supply to M 2. This drives the interest rate, r1, down to the target rate, rT. Panel (b) shows the opposite case. Again, the initial money supply curve is MS1 with money supply M 1. But this time the equilibrium interest rate, r1, is below the target federal funds rate, rT. In this case, the Fed will make an open-market sale of Treasury bills, leading to a fall in the money supply to M 2. The money supply curve shifts leftward from MS1 to MS2, driving the short-term interest rate up to the target federal funds rate, rT. economics in action The Fed Takes Action In January 2001 the Federal Reserve, alarmed by signs of a looming recession, began cutting the target federal funds rate. We’ll explain in the next section why the Fed believed this would be the correct response to a recession. But for now, let’s focus on the Fed’s ability to move interest rates. Figure 14-7 on page 354 shows the movements of three interest rates between 1999 and 2005: the actual federal funds rate, the prime rate, and the 30-year mortgage rate. As you can see, the January 2001 cut in the federal funds rate was followed by several more. In fact, by the end of 2001 the Fed had cut the target federal funds rate 10 times, bringing it down from 6% at the beginning of 2001 to 1.75% at the end of 2001. (This was achieved by making cuts between regular meetings of the FOMC.) In 2002 the Fed cut the target again, to 1.25%; in 2003 it cut the target even further, to just 1%. In 2004, in response to signs of a growing economy, the Fed began gradually raising its target again, by 0.25 percentage point at each meeting. 354 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Figure 14-7 Interest rate, r 10% 8 6 4 2 Federal funds rate Prime rate The Fed Moves Interest Rates In early 2001, in response to a weakening economy, the Fed began cutting the federal funds rate. The prime rate—the interest rate on short-term bank loans to their best customers—fell in parallel. The 30-year mortgage rate, which is used by consumers buying homes, fell, too, though not as much. By 2004, in the face of a growing economy, the Fed began raising the federal funds rate. 30-year mortgage rate 3 20 0 20 0 20 0 20 0 20 0 19 Year ®® ® QUICK REVIEW ® The liquidity preference model of interest rates says that the equilibrium interest rate is determined by the money demand curve and the money supply curve. The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate, and uses open-market operations to achieve that target. The second interest rate shown in Figure 14-7 is the prime rate, the short-term rate that banks charge on loans to their best customers. This is a measure of how much it costs businesses to borrow; it’s always above the federal funds rate because lending to a business customer always involves some risk of nonpayment. But the prime rate moves almost perfectly in parallel with the federal funds rate. The last interest rate in Figure 14-7 is the rate on 30-year mortgages—loans that many people use to buy homes. As you can see, this rate didn’t move nearly as much in synch with the federal funds rate as did the prime rate. This illustrates a point we mentioned earlier in this chapter: long-term interest rates don’t always move closely together with short-term rates. Still, mortgage rates did fall significantly as the Fed cut the federal funds rate repeatedly in 2001. And the fall in mortgage rates helped start a housing boom, which had an expansionary effect on the economy. Housing starts—the number of new homes on which construction has begun—rose by one-third, from 1.2 million in 2000 to 1.6 million in 2004. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 14-2 1. Assume that there is an increase in the demand for money. Using a diagram, show what effect this will have on the interest rate for a given money supply. 2. Now assume that the Fed is following a policy of targeting the federal funds rate. What will the Fed do in the situation described in Question 1 to keep the federal funds rate unchanged? Illustrate with a diagram. Solutions appear at back of book. Monetary Policy and Aggregate Demand In Chapter 12 we saw how fiscal policy can be used to stabilize the economy. Now we will see how monetary policy—changes in the money supply or the interest rate, or both—can play the same role. Expansionary and Contractionary Monetary Policy As we have just seen, the Fed moves the interest rate up or down by increasing or decreasing the money supply. Changes in the interest rate, in turn, change aggregate demand. Other things equal, a fall in the interest rate leads to a rise in investment 20 05 99 0 1 2 4 UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 355 and consumer spending and so to a rise in aggregate demand. And, other things equal, a rise in the interest rate leads to a fall in investment and consumer spending and so to a fall in aggregate demand. As a result, monetary policy, like fiscal policy, can be used to close either a recessionary gap or an inflationary gap. Figure 14-8 shows the case of an economy facing a recessionary gap, where aggregate output is below potential output. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial short-run macroeconomic equilibrium, E1, aggregate output is Y1, below potential output, YE. Suppose the Fed would like to increase aggregate demand, shifting the aggregate demand curve rightward to AD2. This would increase aggregate output to potential output. The Fed can accomplish that goal by increasing the money supply, which drives the interest rate down. A lower interest rate, in turn, leads to higher investment and consumer spending as well as a rise in aggregate demand. Monetary policy that increases aggregate demand is called expansionary monetary policy. Expansionary monetary policy is monetary policy that increases aggregate demand. Figure 14-8 Aggregate price level Expansionary Monetary Policy to Fight a Recessionary Gap Here, initial actual aggregate output, Y1, is below potential output, YE. An expansionary monetary policy reduces the interest rate, shifting the aggregate demand curve rightward from AD1 to AD2 and eliminating the recessionary gap. LRAS SRAS E2 P2 P1 E1 An expansionary monetary policy reduces the interest rate and increases aggregate demand. AD1 Y1 YE AD2 Real GDP Potential output Recessionary gap Figure 14-9 on page 356 shows the opposite case—an economy facing an inflationary gap, where actual output is above potential output. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial short-run macroeconomic equilibrium, aggregate output, Y1, is above potential output, YE. As we’ll explain in later chapters, policy makers often try to head off inflation by eliminating inflationary gaps. To eliminate the inflationary gap illustrated in Figure 14-9, aggregate demand must be reduced. By raising the interest rate, the Fed can cause a leftward shift of the aggregate demand curve, from AD1 to AD2, which reduces aggregate output to potential output. Monetary policy that reduces aggregate demand is called contractionary monetary policy. Does monetary policy, like fiscal policy, have a multiplier effect on aggregate demand? Yes, although it’s important to have a clear understanding of what is being multiplied. Contractionary monetary policy is monetary policy that reduces aggregate demand. “I told you the Fed should have tightened.” Robert Mankoff/Cartoonbank.com 356 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Figure 14-9 Aggregate price level Contractionary Monetary Policy to Fight an Inflationary Gap Here, initial actual aggregate output, Y1, is above potential output, YE. A contractionary monetary policy increases the interest rate, shifting the aggregate demand curve leftward from AD1 to AD2 and eliminating the inflationary gap. LRAS SRAS P1 P2 E2 E1 A contractionary monetary policy increases the interest rate and reduces aggregate demand. AD2 Potential output AD1 YE Y1 Real GDP Inflationary gap Monetary Policy and the Multiplier Suppose the Fed drives down the interest rate, causing a rightward shift of the aggregate demand curve. How expansionary is this? That is, how much does the AD curve shift to the right? We’ll use the multiplier analysis of Chapter 10 to answer that question. In particular, we’ll analyze how monetary policy, via a change in the interest rate, affects aggregate demand. (For the purposes of this analysis, we’ll ignore the effect of taxes on the multiplier and hold the aggregate price level constant.) Figure 14-10 shows the aggregate demand curve shifted to the right by a fall in the interest rate. As you can see, the quantity of aggregate output demanded at any given Figure 14-10 Aggregate price level A fall in the interest rate shifts the AD curve to the right. Monetary Policy and the Multiplier An expansionary monetary policy drives down the interest rate, leading to an initial rise in investment spending, ∆I. This raises disposable income, which causes a rise in consumer spending, which further raises disposable income, and so on. In the end, the AD curve shifts rightward by a multiple of the initial rise in I. ∆ I × 1/(1 – MPC ) P* AD1 AD2 Real GDP Rise in investment spending, ∆ I Induced rise in consumer spending, ∆C UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 357 aggregate price level increases. To calculate how much the quantity of aggregate output demanded increases, we need to know how much a fall in the interest rate increases real GDP at a given aggregate price level, such as P*. To keep things simple, we’ll focus exclusively on changes in investment spending caused by changes in the interest rate, ignoring the direct effects on consumer spending. Although they are present in reality, they are also likely to be much smaller than the effects on investment spending. Assume that the initial aggregate demand curve is AD1, and that the decline in the interest rate increases investment spending at the aggregate price level P* by an amount ∆I. This is an example of an autonomous rise in aggregate spending, a phenomenon we studied in Chapter 10. From this point on, the analysis is exactly the same as that of any autonomous change in spending—such as an increase in consumer spending, C—that occurs because of a rise in expected future income. The initial increase in real GDP translates into an increase in disposable income. This causes a rise in consumer spending, C, and a second-round rise in real GDP. This secondround increase in real GDP leads to yet another rise in consumer spending, and so on. At each round, however, the increase in real GDP is smaller than in the previous round, because some of the increase in disposable income “leaks out” into savings due to the fact that the marginal propensity to save, MPS, is positive. In the end, the AD curve shifts to a new position such as AD2. So a fall in the interest rate, r, leads to a rise in investment spending, ∆I. This rise in investment spending leads, in turn, to a rightward shift of the AD curve that reflects both the increase in investment spending, ∆I, and an induced rise in consumer spending, ∆C. As we saw in Chapter 12, the total rise in real GDP, assuming a fixed aggregate price level, is a multiple of the initial rise in investment spending: (14-6) ∆Y = ∆I × 1 1 − MPC where MPC is the marginal propensity to consume—the increase in consumer spending if disposable income rises by $1. Two Models of Interest Rates, Revisited Earlier in this chapter we developed the liquidity preference model of the interest rate. In this model, the equilibrium interest rate is the rate at which the quantity of money demanded equals the quantity of money supplied. We promised to explain how this is consistent with the loanable funds model of the interest rate we developed in Chapter 9. In this second model, the equilibrium interest rate matches the quantity of loanable funds supplied by savers with the quantity of loanable funds demanded for investment spending. We will now take the first of two steps toward providing that explanation, focusing on what happens in the short run. As we have just discussed, a fall in the interest rate leads to a rise in investment spending, I, which then leads to a rise in both real GDP and consumer spending, C. The rise in real GDP doesn’t lead only to a rise in consumer spending, however. As we noted, it also leads to a rise in savings: at each stage of the multiplier process, part of the increase in disposable income is saved. How much do savings rise? In Chapter 9 we introduced the savings–investment spending identity: total savings in the economy is always equal to investment spending. This tells us that when a fall in the interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending. To put it another way, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded. Figure 14-11 on page 358 shows that our two models of the interest rate are reconciled by the link among changes in the interest rate, changes in real GDP, and changes in savings. Panel (a) represents the liquidity preference model of the interest 358 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Figure 14-11 The Short-Run Determination of the Interest Rate (b) The Loanable Funds Model of the Interest Rate (a) The Liquidity Preference Model of the Interest Rate Interest rate, r Interest rate, r MS1 MS2 S1 S2 r1 r2 E1 E2 MD r1 r2 E1 E2 D M1 M2 Nominal quantity of money, M Quantity of loanable funds the money market leads, through the multiplier effect, to an increase in GDP and savings; to a rightward shift of the supply curve of loanable funds, from S1 to S2,; and to a fall in the interest rate, from r1 to r2. As a result, the new equilibrium interest rate in the loanable funds market matches the new equilibrium interest rate in the money market at E2. Panel (a) shows the liquidity preference model of the interest rate: the equilibrium interest rate matches the money supply to the quantity of money demanded. In the short run, the interest rate is determined in the money market, where an increase in the money supply from M1 to M2 pushes the equilibrium interest rate down from r1 to r2. Panel (b) shows the market for loanable funds model of the interest rate. The fall in the interest rate in rate. MS1 and MD are the initial supply and demand curves for money. According to the liquidity preference model, the equilibrium interest rate in the economy is the rate at which the quantity of money supplied is equal to the quantity of money demanded in the money market. Panel (b) represents the loanable funds model of the interest rate. S1 is the initial supply curve and D is the demand curve for loanable funds. According to the loanable funds model, the equilibrium interest rate in the economy is the rate at which the quantity of loanable funds supplied is equal to the quantity of loanable funds demanded in the market for loanable funds. In Figure 14-11 both the money market and the market for loanable funds are initially in equilibrium at the same interest rate, r1. You might think that this would only happen by accident, but in fact it will always be true. To see why, let’s look at what happens when the Fed increases the money supply. This action pushes the money supply curve rightward to MS2, and the equilibrium interest rate in the market for money falls to r2. What happens in panel (b), in the market for loanable funds? In the short run, the fall in the interest rate leads to a rise in real GDP, which generates a rise in savings through the multiplier process. This rise in savings shifts the supply curve for loanable funds rightward from S1 to S2, reducing the equilibrium interest rate in the loanable funds market, too. And we know that savings rise by exactly enough to match the rise in investment spending. This tells us that the equilibrium rate in the loanable funds market falls to r2, the same as the new equilibrium interest rate in the money market. In the short run, then, the supply and demand for money determine the interest rate, and the loanable funds market follows the lead of the money market. When a change in the supply of money leads to a fall in the interest rate, the resulting rise in real GDP causes the supply of loanable funds to rise. As a result, the equilibrium interest rate in the loanable funds market is the same as the equilibrium interest rate in the money market. UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 359 Notice our use of the phrase “in the short run.” Recall from Chapter 10 that changes in aggregate demand affect only aggregate output in the short run. In the long run, aggregate output is equal to potential output. So our story about how a fall in the interest rate leads to a rise in aggregate output, which leads to a rise in savings, applies only to the short run. In the long run, as we’ll see in the next section, the determination of the interest rate is quite different, because the roles of the two markets are reversed. In the long run, the loanable funds market determines the equilibrium interest rate, and the market for money adjusts to that rate. economics in action The Fed and the Output Gap, 1985–2004 In Figures 14-8 and 14-9 we showed how monetary policy can play a useful role: expansionary monetary policy can close recessionary gaps, and contractionary monetary policy can close inflationary gaps. A look back at U.S. monetary policy between 1985 and 2004 shows that the Federal Reserve did indeed tend to cut interest rates when the economy had a recessionary gap and raise interest rates when the economy had an inflationary gap. The vertical axis on the left of Figure 14-12 shows the federal funds rate; the line labeled “federal funds rate” shows the average yearly value of that rate between 1985 and 2004. The vertical axis on the right shows the Congressional Budget Office estimate of the output gap, measured as a percentage of potential output. This number is positive when there is an inflationary gap, as in 1999 and 2000, and negative when there is a recessionary gap, as in 2001 through 2004. Figure 14-12 Federal funds rate Output gap (percent of potential output) Federal Reserve Policy and the Business Cycle The left vertical axis shows the federal funds rate. The right vertical axis shows the output gap, measured as the difference between actual and potential output as a percentage of potential output. Over the past 20 years, the Fed has pursued a contractionary monetary policy, raising the federal funds rate when the economy was operating above potential output— that is, when there was an inflationary gap. It has pursued an expansionary monetary policy, reducing the federal funds rate when the economy was operating below potential output—that is, when there was a recessionary gap. 10% 8 6 4 2 0 Federal funds rate 3% 2 1 0 –1 Output gap –2 –3 –4 90 85 95 00 19 19 20 19 Year As you can see, there’s a positive association between the federal funds rate and the output gap: the Fed tended to raise interest rates when aggregate output was moving above potential output and to reduce them when aggregate output was moving below potential output. In other words, the Fed was following pretty much the policy illustrated in Figures 14-8 and 14-9. The two lines aren’t perfectly synchronized. As you can see, the Fed did not raise interest rates in 1998 and 1999, even though the economy had developed a substantial 20 04 360 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition ®® ® QUICK REVIEW ® ® The Federal Reserve can use expansionary monetary policy to close a recessionary gap and contractionary monetary policy to close an inflationary gap. Like fiscal policy, monetary policy gives rise to a multiplier effect through changes in the interest rate that affect aggregate spending and savings. In the short run, the equilibrium interest rate in the economy is determined in the money market by the liquidity preference model. Changes in the interest rate induce changes in aggregate output and savings, and the loanable funds market adjusts to the equilibrium interest rate arising in the money market. inflationary gap. We’ll explain why in Chapter 17, when we discuss monetary policy controversies. For now, let’s just say that some economists believe that the Fed should have raised rates. Also, data from years earlier than 1985 look very different. Prior to 1985 the Fed was grappling with the problem of inflationary expectations, which we will discuss in Chapter 16. The important lesson, however, is that over the past two decades the Fed’s actual policy has largely followed our basic analysis of how monetary policy should work. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 14-3 1. Suppose the economy is currently suffering from a recessionary gap and the Federal Reserve uses an expansionary monetary policy to close that gap. Describe the short-run effect of this policy on the following: a. The money supply curve b. The equilibrium interest rate c. Investment spending d. Consumer spending e. Aggregate output f. The aggregate price level g. Savings h. The supply of loanable funds in the loanable funds market Solutions appear at back of book. Money, Output, and Prices in the Long Run Through its expansionary and contractionary effects, monetary policy can be used to move the economy more quickly to long-run macroeconomic equilibrium. Sometimes, however, there are monetary events that move the economy away from longrun macroeconomic equilibrium. Sometimes the central bank simply makes a mistake. For example, it may believe that potential output is higher or lower than it really is and implement a misguided monetary policy. In addition, central banks are sometimes forced to pursue considerations other than stabilizing the economy. For example, as we’ll see in Chapter 16, central banks sometimes help the government pay its bills by printing money, an action that increases the money supply. What happens when a change in the money supply pushes the economy away from, rather than toward, long-run equilibrium? We learned in Chapter 10 that the economy is self-correcting in the long run: a demand shock has only a temporary effect on aggregate output. If the demand shock is the result of a change in the money supply, we can make a stronger statement: in the long run, changes in the quantity of money affect the aggregate price level, but they do not change aggregate output or the interest rate. To see why, let’s look at the case of an increase in the money supply. Short-Run and Long-Run Effects of an Increase in the Money Supply To analyze the long-run effects of an increase in the quantity of money, we need to recall the distinction between the short-run and long-run aggregate supply curves. The short-run aggregate supply curve slopes upward: in the short run, a higher aggregate price level leads to higher production. The long-run aggregate supply curve, however, is vertical at potential output: in the long run, a rise in prices of final goods and services leads to an equal rise in factor prices, and output remains equal to potential output. Figure 14-13 shows the short-run and long-run effects of an increase in the money supply when the economy begins at potential output, Y1. The initial short-run aggregate supply curve is SRAS1, the long-run aggregate supply curve is LRAS, and the initial aggregate demand curve is AD1. The economy’s initial equilibrium is at E1, a point of both short-run and long-run macroeconomic equilibrium because it is on UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 361 Figure 14-13 Aggregate price level An increase in the money supply reduces the interest rate and increases aggregate demand . . . The Short-Run and Long-Run Effects of an Increase in the Money Supply An increase in the money supply generates a positive short-run effect, but no long-run effect, on real GDP. Here, the economy begins at E1, a point of short-run and long-run equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short-run equilibrium at E2 and a new real GDP of Y2. But E2 is not a long-run equilibrium: Y2 exceeds potential output, Y1, inducing over time an increase in nominal wages in the economy. In the long-run, the increase in nominal wages will shift the short-run aggregate supply curve leftward, to a new position at SRAS2. The economy reaches a new short-run and long-run equilibrium at E3 on the LRAS curve, and output falls back to potential output, Y1. The only long-run effect of an increase in the money supply is an increase in the aggregate price level, to P3. LRAS SRAS2 SRAS1 E3 P3 P2 P1 E1 AD1 Y2 E2 . . . but the eventual rise in all prices leads to a fall in short-run aggregate AD2 supply back to potential output. Potential output Y1 Real GDP both the short-run and the long-run aggregate supply curves. Real GDP is at potential output, Y1. Now suppose there is an increase in the money supply. This shifts the AD curve to the right, to AD2. In the short run, the economy moves to a new short-run macroeconomic equilibrium at E2. The price level rises from P1 to P2, and real GDP rises from Y1 to Y2. That is, both the aggregate price level and aggregate output increase in the short run. But the aggregate output level Y2 is above potential output. As a result, nominal wages will rise over time, causing the short-run aggregate supply curve to shift leftward. This process stops only when the SRAS curve ends up at SRAS2 and the economy ends up at point E3, a point of both short-run and long-run macroeconomic equilibrium. The long-run effect of an increase in the money supply, then, is that the aggregate price level has increased from P1 to P3, but aggregate output is back at potential output, Y1. In the long run, a monetary expansion raises the aggregate price level but has no effect on real GDP. We won’t describe the effects of a monetary contraction in detail, but the same logic applies. In the short run, a fall in the money supply leads to a fall in aggregate output as the economy moves down the short-run aggregate supply curve. In the long run, however, the monetary contraction reduces only the aggregate price level, and aggregate output returns to potential output. Monetary Neutrality How much does a change in the money supply change the aggregate price level in the long run? A change in the money supply leads to a proportional change in the aggregate price level in the long run. For example, if the money supply falls 25%, the aggregate price level falls 25% in the long run; if the money supply rises 50%, the aggregate price level rises 50% in the long run; and so on. 362 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition There is monetary neutrality when changes in the money supply have no real effects on the economy. How do we know this? Consider the following thought experiment: Suppose all prices in the economy—prices of final goods and services and also factor prices, such as the nominal wage rate—double. And suppose the money supply doubles at the same time. What difference does this make to the economy in real terms? The answer is none. All real variables in the economy—including the real value of the money supply—are unchanged, so there is no reason for anyone to behave any differently. We can state this argument in reverse: if the economy starts out in long-run macroeconomic equilibrium and the nominal money supply changes, restoring longrun macroeconomic equilibrium requires restoring all real values to their original values. This includes restoring the real money supply to its original level. So if the money supply falls 25%; the aggregate price level must fall 25%; if the money supply rises 50%, the price level must rise 50%; and so on. This analysis demonstrates the concept known as monetary neutrality, in which changes in the money supply have no real effects on the economy—no effects on real GDP or its components—and the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage. Economists argue that money is neutral in the long run. This is, however, a good time to recall the dictum of John Maynard Keynes: “In the long run we are all dead.” In the long run, changes in the money supply don’t have any effect on real GDP, interest rates, or anything else except the price level. But it would be foolish to conclude from this that the Fed is irrelevant. Monetary policy does have powerful real effects on the economy in the short run, often making the difference between recession and expansion. And that matters a lot for society’s welfare. The Interest Rate in the Long Run In the short run an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate. Figure 14-14 shows why. It is similar to Figure 14-11, but in this case panel (a) shows the real money demand curve, RMD. Panel (b), as in Figure 14-11, shows the supply and demand for loanable funds. We assume that the economy is initially in long-run macroeconomic equilibrium at potential output, E, in both panels, with the nominal money supply equal to M 1 and the price level equal to P1. The demand curve for loanable funds is D, and the initial supply curve for loanable funds is S1. The initial equilibrium interest rate is r1. Now suppose the nominal money supply rises from M 1 to M 2. We already know from the neutrality of money that in the long run the aggregate price level rises by the same proportion as the increase in the money supply but that in the short run the price level rises by a smaller amount. So the initial effect of an increase in the nominal money supply is a rise in the real money supply, from M 1/P1 to M 2/P2. Given the real money demand curve, RMD, this reduces the equilibrium interest rate from r1 to r2, and the money market moves to X in panel (a). And as we saw earlier, the supply of loanable funds shifts rightward by just enough that the quantity of loanable funds supplied and the quantity of loanable funds demanded are equalized at r2. Correspondingly, the loanable funds market moves to X in panel (b). X corresponds to an aggregate output greater than potential output because the interest rate at X, r2, is lower than the interest rate that holds at potential output, r1. In the long run, however, the aggregate price level rises further, from P2 to P3. As we’ve already seen, this reduces the real money supply back to its original level: M2/ P3 is equal to M1/P1. As a result, the equilibrium interest rate goes back to r1 and each market moves back to E. Meanwhile, aggregate output also falls back to potential output—which means that savings return to their original level, too. In panel (b), the supply of loanable funds, which initially shifted from S1 to S2, shifts back to S1. UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 363 Figure 14-14 The Long-Run Determination of the Interest Rate (b) The Loanable Funds Model (a) The Real Liquidity Preference Model Interest rate, r Potential output equilibrium 2. . . . but in the long run, the increase in all prices reduces the real money supply back to its original level . . . Interest rate, r Potential output equilibrium S1 S2 3. . . . and reduces the supply of loanable funds to its original level and aggregate output back to potential output. r1 r2 E X RMD 1. In the short run, an increase in the real money supply reduces the interest rate . . . r1 r2 E X D Q1 Q2 Quantity of loanable funds M1/P1 = M2/P3 M2/P2 Real quantity of money, M/P Panel (a) shows the money market expressed in real terms and panel (b) shows the loanable funds market. Each market starts at point E, where the economy is at potential output. In the short run, an increase in the money supply increases the real money supply from M1 /P1 to M2 /P2 and reduces the equilibrium interest rate from r1 to r2 as the money market moves from point E to point X. The fall in the interest rate leads to higher real GDP and higher savings through the multiplier effect. This shifts the supply curve of loanable funds rightward, from S1 to S2, also moving the market for loanable funds from point E to point X. In the long run, however, the increase in the money supply raises prices: the real money supply returns to its original level, M2 /P3 = M1 /P1, and the supply curve of loanable funds shifts back to its initial position, S1. So in the long run the equilibrium interest rate is determined by the supply and demand for loanable funds that arise at potential output. In the long run, then, changes in the money supply do not affect the interest rate. So what determines the interest rate in the long run—that is, what determines r1 in Figure 14-14? The answer is the supply and demand for loanable funds. More specifically, in the long run the equilibrium interest rate matches the supply and demand for loanable funds in the loanable funds market that arise at potential output. economics in action International Evidence of Monetary Neutrality These days monetary policy is quite similar among wealthy countries. Each major nation (or, in the case of the euro, group of nations) has a central bank that is insulated from political pressure; all of these central banks try to keep the aggregate price level roughly stable, which usually means inflation of at most 2% or 3% per year. But if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. Between 1970 and the present the money supply rose only a few percent per year in some countries, such as Switzerland and the United States, but rose much more rapidly in some poorer countries, such as Bolivia. These differences allow us to see whether it is really true that increases in the money supply lead, in the long run, to equal percentage rises in the aggregate price level. Figure 14-15 on page 364 shows the annual percentage increases in the money supply and in the aggregate price level for a sample of countries over the period 364 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Figure 14-15 Inflation rate, 1970–2000 60% 50 40 30 20 10 0 10 20 30 40 50 60% Money supply growth rate, 1970–2000 Switzerland United States Bolivia The Long-Run Relationship Between Money and Inflation The horizontal axis shows the annual percent increase in a country’s quantity of money between 1970 and 2000. The vertical axis shows the annual percent increase in a country’s aggregate price level over the same period. Each point represents a specific country. The scatter of points lies close to a 45-degree line, demonstrating that in the long run increases in the quantity of money lead to roughly equal percent increases in the aggregate price level. Source: United Nations Statistical Database. 45-degree line ®® ® QUICK REVIEW ® According to monetary neutrality, changes in the money supply do not affect real GDP or the interest rate, only the aggregate price level. Economists believe that money is neutral in the long run. In the long run, the equilibrium interest rate in the economy is determined in the loanable funds market. It is the interest rate that matches the supply and demand for loanable funds that arise when the economy is at potential output. 1970–2000, with each point representing a country. If the relationship between increases in the quantity of money and changes in the aggregate price level were exact, the points would lie precisely on a 45-degree line. In fact, the relationship isn’t exact, because other factors besides money affect the aggregate price level. But the scatter of points clearly lies close to a 45-degree line, showing a more or less proportional relationship between money and the aggregate price level. That is, the data support the idea that money is neutral in the long run. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 14-4 1. Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short-run and long-run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible) on the following: a. Aggregate output b. The aggregate price level c. The real quantity of money d. The interest rate Solutions appear at back of book. • A LOOK AHEAD • Monetary and fiscal policy can be used to help close gaps: a recessionary gap, in which the economy is producing less than potential output, or an inflationary gap, in which it is producing more than potential output. We have not yet explained, however, why closing such gaps is so important. In the case of a recessionary gap, the answer is that recessionary gaps are associated with high unemployment. To deepen our understanding of that concern, however, we need to look more deeply into the causes and meaning of unemployment. That’s the subject of Chapter 15. The causes and costs of inflation are a more subtle issue, which we deal with in Chapter 16. UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 365 SUMMARY 1. The money demand curve arises from a trade-off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short-term interest rates, not long-term interest rates. 2. Other things equal, the nominal quantity of money demanded is proportional to the aggregate price level. So money demand can also be represented using the real money demand curve. Changes in real aggregate spending, technology, and institutions also shift the money demand curve. According to the velocity of money approach to money demand, the real quantity of money demanded is proportional to real aggregate spending. 3. The liquidity preference model says that the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shifting the money supply curve. In practice, the Fed uses open-market operations to achieve a target federal funds rate, which other interest rates generally track. 4. Expansionary monetary policy, which reduces the interest rate and increases aggregate demand by increasing the money supply, is used to close recessionary gaps. Contractionary monetary policy, which increases the interest rate and reduces aggregate demand by decreasing the money supply, is used to close inflationary gaps. 5. Like fiscal policy, monetary policy has a multiplier effect, because changes in the interest rate lead to changes in consumer spending and savings as well as investment spending. In the short run, a change in the equilibrium interest rate determined in the money market results in a change in real GDP and in savings through the multiplier effect. This shifts the supply of loanable funds in the market for loanable funds until it reaches equilibrium at the new equilibrium interest rate. 6. In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. In fact, there is monetary neutrality: changes in the money supply have no real effect on the economy. So monetary policy is ineffectual in the long run. 7. In the long run, the equilibrium interest rate matches the supply and demand for loanable funds that arise at potential output in the market for loanable funds. KEY TERMS Short-term interest rates, p. 000 Long-term interest rates, p. 000 Money demand curve, p. 000 Real quantity of money, p. 000 Real money demand curve, p. 000 Velocity of money, p. 000 Quantity equation, p. 000 Liquidity preference model, p. 000 Money supply curve, p. 000 Target federal funds rate, p. 000 Expansionary monetary policy, p. 000 Contractionary monetary policy, p. 000 Monetary neutrality, p. 000 PROBLEMS 1. Go to the FOMC page of the Federal Reserve Board’s website (http://www.federalreserve.gov/FOMC/) to find the statement issued after the most recent FOMC meeting. (Hint: go to the bottom of the web page and click on the most recent statement listed in the calendar.) there is a shift of the demand curve or a movement along the demand curve and its direction. a. There is a decrease in the interest rate from 12% to 10%. b. Thanksgiving arrives and, with it, the beginning of the holiday shopping season. a. What is the target federal funds rate? b. Is the target federal funds rate different from the target federal funds rate from the previous FOMC statement? If yes, by how much does it differ? c. McDonald’s and other fast-food restaurants begin to accept credit cards. d. The Fed engages in an open-market purchase of U.S. Treasury bills. 3. The accompanying table shows nominal GDP, M1, and M2 in billions of dollars in five-year increments from 1960 to 2000 as published in the 2005 Economic Report of the President. Complete the table by calculating the velocity of money using both M1 and M2. What trends or patterns in the velocity of money do you see? What might account for these trends? c. Does the statement comment on macroeconomic conditions in the United States? How does it describe the U.S. economy? 2. How will the following events affect the nominal demand for money (as defined by M1)? In each case, specify whether 366 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition Year 1960 1965 1970 1975 1980 1985 1990 1995 2000 GDP (billions of dollars) $526.4 719.1 1,038.5 1,638.3 2,789.5 4,220.3 5,803.1 7,397.7 9,817.0 M1 (billions of dollars) $140.7 167.8 214.4 287.1 408.5 619.8 824.8 1,127.0 1,087.9 M2 (billions of dollars) $312.4 459.2 626.5 1,016.2 1,599.8 2,495.7 3,279.2 3,641.2 4,932.5 Velocity using M1 ? ? ? ? ? ? ? ? ? Velocity using M2 ? ? ? ? ? ? ? ? ? Aggregate price level P1 LRAS SRAS E1 AD1 Potential output YE Y1 Real GDP 4. The accompanying table shows the annual growth of M1 and nominal GDP in Japan during the early 2000s. What must have been happening to velocity during this time? 7. In the economy of Eastlandia, the money market is initially in equilibrium when the economy begins to slide into a recession. a. Using the accompanying diagram, explain what will happen to the interest rate if the central bank of Eastlandia keeps the money supply constant. Year 2000 2001 2002 2003 M1 growth 8.2% 8.5% 27.6% 8.2% Nominal GDP growth 2.9% 0.4% −0.5% 2.5% b. If the central bank is instead committed to maintaining an interest rate target of r1, how should the central bank react as the economy slides into recession? Interest rate, r 5. An economy is facing the recessionary gap shown in the accompanying diagram. To eliminate the gap, should the central bank use expansionary or contractionary monetary policy? How will interest rates, investment spending, consumer spending, real GDP, and prices change as the monetary policy closes the recessionary gap? LRAS SRAS MS1 r1 Aggregate price level E1 MD1 Nominal quantity of money, M E1 P1 8. An economy is in long-run macroeconomic equilibrium with an unemployment rate of 5% when the government passes a law requiring the central bank to use monetary policy to lower the unemployment rate to 3% and keep it there. AD1 a. How could the central bank achieve this goal in the short Real GDP Y1 YE Potential output run? b. What would happen in the long run? 9. According to the European Central Bank website, the treaty establishing the European Community “makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.” If price stability is the only goal of monetary policy, explain how monetary policy would be conducted during recessions. Analyze both the case of a recession that is the result of a demand shock and the case of a recession that is the result of a supply shock. 6. An economy is facing the inflationary gap shown in the accompanying diagram. To eliminate the gap, should the central bank use expansionary or contractionary monetary policy? How will interest rates, investment spending, consumer spending, real GDP, and prices change as the monetary policy closes the inflationary gap? UNCORRECTED Preliminary Edition CHAPTER 14 M O N E TA R Y P O L I C Y 367 10. The effectiveness of monetary policy depends on how easy it is for changes in the money supply to change interest rates. By changing interest rates, monetary policy affects investment spending and the aggregate demand curve. The economies of Albernia and Brittania have very different money demand curves, as shown in the accompanying diagram. In which economy will monetary policy be more effective? Why? 11. During the Great Depression, businesspeople in the United States were very pessimistic about the future of economic growth and reluctant to increase investment spending even when interest rates decreased. How did this limit the potential for monetary policy to help alleviate the Depression? 12. Using a figure similar to Figure 14-11, explain how the money market and the loanable funds market react to a decrease in the money supply. 13. Contrast the short-run effects of an increase in the money supply on the interest rate to the long-run effects of an increase in the money supply on the interest rate. Which market determines the interest rate in the short run? Which market does so in the long run? What are the implications of your answers for the effectiveness of monetary policy in the short run and the long run in influencing real GDP? (a) Albernia MS1 Interest rate, r r1 MD Nominal quantity of money, M (b) Brittania MS1 Interest rate, r r1 MD Nominal quantity of money, M >web... To continue your study and review of concepts in this chapter, please visit the Krugman/Wells website for quizzes, animated graph tutorials, web links to helpful resources, and more. www.worthpublishers.com/krugmanwells ...
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