Ch 17 Notes (ECON E-202; Introduction to Macroeconomics; Wenyi Shen)

Ch 17 Notes (ECON E-202; Introduction to Macroeconomics; Wenyi Shen)

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Unformatted text preview: Chapter 17 Monetary Policy Chapter Outline Demand For Money Effects of an Increase in The Money Supply Effects of a Change in the Money Supply on AD/AS: Keynesian Model Monetary Policy and Inflation: Monetarism Monetary Policy Targets The Way Fed Policy is Currently Implemented The Demand for Money To use money, one must hold money If people desire to hold money, there is a demand for money. ' The demand for money, What people wish to hold - People have certain motivation that causes them to want to hold money balances. - There is a demand for money by the public, motivated by several factors. Transactions demand Precautionary demand Asset demand The Demand for Money ' Transactions Demand -— Holding money as a medium of w; exchange to make payments may WM - The level varies directly with mammal GU? ° Precautionary Demand - Holding money to meet unplgmled U expenditures and emergencies — The level varies with ifi’rev’eel’ rate , wwwf flaw? (M J MM a9 nailed ' Asset Demand - Holding money as a store of value cm ‘ instead of other assets such as certificates of deposit, corporate bonds, and stocks - The level varies with {Meresf me . The Demand for Money 0 The demand for money curve Interest Rate Quantity of Money if“ The Demand for Money nmimeuak mt» CW5 Shifts in the Money Demand Curve Interest Rate Quantity of Money The Supply for Money Shifts in the Money Supply Curve My“, it; mall‘- 3; “Law adj/filed How the Fed Influences Interest Rates Interest Rate Quantity of Money Effects of an Increase in the Money Supply Question: ° What if hundreds of millions of dollars in just—printed bills is dropped from a helicopter? "xt ' People pick up the money and put it in their pockets, but how do they dispose of the new mone ? A y -Q \ (PM) (a? ‘ 7% «QM [4/ minty cm»; L's 4W”: ‘ I “f __:__ ~+ (final-1W: é 5 +1) y W sHl mam “\‘aflriim $1: {21: t T (Mg/7 l Effects of an Increase in the Money Supply ° Direct effect 4%” C T Aggregate demand rises because with an increase in the money gage/K , at any given price level people now want to purchase more output of real goods and services. ° Indirect effect «ii t Will everybody necessarily spend the newfound money on goods and services? Some of the money gets deposited, so banks have higher reserves. - Banks {awer rates to induce borrowing. - Businesses engage in Emma-imi— . - Individuals consume durable goods - Increased loans generate an increase in aggregate demand. Effects of a Change in the Money Supply on AD/AS: Keynesian Model Interest Rate Quantity of Money VL ~—-—7 *9 Min, 5% 10 Effects of a Change in the Money Supply 011 AD/AS: Keynesian Model Expansionary monetary policy Price Level SQQSt n RAE RGDP ntmctionary monetary policy 1 Fr ‘ce Level 11 [451‘ LRAS 5 H6 I W'Wk A DI «m < m m“ 1 RG DP Effects of a Change in the Money Supply 011 AD/AS: Keynesian Model The Fed Responds to“ the Terrorist Attacks of September I], 2001 The day after the terrost attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, was the chairman of the Fed at the time of the attacks. Can the F ed Eliminate Recessions? 12 Effects of a Change in the Money Supply 011 AD/AS: Keynesian Model A Summary of How Monetary Policy Ms IL 4/ FOMC orders Th? “my supdp'V an expansionary —+ Igctmraszafg policy a 8 fall (a) An expansionary policy Fwy/0,114 new 6mm FOlvlC orders 0 r d a oonlraclionary _.. lee eases an ’ Interest rates policy I rise (bjnconlraotionarv poliov “L 4, l‘ The money supply l/I/orks,‘~~ " 7‘ 1 c r Inveslmenl. consumption. and nel exports all increase W Investment. I consumption, and net expone all decrease “Li: C1: XL: 13 The AD curve shins to the right mi The AD curve shifts to the left mt Real GDP and the price level rise (toil {9 L51k Real GDP and the price level iall an? 1r Pb v Open Economy Transmission of Monetary Policy ° The net export effect of contractionary monetary policy - Boosts the market interest rate 4', It - Higher rates mar/r foreign investment m Uififimwi — International price of dollar riscug - Appreciation of dollar mm»; net 9H" 1, TIM 4"? => exports 52‘? i“ 54 k b - Egcfimt net export effect 0 L ° The net export effect of expansionary monetary policy - Lower interest rates - Financial capital QM 0"" of US - Demand for dollars will MC Nara - International price of dollar 90» 01W" h Foreign goods look more in United States ' - Net exports (imports ) 14 Monetary Policy and Inflation: \ onetarism ' Most theories of inflation relate to the short run and the price index in the short run can fluctuate due to - Oil price shocks, labor union strikes ' In the long run, there is a more stable relationship between growth in the money supply and inflation. Why the price level rises when the money supply is increased? 15 Monetary Policy and Inflation: Monetarism ' The Equation of Exchange The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP \A 9R" «5" MSVzPY *- MS = actual money balances held by nonbanking public h V = income velocity of money; the number of times, on average per year, each monetary unit is spent on final goods and services - P = price level or price index - Y = real GDP per year 15 Monetary Policy and Inflation: Monetarism ° The equation of exchange as an identity - Total funds sgent on final output @’ = total funds received@ - The value of goods purchasedithe value of goods sold — MSV/g '5— nominal GDP \{ i)“ (a at)?“ 17 Monetary Policy and Inflation: Monetarism ° Quantity theory of money and prices - Assume: Vis constant Yis stable 2 70/5 - V: $ ZP-‘f MSVZPY Increases in Ms must be matched by increases in the price level 4' The Relationship Between Money Supply Growth Rates and Rates of Inflation 1 .000 100 Rate of Inflation per Year [%, Ratio Scale) 1 10 100 L000 Monetary Policy Targets The Fed’s Target Choice: Interest Rates or Money Supply? ' It is not possible to stabilize the money supply and interest rates simultaneously. ° The Fed has often sought to achieve an interest rate target. ' There is a fundamental tension between targeting interest rates and controlling the money supply. Ms M; If the Fed selects re. it / must accept MS A MD l I l. 5‘: -. / If the Fed selects M’s. l _ it must allow the " 8 interest rate to fall Interest Rate Quantity of Money Supplied and Demanded 19 Monetary Policy Targets ° Choosing a policy target — Money supply ' When variations in private spending occur - Interest rates ' When the demand for (or supply of) mone is unstable At present the Fed announces an interest rate target. The rate referred to is the federal funds rate of interest. Federal 13% f” “d5 “19 Acmal federal ‘ufidfi. mte F‘-‘1 Target iederc-nl funds. rate: 1i__1 ,z_._ .L____.L _1_.__:_ _J_ [J .1 Jan. Jan, Jan. Jan. Jan Jan. Jan. Jan. Jan. Jan. fian 1951‘! 1395 1999 2mm PUG-‘1 550:1}: SLIDE 2mm 213-135 Q-EIQIS :E‘Dni' 20 Monetary Policy Targets The Taylor Rule A rule developed by John Taylor that links the F ed’s target for the federal funds rate to economic variables. Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) * Inflation gap + ( 1/2) * Output gap m {MM _ inzahw Myer 3 (0”4'2’4 “awrpul'powgg "1’ 12 . . . . ‘ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ‘ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ‘ . . . . . . . . . . . . . . . . . t . . . . , . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ‘ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 4% 3% 2% 1% 0% Target inflation rates Percent 1999 2000 2001 2002 2003 2004 2005 2006 200? 2008 2000 2010 Year 21 The Way Fed Policy is Currently Implemented ' If the Fed wants to raise “the” interest rate, it engages in 4mm Lia-Mary Open market operations. * Fed sells more Treasury securities than it buys, thereby reducing the money supply. ' This tends to boost “the ” rare ofz'm‘eresr. ' Conversely, if the Fed wants to decrease “the” rate of interest, it engages in argon/tower}; open market operations. - Fed buys more Treasury securities, Mat/flung, the money supply. This tends to lower “the ” rate of interest. 22 Policy Example: Reading the Tea Leaves of Fed Policy Statements 0 After each Fed meeting, the FOMC issues a statement explaining the rationale for its Directive to the Trading Desk. ' Subtle changes in wording may provide hints about possible future changes in interest rate policy. ' Question Why do you suppose that members of the F OMC devote a considerable portion of their time to carefully crafting changes in the FOMC’s policy statement to the public? 23 Chapter 17 Problem Set Potential Year Rea! GDP Rea! GDP Price Lave 2010 $13.5 trillion $13.5 trillion 142 201] $14.0 trillion $14.4 trillion 150 Refer to the above table. The hypothetical. information in the table shows what the values for real GDP and the price level will be in 201 1 if the Federal Reserve does not use monetary policy: A) lfthe Fed wants to keep real GDP at its potential level in 201 I, should it use an expansionary policy or a CW‘IEIW policy? Should the trading desk hairy government securities or seflt’hgn? B) Suppose the Fed's policy is Sucoessfu] in keeping real GDP at its potential level in 2011. State whether each of the following will be higher, the same as, or lower than ifthe Fed had taken no action: (i) Real GDP ’i‘ (ii) Full—employment real GDP “'- (iii) The inflation rate J; (iv) The unemployment rate J} C) Draw an aggregate demand and aggregate supply graph to illustrate your answer. Be sure that your graph contains LRAS curves for 2010 and 201 l; SRAS curves 2010 and 2011; AD curve for 2010 and 2011, with and without monetary policy actions; and equilibrium real GDP and the price level in 201 1 with and without policy. VL- "‘ a“. \ fit}? Consider a world in which there is no currency and depository institutions issue only transactions deposits and desire to hold no excess reserves. The required reserve ratio is 20 percent. The central bank sells $1 billion in government securities. What ultimately happens to the money supply? 1x.) ...
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Ch 17 Notes (ECON E-202; Introduction to Macroeconomics; Wenyi Shen)

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