Ch14Spring2011

Ch14Spring2011 - CHAPTER 14 CHAPTER MONEY AND THE FEDERAL...

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Unformatted text preview: CHAPTER 14 CHAPTER MONEY AND THE FEDERAL RESERVE SYSTEM RESERVE Spring, 2011 1 2 LINKING THE “REAL” AND LINKING FINANCIAL SECTORS OF THE ECONOMY ECONOMY Equilibrium in the market for goods Equilibrium and services requires AD = AS and AD depends in part on Investment AD expenditures. (Ch. 10) expenditures. Investment expenditures depend on Investment the rate of interest. (Ch. 9) the Interest rate determined in financial Interest sector of the economy (Ch. 16) sector We cannot predict investment We expenditures unless we can first predict the rate of interest. 3 GRAPH OF EQUILIBRIUM GRAPH INTEREST RATE: INTEREST Determined in the Money Market. Determined (See Chapter 16, Exhibit 2, p. 400) (See Interest Rate Money Supply Determined. by FED Equilibrium rate of interest. i(e) Demand for Money Money 4 THE EFFECTS OF CHANGES IN THE MONEY SUPPLY (see Chapter 16, Exhibit 3, p. 402) Exhibit Figure 26.3 (Macro 16.3) IMPACT OF CHANGE IN INTEREST IMPACT RATE ON INVESTMENT EXPENDITURES EXPENDITURES (See Chapter 8, Exhibit 9, P. 211) Interest Rate i(1) i(2) I(p) I(p) 6 THE EFFECT OF EXPANSIONARY MONETARY POLICY ON AGGREGATE DEMAND (See Chapter 10, Exhibit 8, p. 254) Exhibit Figure 26.5 (Macro 16.5) WHAT FUNCTIONS DOES MONEY WHAT PERFORM? PERFORM? Barter economy: Barter Goods/services exchanged Goods/services for other goods and services Principle of the “double Principle coincidence” of wants Barter is inefficient and Barter limits specialization Money-using economy Money-using Goods sold for money Money used to buy other Money goods “Single coincidence” of Single wants Money increases the Money efficiency of specialization and exchange 8 and WHAT FUNCTIONS DOES MONEY WHAT PERFORM? PERFORM? Page 2 Functions of money Functions Medium of exchange Medium Unit of account Store of value Store What constitutes the money What supply? Coins Currency Checkable deposits Travelers’ checks Why credit cards are not money Short-term loans Must ultimately paid in Must money; cannot serve as a store of value store 9 THREE DEFINITIONS OF THE THREE MONEY SUPPLY MONEY M1: The narrowest definition M1: Currency Traveler’s checks Coins Checkable deposits Checkable Focuses on “medium of Focuses exchange” definition of money money M2: The broadest definition Includes M1 plus savings Includes deposits + small time deposits + money market accounts accounts 10 WHAT BACKS THE MONEY WHAT SUPPLY? SUPPLY? The Bi-Metallic Standard: 1792-1900 (Note: De facto gold standard over (Note: much of this period. Silver Certificates continued to be produced until 1963.) The Gold Standard: 1900-1934 The Gold Exchange Standard (and fixed The exchange rates) : 1934-1971 exchange Inconvertible paper standard (and Inconvertible floating Exchange Rates): 1971-present floating Result: no precious metals backing for Result: our money supply today. FDIC insures bank deposits today. FDIC All money is “token” or “fiat” money. 11 THE FEDERAL RESERVE SYSTEM: Some U.S. banking history Financial panics in U.S. before 1913 in: Financial 1817, 1857, 1873, 1893, 1907 Little federal involvement in banking Little prior to 1913: prior First and Second U.S. Banks National Banking Acts of 1862 & National 1864 1864 State banks very independent State No national monetary policy No Panics created shortage of reserves A lender of the last resort was lender needed. needed. 12 STRUCTURE OF THE FEDERAL STRUCTURE RESERVE SYSTEM (THE “FED”) RESERVE Board of Governors Board 7 in number with 14 year in terms Appointed by President President Congress advises and Congress consents Federal Advisory Council Federal 12 Fed District Bank 12 Presidents Presidents Open Market Committee 7 members of Board of members Governors + 5 members of Federal Adv. Council Federal 12 Federal Reserve Districts 13 THE TWELVE FEDERAL RESERVE DISTRICTS, P. 364 DISTRICTS, Figure 24.2 (Macro 14.2) The Organization of the Federal Reserve System, P. 365 System, Figure 24.3 (Macro 14.3) TRADITIOINAL FUNCTIONS OF TRADITIOINAL THE FEDERAL RESERVE SYSTEM THE 1. Controlling the money supply 1. 2. Clearing checks 2. 3. Supervising and regulating 3. member banks member 4. Maintaining and circulating 4. currency currency 5. Maintaining Federal Government 5. checking accounts and gold checking 6. Protecting consumers 6. 16 THE U.S. BANKING REVOLUTION 1. The Monetary Control Act of 1980 strengthened the Fed’s regulatory strengthened role. 2. 2. Repeal of the Glass –Seigal Actn Repeal 1999 greatly reduced the Fed’s regulatory role 3. Giant investment banks emerged as a “shadow” banking system outside of Fed control. 4. They operated on borrowed money and made very risky financial investments. financial 17 WHAT DO INVESTMENT BANKS WHAT DO? DO? 1. They do not accept deposits 1. and make loans like commercial banks. 2. Assist firms in raising capital 2. for acquisitions and mergers. 3. Investment management and 3. consulting advice. consulting 4. Buying, selling and reselling 4. financial products including mortgages and credit default swaps. 18 HOW ARE INVESTMENT BANKS HOW REGULATED? REGULATED? 1. They are not regulated by the 1. FED FED 2. They technically are regulated by 2. the SEC the 3. There is no clearinghouse or 3. national reporting system for credit default swaps. Very little information is available. information 4. There is little required reporting 4. so no one knows what the balance sheets of these firms look like. sheets 19 WHAT HAPPENED (1)? 1. 1. Congress and the financial services industries encourages subprime mortgage lending. mortgage 2. Thousands of mortgages “bundled” 2. together and resold in pieces called “collaterized debt obligations “collaterized 3. They “hedged” their bets by purchasing 3. a form of insurance called “credit default swaps.” These were outlawed in 1933 but reauthorized by Congress (under pressure from the financial services industry) in 1999. 4. When housing prices fell, borrowers in the subprime market began to default on their mortgages. their 20 WHAT HAPPENED(2)? 1. 1. Sellers of CDOs were not required to hold “reserves” against possible losses. 2. Purchasers of subprime mortgages purchased a large number of CDOs from the same firms. These firms did not have sufficient reserves to meet their obligations. 3. The federal government began to step in to “bail out” failing firms because of the fear of system-wide financial collapse. 4. Problem worsened when the federal government allowed Lehman Brothers to fail. 5. No investment banks remaining today. 21 END OF CHAPTER 14 LECTURE QUESTIONS????????? 22 CHAPTER 15 CHAPTER MONEY CREATION MONEY FALL, 2010 23 23 GRAPH OF EQUILIBRIUM INTEREST GRAPH RATE: RATE: Determined in the Money Market Interest Rate Money Supply Determined. by FED Equilibrium rate of interest. i(e) Demand for Money Money 24 IMPACT OF CHANGE IN INTEREST IMPACT RATE ON INVESTMENT EXPENDITURES EXPENDITURES Interest Rate i(1) i(2) I(p) I(p) 25 INCREASED I(p) SHIFTS AD INCREASED SCHEDULE TO THE RIGHT SCHEDULE Price Level AS1 AD3 AD2 AD1 GDP 26 HOW THE FED CONTROLS THE HOW MONEY SUPPLY MONEY AD-AS model allows equilibrium AD-AS GDP ) to be determined for any given rate of interest. Interest rate determines investment spending, and hence aggregate demand. AD and AS functions then determine the equilibrium level of real GDP and the price level. The equilibrium interest rate is determined by the demand for and the supply of money. and 27 27 INTRODUCTION Financial institutions are for-profit Financial corporations. corporations. Accept deposits Make loans Make Goal is to maximize profits. Goal BUT, the result of these profit-maximizing BUT, transactions is that: transactions The money supply changes Interest rates change Investment changes Y(e) changes This chapter shows the impact on the This money supply of private sector, profitmoney maximizing transactions 28 THE PROCESS OF MONEY CREATION History of fractional reserve banking History The gold standard The role of goldsmiths Centralized deposits of gold The introduction of checking The accounts accounts Fractional reserves: only some % Fractional of new deposits must be held as required reserves. Fractional reserve banking today: Fractional Not to protect checking deposits FDIC insures deposits As an instrument of monetary As control control 29 THE PROCESS OF MONEY CREATION P. 76 Bank A: Balance Sheet 1 Bank Assets Assets Required Res. $05M Excess Res $45M Loans $00M --------------Total $50M Liabilities Liabilities Deposits $50M -------$50M Assets: What the bank owns: Required Reserves Required Loans (collateral value) Loans Liabilities: What the bank owes: Funds to depositors Funds Total reserves = Required reserves + Total Excess reserves Excess 30 THE PROCESS OF MONEY CREATION P. 378 Legal reserve requirement: % of deposits that cannot be cannot loaned out. Note: Example below assumes all banks subject to same legal reserve requirement (see text p. 353) requirement Accepting a new deposit: Accepting Best Bank: Balance Sheet #2, p. 363 Best Assets Liabilities Assets Liabilities Req. Res. $10,000 B. Rich Dep. 100,000 Req. Ex. Res. $90,000 Ex. -------------------------Totals $100,000 $100,000 Totals 31 THE PROCESS OF MONEY CREATION PP. 364-365 Best Bank: Balance Sheet #3, p. 379 Best Assets Liabilities Liabilities Req. Res. $19,000 $19,000 Excess Res.$81,00 Loans $90,000 Loans ----------------------Totals $190,000 Rich Dep. Jones Dep. $100,000 $100,000 $090,000 $090,000 ----------$190,000 Best Bank: Balance Sheet #4, p. 380 Best Assets Req. Res. $10,000 Req. Excess Res.$00,000 Excess Loans $90,000 Loans --------------------Total $100,000 Total Liabilities Liabilities Rich Dep. $100,000 $100,000 Jones Dep. $000,000 $000,000 -----------$100,000 32 THE PROCESS OF MONEY CREATION PP. 350-351 Funds re-deposited in Bank B Yazoo Bank : Balance Sheet #5, p. 380 Assets Req. Res. $09,000 Ex. Res. $81,000 $81,000 ----------------------Totals $90,000 Liabilities Liabilities New deposit $90,000 ----------$90,000 Yazoo Bank Bal. Sheet #6 (no text page) Assets Req. Res. $9,000 Req. Loans $81,000 Loans --------------------Total $90,000 Total Liabilities Liabilities New Deposit $90,000 -----------33$90,000 THE PROCESS OF MONEY CREATION P. 381 Expansion of the Money Supply Rd 1 2 3 4 5 6 ∆ ∆ ∆ in Dep. In Req. Res. in Excess Res. in $100,000 $100,000 $090,000 $081,000 $072,900 . . Totals:----------Totals:----------$1,000,000 $1,000,000 $10,000 $09,000 $08,100 . . . -----------$100,000 $90,000 $81,000 $72,900 . . $00,000 -----------$900,000 Note: A $100,000 increase initial deposits Note: leads to a $1,00,000 increase in the money supply. New loans created $900,000 in new deposits. $900,000 34 THE MONEY MULTIPLIER Money multiplier is equal to reciprocal of the reserve requirement: If Res. Req. = 10%, money multiplier is equal to 10 in above example. equal IMPORTANT Assumptions: IMPORTANT No leakages into cash No Banks are willing to loan out all willing excess reserves Banks are able to loan out all able excess reserves excess 35 MONEY CREATION: Page 1 Money is created on the basis of: (1) Excess reserves (1) (2) The money multiplier In above example, $900,000 deposits created by the banking system: $90,000 in initial excess reserves $90,000 Money multiplier = 1/Res. Req. = 1/10% = 10 $90,000 * 10 = $900,000 $900,000 in new deposits increases the amount of Req. Res by $90,000, and this is the amount of initial excess reserves. Excess reserves “converted” into requird reserves. reserves. 36 MONEY CREATION: Page 2 Rework the above example with a 20% reserve requirement: Initial deposit = $100,000 Initial Initial Res. Req.= $20,000 Initial Initial Excess Res. $80,000 Money multiplier = 1/20% = 1/5 = 5 Money Money creation -= $80,000 * 5 = $400,000 $400,000 Rationale: $80,000 in initial excess reserves must be converted to $80,000 in required reserves. So there are no more excess reserves and the expansion (relending) process stops. process 37 NUMERICAL EXAMPLE: NUMERICAL Expanding the Money Supply Suppose the private commercial banking Suppose system has $800 in deposits and no excess reserves when the legal reserve requirement is 25%. By how much can the money supply expand if the legal reserve requirement is reduced to 20%? reserve ANSWER: $200 ANSWER: Calculation process for expansion 1. Find the amount of excess reserves 1. ($40). ($40). 2. Calculate the value of the money 2. multiplier. (1/20% = 5) multiplier. 3. Multiply excess reserves times the 3. money multiplier to get potential money-creating effect. (5 * 40 = $200) money-creating 38 Sample Problem: Expanding the Sample Money Supply Money BANKING SYSTEM Assets Liabilities Assets Liabilities Req. Res. Loans Loans Ex. Res. $200 $200 $600 $600 $000 Deposits $800 Now let the legal res. req. drop to 20% Now BANKING SYSTEM BANKING Assets Req. Res. Lo Ex. Res. Liabilities $160 $600 $040 Deposits $800 Given the maximum value of the money Given multiplier (1/20% = 5), the amount of deposits yet to be created is 5 * $40 = $200. 39 CONTRACTING THE MONEY CONTRACTING SUPPLY: SUPPLY: Banking system can destroy deposits as Banking destroy well as create them. Deposits are destroyed on the basis of a shortage of required reserves. shortage Maximum contraction given by the product of: Shortage of Required Reserves AND Shortage The money multiplier. This product shows the amount of deposits This that have to be destroyed to eliminate the destroyed shortage of required reserves. If initial shortage is $10,000 and money multiplier is 5, then: $10,000 * 5 = $50,000 * $10,000 40 CONTRACTING THE MONEY CONTRACTING SUPPLY SUPPLY (continued) BANK A Assets Assets Req. Res. Req. Loans & Loans Investments Investments Liabilities Liabilities $10,000 Deposits $100,000 $90,0000 No excess reserves in the system. A check for No $10,000 is “cashed” at Bank A. $10,000 BANK A BANK Assets Req. Res. $000000 Loans & Loans Investments $90,000 Investments Liabilities Deposits $90,000 Note the deficiency of required reserves! Cashing a Note check does NOT reduce loans and investments! check 41 CONTRACTING THE MONEY SUPPLY (continued) . Note that bank sells off loans and investments of $9000 to replenish required reserves. Assets Assets Liabilities Liabilities Req. Res. $9000 Deposits $90,000 Loans & Loans Investments $81,000 Investments Note: deficiency in required reserves Note: resolved by calling in loans and investments. So some other bank will have a check clear against their deposits, and they will lose required reserves. and 42 CONTRACTING THE MONEY SUPPLY Page 4 Contracting the Money Supply Sales of Sales Rd Rd ∆ in Dep. ∆ In Req. Res. 1 -$10,000 -$10,000 2 -$09,000 3 -$08,100 4 . 5 . 6 . Totals:----------- $100,000 $100,000 - $01,000 - $00,900 -$00,810 . . . ------------$10,000 Securities . Securities - $9,000 -$8,100 - $7,290 . . . ------------$90,000 Sales of $9,000 worth of securities leads to Sales a $90,000 decrease in the money supply. 43 CONTRACTING THE MONEY CONTRACTING SUPPLY: Page 5 SUPPLY: Full contraction more likely to be achieved Full BECAUSE: Money contraction is not permissive: Money not Banks compelled by law to meet Banks reserve requirements Banks must call in loans, which Banks reduces deposits in other banks. Process continues until enough Process deposits are “destroyed” to eliminate the shortage of required reserves. required 44 NUMERICAL EXAMPLE: NUMERICAL Contracting the Money Supply Suppose the private commercial banking Suppose system has $800 in deposits and no excess reserves when the legal reserve excess requirement is 10%. By how much will the money supply contract if the legal reserve requirement is raised to 20%? reserve ANSWER: $400 Calculation process for expansion 1. Find the shortage of required 1. reserves. ($80) reserves. 2. Calculate the value of the money 2. multiplier. (5) multiplier. 3. Multiply the shortage of required 3. reserves times the money multiplier to get potential money-destroying effect. ($400) effect. 45 OPEN MARKET OPERATIONS: (continued) Bond prices and bond yields move in Bond opposite directions. opposite Example: GM Bond GENERAL MOTORS CORPORATION $1000 Bond Pays owner $60.00 per year Bond matures 2075 AD 46 OPEN MARKET OPERATIONS: (continued) Bond prices and bond yields: Bond Price Yield Yield $500 12% $1000 06% $1000 06% $2000 03% 03% Conclusion: Conclusion: As bond prices rise, yields fall As If FED enters market as a buyer: Prices rise, yields fall Wealth holders sell government Wealth bonds and buy other financial assets, whose prices rise and yields fall yields 47 FEDERAL RESERVE MONETARY FEDERAL POLICY POLICY • Instruments of Monetary Control 1. Open market operations 2. Changes in the discount rate 3. Changes in the reserve Changes requirement requirement • Keynesian monetary policy: Keynesian 1. 2. 3. 4. 5. 5. ∆ the money supply the ∆ the rate of interest the ∆ the level of Investment the ∆ the level of Y(e) Above assumes a downwardsloping demand schedule for sloping money (see Chapter 16) money 48 OPEN MARKET OPERATIONS: Open market operations: Involve the purchase and sale of Involve short-term government securities Are conducted by the Open Market Are Committee Committee A. With private sector firms that A. are profit oriented are Are intended to change the money Are supply and interest rates Are the most frequently-used tool of Are monetary policy If FED buys (sells) securities, their If prices rise and yields fall (rise) prices 49 OPEN MARKET OPERATIONS: Purchases from a Bank Bank A: Balance Sheet #1 ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Required Loans $35M Bonds $05M Now FED buys $5M bonds from Bank A: Bank A: Balance Sheet #2 Bank ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Required Loans $35M Loans Excess Reser. $05M 50 OPEN MARKET OPERATIONS: Purchases from a Non-Bank firm Bank A: Balance Sheet #1 ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Required Loans $35M Bonds $05M Now FED buys $5M bonds from XYZ Corporation: Bank A: Balance Sheet #2 Bank ----------------------------------------------------------------------------------------------------------Required Res. $11M Deposits $50M Required Loans $35M + Dep. $05M Loans Bonds $05M Bonds Excess Res. $04M ----------------Total $55M $55M 51 OPEN MARKET OPERATIONS: (continued) Summary of Open Market Operations Case #1: Shift AD schedule to the right Fed buys bonds Bond prices rise and yields fall Banks get more excess reserves Multiple expansion of the money Multiple supply occurs supply Bank interest rates fall Bank Investment rises Y(e) rises GDP gap is closed through GDP monetary policy 52 OPEN MARKET OPERATIONS: (continued) If FED enters the market as a seller, If prices fall and yields rise prices Other wealth holders readjust their Other portfolios to buy government bonds, so prices of other assets fall and yields rise rise Effect of open-market operations Effect spreads throughout the financial markets Equilibrium reestablished when yields Equilibrium have adjustment throughout the financial markets financial Everyone just willing to hold existing Everyone financial assets at existing prices and yields yields 53 EQUILIBRIUM INTEREST RATE EQUILIBRIUM CHANGED BY OPEN MARKET OPERATIONS OPERATIONS Increase in M lowers interest rate! i rate S1 (Fed) S2(FED) D1 M 54 54 DECLINE IN INTEREST RATE DECLINE INCREASES INVESTMENT INCREASES i rate I(p) $ 55 55 OPEN MARKET OPERATIONS: (continued) Case #2: Shift AD schedule to left Fed sells bonds Bond prices fall and yields rise Banks experience a shortage of Banks required reserves required Multiple contraction of the money Multiple supply occurs supply Bank interest rates rise Bank Investment falls Y(e) falls GDP gap is closed through monetary GDP policy policy 56 INCREASED I(p) SHIFTS AD INCREASED SCHEDULE TO THE RIGHT SCHEDULE Price Level AS1 AD3 AD2 AD1 GDP 57 CHANGES IN THE DISCOUNT RATE 1. The discount rate: Is the rate of interest The FED District Banks charge commercial banks when the borrow excess reserves. 2. Commercial banks gain an additional 2. Commercial asset (excess reserves) and an additional liability (loan from FED) 3. Why would commercial banks borrow 3. Why excess reserves? A. To make profitable loans 4. Why would discount rate impact 4. Why decisions of commercial banks to borrow excess reserves? borrow A. Affects profitability of loans! 58 CHANGES IN THE DISCOUNT RATE: (continued) Bank A: Balance Sheet #1 Bank ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Loans $40M Bank A unable to extend additional loans Bank because no excess reserves are available. available. Bank A now borrows $5M from FED Bank Bank A: Balance Sheet #2 Bank ------------------------------------------------------Req. Res. $10M Deposits $50M Loans $40M FED loan $05M Excess. Res . $05M -----------------------Total $55M $55 M 59 CHANGES IN THE DISCOUNT RATE CHANGES (continued) (continued) Summary of Discount Rate Case #1: Shift AD Schedule to the right Case ¢ 1. 1. 2. 3. 4. 5. 6. 6. 7. 8. 8. FED lowers discount rate Commercial banks borrow excess Commercial reserves reserves Excess reserves loaned out Multiple expansion of money Multiple supply occurs supply Interest rates fall Interest I(p) rises Y(e) rises Y(e) GDP gap is closed GDP 60 CHANGES IN THE DISCOUNT RATE (continued) Case #2: Shift AD schedule to the left FED rises discount rate Commercial banks reduce their Commercial borrowings of excess reserves borrowings Fewer loans are made by banks Money supply declines Interest rates rise Y(e) falls Y(e) GDP gap is closed The discount rate as a signal to the The financial community. 61 CHANGES IN THE REQUIRED RESERVE RATIO Changes in the required reserve ratio: Changes Cause changes in the amount of Cause excess reserves excess Which changes the base upon Which which multiple changes in the money supply occur money Cause changes in the money Cause multiplier, which is equal to the reciprocal of the reserve requirement. requirement. If the reserve ratio rises, the If reciprocal of the reserve ratio falls. Reserve Ratio Money Multiplier 10% 10 10 20% 05 20% 62 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Banking System: Balance Sheet #1 ------------------------------------------------------Required Res. $10M Deposits $50M Loans $40M Result:: Money multiplier = 1/20% = 5 Result:: No excess reserves available No ---------------------------------------------------------Banking System: Balance Sheet #2 -----------------------------------------------------Required Res. $05M Deposits $50M Loans $40M Excess Res. $05M Result: Money multiplier = 1/10% = 10 Excess reserves = $5M Excess 63 CHANGES IN THE REQUIRED RESERVE RATIO (continued) 1. What is ultimate possible impact on What money supply of reduction in reserve requirement? A. (Increase in excess reserves) * A. (Increase (money multiplier) = total potential change in the money supply B. $5M * 10 = $50M possible change B. $5M 1. 1. Lowering reserve requirement: Lowering A. Increases excess reserves A. B. Increases value of money Increases multiplier C. Both work to increase the money C. Both supply supply 64 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Raising the reserve requirement: Reduces excess reserves Or, creates a shortage of required Or, reserves reserves Reduces the value of the money Reduces multiplier multiplier Both work to reduce the moneycreating potential of the banking creating system system 65 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Case #1: Shift AD Schedule to the Right 1. 2. 3. 4. 5. 6. 6. 7. 8. 8. Lower the reserve requirement Creates additional excess Creates reserves reserves Raises money multiplier Causes money supply to rise Causes interest rates to fall Causes Increases I(p) Increases Y(e) Increases Closes GDP gap 66 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Case #2: Shift AD Schedule to the Left Case Raise the reserve requirement Reduces excess reserves (or Reduces creates a shortage of required reserves) reserves) Reduces money multiplier Causes money supply to fall Causes interest rates to rise reduces(p) Reduces Y(e) Reduces Closes GDP gap 67 Review: Chapter 15 Review: 1. 1. Suppose the FED wants to Suppose increase aggregate expenditures. What policies should they follow? 2. 2. Suppose the FED wants to Suppose decrease aggregate expenditures. What policies should they follow? 3. 3. What factors could limit the What ability of monetary policy to change the level of aggregate expenditures? 68 68 CHAPTER 16 CHAPTER MONETARY POLICY MONETARY FALL, 2010 69 69 The DEMAND FOR MONEY What is meant by the “demand for What money?” Why would households be willing to Why hold a portion of their wealth in the form of money? A. A. B. C. C. Transactions demand Precautionary demand Speculative demand The total demand for money as a The function of the rate of interest function 70 THE TRANSACTIONS DEMAND M(t) M(t) B A GDP GDP1 GDP2 71 THE PRECAUTIONARY DEMAND M(p) M(p) GDP 72 THE SPECULATIVE DEMAND interest rate i(n) M(s) Money 73 THE TOTAL DEMAND FOR MONEY Text, p. 399 Interest. rate M(t) + M(p) M(t) + M(p) + M(s) i(1) M(Total) 0 Money A 74 GRAPH OF EQUILIBRIUM INTEREST GRAPH RATE: Text, p. 400 RATE: Interest Rate Money Supply Determined. by FED Equilibrium rate of interest. i(e) Demand for Money Money 75 THE EQUILIBRIUM INTEREST RATE 1. 1. The concept of equilibrium The 2. 2. The total demand for money The 3. 3. The supply of money given by the FED The 4. 4. How the equilibrium interest rates How changes as: A. The supply of money increases A. B. The supply of money decreases The C. See Exhibit 2, p. 402 C. 76 THE EQUILIBRIUM RATE OF INTEREST, P. 400 INTEREST, Figure 26.2 (Macro 16.2) THE EFFECTS OF CHANGES IN THE MONEY SUPPLY, P. 402 MONEY Figure 26.3 (Macro 16.3) REVIEW OF KEYNESIAN MONETARY REVIEW POLICIES: POLICIES: EXPANSIONARY POLICIES Initial situation: Recession 1. Recognize macro problem 1. 2. Select monetary policy (rather than 2. fiscal policy) 3. Select monetary tool: A. Lower Res. Req. A. B. Lower discount rate B. C. Open market purchases C. 4. Implement monetary policy A. Money supply rises A. B. Interest rate falls B. C. I(p) rises D. Aggregate demand shifts to right E. Real GDP and prices change E. 79 GRAPH OF EQUILIBRIUM INTEREST GRAPH RATE: RATE: Determined in the Money Market Interest Rate Money Supply Determined. by FED Equilibrium rate of interest. i(e) i2 MS2 Demand for Money Money 80 IMPACT OF CHANGE IN INTEREST IMPACT RATE ON INVESTMENT EXPENDITURES EXPENDITURES Interest Rate i(1) i(2) I(p) I(p) 81 INCREASED I(p) SHIFTS AD INCREASED SCHEDULE TO THE RIGHT SCHEDULE Price Level AS1 AD3 AD2 AD1 GDP 82 WEAKNESSES OF KEYNESIAN MONETARY WEAKNESSES POLICY in Recession POLICY Problem #1: the liquidity trap Suppose the interest rate does not fall as the money supply increases? Caused by a horizontal demand Caused function for money function Problem #2: insensitivity of I(p) to i rate Suppose I(p) does not increase as a result of a decline in the rate of interest? interest? Caused by a vertical investment Caused demand schedule demand Note: if changes in the money supply do Note: not change I(p), Keynesians believe monetary policy will not work. Monetary monetary Monetary policy is almost ineffective in today’s economic situation! 83 GRAPH OF THE LIQUIDITY TRAP interest Rate S1 S2 DD(M) Money 84 GRAPH OF I(p) UNRESPONSIVENESS TO GRAPH CHANGES IN INTEREST RATES CHANGES Interest rate I(p) 6% 3% I(p) Note: No change in planned investment expenditures as the rate of interest declines. 85 REVIEW OF KEYNESIAN MONETARY REVIEW POLICIES: POLICIES: Contractionary Policies Initial situation: Demand-Pull Inflation 1. Recognize macro problem 1. 2. Select monetary policy (rather than 2. fiscal policy) 3. Select monetary tool: A. Raise Res. Req. A. B. Raise discount rate B. C. Open market sales 4. Implement selected monetary 4. policy policy A. Money supply falls A. B. Interest rate rises B. C. I(p) falls D. Aggregate demand shifts to left E. Real GDP and prices change E. 86 Monetary vs. Fiscal Policies Fiscal (discretionary) Fiscal 1. Slow to implement 1. 2. Difficult to terminate 3. Subject to political process 3. 4. Effectiveness reduced by automatic 4. fiscal policy fiscal 5. Subject to upward-sloping AS 5. schedule 6. Subject to crowding out (unless 6. balanced-budget approach used) 7. Basic advantage—once implemented in a sufficient magnitude, it is most likely to move an economy out of a serious recession. A. Fiscal policy is not “permissive” B. Increases in G directly increased AD 87 Monetary vs. Fiscal Policies Monetary Policy (Keynesian) 1. Easy to implement 1. 2. Each to terminate 3. Not subject to political process 4. Is permissive: changes in M do not 4. directly or immediately shift the AD schedule schedule 5. Still subject to upward-sloping 5. AS schedule AS 6. Not subject to crowding out 7. Effectiveness depends on response: 7. A. I(p) to changes in interest rate, B. Responsiveness of interest rate to B. Responsiveness changes in money SS changes C. Feedback effect (see next page) 88 PRINCIPLES OF MONETARISM 1. Keynesians incorrectly describe how Keynesians incorrectly monetary policy works. 2. 2. Need to focus directly on the Need directly relationship between M(s) and GDP (rather than indirect relationship that depends on interest rate and I(p) changes) changes) 3. The Quantity Theory of Money (the The equation of exchange) equation A. B. C. C. D. E. E. MV = PQ = GDP where: M = Money supply Money V = Velocity of money P = Price level Price Q = Real GDP Real 89 THREE VIEWS OF THE QUANTITY THEORY (1) As an identity (early Classical theory) (1) identity MV ≡ PQ (true by definition) MV Total spending ≡ total spending! Total Relates to circular flow graph (2) As a theory of the price level (later price Classical theory ) MV = PQ = GDP MV Requires certain assumptions about Requires V (fixed)and Q (fixed) (3) As a theory of the demand for money (Monetarists) Requires only certain assumptions about V (predictable) and 90 Q. about QUANTITY THEORY AS A THEORY OF THE QUANTITY PRICE LEVEL (Classical View) PRICE Assume the following: Assume Economy at full employment GDP so Q Economy is fixed V is fixed by assumption Then: M and P are proportionately Then: related. related. Numerical example: M = 100; V = 4; Q = 200; P = $2 100; MV = PQ $100 * 4 = $2 * 200 Note: If M doubles to $200, then P Note: doubles to $4 because Q and V are fixed fixed In this case the quantity of money In determines the price level at full employment output levels. 91 THE CLASSICAL (VERTICAL) AGGREGATE SUPPLY SCHEDULE, P. 239 239 Figure 20.4 (Macro 10.4) THE MONETARISTS MONEY POLICY TRANSMISSION MECHANISM, P. 391 TRANSMISSION Figure 26.6 (Macro 16.6) AS-AD GRAPH OF MONETARISM AS-AD IN THE SHORT-RUN Price Level AS AS AD1 AD2 GDP1 REAL GDP GDP2 94 MODERN QUANTITY THEORY AS A MODERN THEORY OF THE DEMAND FOR MONEY (Demand for Money Depends only on GDP) (Demand (1) MV = GDP Now divided by sides by V (2) M(d) = GDP/V (note: no speculative (2) demand for money in this theory) (3) M(s) = M(Fed) given by the FED (4) M(s) = M(d) [for equilibrium] (4) Then, by substituting (2) and (3) into (4) (5) M(Fed) = GDP/V (5) (6) M(Fed) * V = GDP (7) ∆ in M(Fed) * V = ∆ GDP 95 Note: Assumes V is fixed or predictable Note: NUMERICAL EXAMPLE OF QUANTITY NUMERICAL THEORY THEORY (1) MV = GDP (2) Let M = $100; V = 4;GDP = $400 (3) Then let M change to $200 (3) (200) * (4) = $800 (4) The change in GDP from $400 to $800 (4) could result in: could Higher prices only Higher Higher output only Both higher prices and higher output (5) Need AD = AS graph to determine (5) division into P and Q components. division 96 DEMAND FOR MONEY IN DEMAND MONETARIST THEORY MONETARIST MONEY MD MD2 MS2 MS1 MD1 GDP GDP1 GDP2 97 AS-AD GRAPH OF MONETARISM AS-AD IN THE LONG-RUN IN LRAS SRAS Price Level AD1 AD3 AS0 AD2 REAL GDP MONETARISTS FIRST SCHOOL TO DISTINGISH BETWEEN SHORT AND LONGRUN EFFECTS OF CHANGE IN AGGREGATE 98 DEMAND ON P AND Q PRINCIPLES OF MONETARISM (1) If M(s) rises, either P and/or Q must rise if V is constant. (See SRAS in previous slide) previous (2) The velocity of money is either: (2) Fixed; 0R Predictable; OR At least more Fixed 0R Predictable OR predictable than the Keynesian MPC predictable which determines the value of the expenditures multiplier (see graph next slide) next (3) Changes in M(s) affect total spending, (3) not interest rates (4) (4) In short-run Q is not fixed so change in In M can lead to change in P or Q or both! can (5) In long-run Q is fixed at full In employment so that ∆ ’s in M can lead ’s only to ∆ ’s in the price level. 99 The Velocity of Money, (M1 and M2 The definitions), P. 409 definitions), V based on M2 Figure 26.7 (Macro 16.7) 100 MONETARIST POLICIES (1) Increase M(s) at the rate of growth of (1) real GDP Announce the policy in advance Announce This will facilitate a stable price level This while real GDP is growing while (2) Do not attempt to use monetary policy to close inflationary or deflationary gaps. The FED should not engage in “contraThe cyclical policies cyclical The FED should ignore short-term changes in interest rates or the demand for money demand (3) Example: Monetary policy during (3) the depression of the 1930’s the 101 COMPARISONS OF COMPARISONS MACROECONOMIC VIEWS MACROECONOMIC Classical views Wages and prices will adjust to Wages ensure that Y(f) is achieved. Long Run aggregate supply schedule is vertical Stabilization policy not needed Keynesian Views Keynesian Wages and prices fixed (or nearly so) until Y(f) is achieved Short-run aggregate supply schedule is nearly L-shaped Monetary policy may not be effective in severe recessions in Crowding out unlikely to occur 102 COMPARISONS OF COMPARISONS MACROECONOMIC VIEWS MACROECONOMIC (continued) (continued) Monetarism Monetarism 1. Fiscal policy unlikely to be Fiscal effective because crowding out is a serious problem. 2. 2. Long-run aggregate supply Long-run schedule is vertical. 3. 3. Traditional monetary and fiscal Traditional policies affect only the price level in the long run in 4. Money-supply rule is to be 4. followed and announced in advanced advanced 103 END OF CHAPTER 16 LECTURE QUESTIONS???????? 104 104 EQUILIBRIUM IN THE MONETARIST MODEL MS(1) = MD(1) MS(1) = MD2 The original money market equilibrium is where MS1 = MD1. The FED increases the money supply and GDP rises to GDP2. The quantity of money demanded as GDP rises until MS(2) = MD(2) Interest Rate Money Original equilibrium New equilibrium 105 FEEDBACK EFFECTS OF MONETARY POLICY Interest. rate S(FED) 1 S(FED) 2 i(1) I(3) M(total)2 I(2) M(Total)1 0 Money 106 PUTTING IT ALL TOGETHER: EQUILIBRIUM IN THE PUTTING “REAL” AND “FINANCIAL SECTORS “REAL” INTEREST RATE M(s) = M(d) Full Employment GDP I (1) Saving =Inves tment Y(e) Y(f) GDP 107 107 ...
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This note was uploaded on 01/12/2012 for the course ECN 211 taught by Professor Kingston during the Spring '08 term at ASU.

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