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Unformatted text preview: CHAPTER 16 CHAPTER MONETARY POLICY MONETARY Spring, 2011 1 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 2 THE TRANSACTIONS DEMAND M(t) M(t) B A GDP GDP1 GDP2 3 THE PRECAUTIONARY DEMAND M(p) M(p) GDP 4 THE SPECULATIVE DEMAND interest rate i(n) M(s) Money 5 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 6 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 7 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. 8 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. 11 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 12 IMPACT OF CHANGE IN INTEREST IMPACT RATE ON INVESTMENT EXPENDITURES EXPENDITURES Interest Rate i(1) i(2) I(p) I(p) 13 INCREASED I(p) SHIFTS AD INCREASED SCHEDULE TO THE RIGHT SCHEDULE Price Level AS1 AD3 AD2 AD1 GDP 14 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! 15 GRAPH OF THE LIQUIDITY TRAP interest Rate S1 S2 DD(M) Money 16 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. 17 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. 18 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 19 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) 20 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 21 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 22 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. 23 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 26 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 27 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 28 DEMAND FOR MONEY IN DEMAND MONETARIST THEORY MONETARIST MONEY MD MD2 MS2 MS1 MD1 GDP GDP1 GDP2 29 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 30 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. 31 The Velocity of Money, (M1 and M2 The definitions), P. 409 definitions), V based on M2 Figure 26.7 (Macro 16.7) 32 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 33 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 34 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 35 END OF CHAPTER 16 LECTURE QUESTIONS???????? 36 36 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 37 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 Money 0 38 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 39 39 ...
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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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