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: DemandPull 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 upwardsloping AS
5.
schedule
6. Subject to crowding out (unless
6.
balancedbudget 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 upwardsloping
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) ASAD GRAPH OF MONETARISM
ASAD
IN THE SHORTRUN 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 ASAD GRAPH OF MONETARISM
ASAD
IN THE LONGRUN
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 shortrun Q is not fixed so change in
In
M can lead to change in P or Q or both!
can (5) In longrun 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 shortterm
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
Shortrun aggregate supply schedule
is nearly Lshaped
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. Longrun aggregate supply
Longrun
schedule is vertical. 3.
3. Traditional monetary and fiscal
Traditional
policies affect only the price level
in the long run
in 4. Moneysupply 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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 Spring '08
 Kingston
 Macroeconomics, Inflation, Interest Rates, Monetary Policy, Keynesian economics

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