macro presentation 15 top 5 revised

8/13/2019 Macro Presentation 15 Top 5 Revised

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Macroeconomics

Unit 15

Monetary Policy and Theory

The Top Five Concepts


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Introduction

This unit discusses another economic policy tool calledmonetary theory. Similar to fiscal policy or Keynesian theory itfocuses on demand. However, its main emphasis is controllingthe demand for moneyby consumers and businesses.

In the United States, monetary policy and the tools used tocontrol the supply of money are controlled and implemented bythe Federal Reserve.


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Concept 1: The Money Market

Money is confronted with its own demand and supply curve.

The demand and supply of money is controlled through theinterest rate.

The interest ratein this case is the price paid for the use of

money. The amount of money demanded is based upon theinterest rate. Think of the interest rate as the cost of money.When interest rates are low, borrowing money to buy a home orcar is less expensive. When interest rates are higher, your cost(and monthly payment) increases.

There are three types of demand for money: transactions,precautionary, and speculative.


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Concept 1: Money Demand

Transactions demandThis is money that is being held for

the purpose of making everyday market purchases.

Examples of routine market purchases include paying for gas,buying lunch, shopping for clothes, buying a home.

Payments are made using cash, check, debit card, credit card,and loans.

Think about the money that you have in your wallet or purse,and in your checking account. Chances are this money is foryour routine transactions that occur every day.


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Precautionary demandThis is money held in reserve for

unexpected needs or purchases, and emergencies.

Examples include money held in certificates of deposit, extracash kept in a checking account, and extra cash kept in a

money market account or a savings account.

Uses of money for precautionary demand included unexpectedillnesses, a great deal on some new electronic equipment, orthe unexpected loss of a car or home not adequately coveredby insurance. Most people think of this money as theiremergency money although it can also be used to takeadvantage of a great bargain.


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Speculative demandThis is themoney you keep in reserve for laterfinancial opportunities or speculation.

For example, extra cash in the bankreserved for when stocks fall to acertain price. Its also the extra cash

being held to buy some property whenthe price falls enough. Or, it could be

the extra cash you use to invest in afriends business.


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The three different types of demand affect the market demand

for money.

The market demand curve for moneyindicates that as theprice of money falls (the cost in terms of the interest rate), the

demand for money will increase.

The supply of moneyis fixed by current monetary policyinitiated and controlled by the Federal Reserve. So in regardsto the money supply, the supply curve is vertical, while thedemand for money is a downward sloping curve.


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The Demand For Money

Money supply

0Inte

restRate(percentperyear)

Moneydemand

Quantity Of Money (billions of dollars)

The amount of moneydemanded (held) depends

on interest rates

Equilibrium


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Concept 2: Money Equilibrium

At the equilibrium point the demand and supply of money

intersect indicating that people are willing to hold as muchmoney as is available.

If interest rates increase, then money will be transferred to

other markets, like the bond market. The demand for moneyfalls.

The equilibrium pointrepresents the equilibrium rate ofinterest indicating the interest rate at which the demand andsupply of money are equal.


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Concept 2: Changes to Equilibrium

Federal Reserve policy can have an impact on the equilibrium

rate of interest.

The Federal Reserve can increase the supply of money by:

lowering the reserve requirement lowering the discount rate

buying bonds in the open market

The increase in the supply of money causes the equilibriumrate of interest to fall.


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Changing Interest Rates

Demand formoney

E1E2

Quantity Of Money (billions of dollars)

InterestRate(percentperyear)

76

0

When rates drop from 7% to 6%, there is movement along thedemand curve to the right. The demand for money increases.


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Economic Effects

Federal Reserve policy changes have an effect on aggregate

demand.

Monetary stimulusis achieved by the Federal Reservethrough:

Increasing the supply of money.

Reducing interest rates.

Buying bonds in the market.

As a rule, a 1/10 point reduction in long-term interest rates canproduce $10 billion dollars in fiscal stimulus according to AlanGreenspan, former chair of the Federal Reserve.


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Economic Effects

Federal Reserve policy can also be used to restrain the

economy.

To reduce aggregate demand, the Federal Reserve can:

Decrease the money supply.Increase interest rates.

Sell more bonds at attractive prices.

All three policy changes will cause a leftward shift in aggregatedemand.


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Concept 3: Policy Constraints

Changes in short-term interest rates (federal funds rates, 6

month Treasury bonds) need to produce changes in long-terminterest rates. Long-term interest rates are the rates on homemortgages, installment loans, 10 year Treasury bonds, etc.

Most Federal Reserve Open Market operations focus on short-term rates.

In order to have a lasting effect on the economy, long-termrates need to change as well as short-term rates. The success

of Federal Reserve policy changes is often measured bychanges in long-term interest rates.


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Concept 3: Policy Constraints

Long-term rates may not change as fast or as much due to the

following:

Reluctant LendersPrivate banks may not be willing toincrease their lending activity. They may be concerned about

consumer or business credit quality and/or general economicconditions.

Liquidity TrapIf interest rates are already low, people maycontinue to hold money waiting for better investment options,

and not seek loans or conduct additional spending. At thispoint the demand curve is horizontal and increases in thesupply of money do not push rates lower.


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Concept 4: Monetarists

Keynes believed changes in the money supply can affect

aggregate demand. Changes in the supply of money occurwhen interest rates change.

Monetaristsbelieve that changes in short-term interest rates

(like the discount rate and federal funds rate) do not have asignificant effect on the supply of money. They believe thechanges in these rates affect the price of money.

Monetarists believe that monetary policy is not effective for

recessionary problems, but is effective against inflation.


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Concept 4: Equation of Exchange

V indicates the number of times per year, on average, a dollar

is used to purchase final goods and services.

Monetarists believe that V is stable and does not change overthe long run.

M X V = P X Q

Any change that occurs in M indicates a change will also occurin P and/or Q. The equation must remain in balance.

Monetarists believe that any change in the supply of money (M)will alter total spending (PQ), even if interest rates change.


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Concept 5: Monetary Theory

Monetarists believe that Federal Reserve policy should be

directed at increasing/decreasing the supply of money, not atchanging interest rates.

Expanding upon the basic theories of monetarists, somebelieve that Q is stable too. Under this theory, a natural rate ofunemployment exists within the economy that is not affected byshort term monetary policy changes.

If this is true, then some monetarists believe that changes in M

will lead to changes only in P.


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Concept 5: Monetary Theory

Monetarists believe that the real rate of interest is stable and

that changes in nominal interest rates are caused by changesin the anticipated rate of inflation.

If inflation exists, monetarists believe that a reduction in thesupply of money will lessen inflation. As the supply of money isgradually reduced by the Federal Reserve through open marketoperations and/or changes in the reserve ratio, nominal interestrates will fall.

Keynesians believe that increasing interest rates (discount and

federal funds rate) is an effective method to lessen inflation.


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Concept 5: Monetary Policy

For recessionary problems, monetarists believe that increasing

the supply of money or reducing interest rates is not aneffective way to end recessions.

Keynesians believe that lowering rates and increasing thesupply of money (M) can help eliminate a recession, along withfiscal policy changes.

Monetarists believe that increasing the supply of money (M)could cause an increase in prices (P). Rising prices and

interest rates would stall any economic recovery.

Monetarists Keynesians


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MonetaristsKeynesians

Comparison

MonetaristsChanges in interest rates do not affect the

supply of money. To change the money supply, you need tochange bond prices through the buying and selling of bonds bythe Federal Reserve, or change the bank reserve requirements(reserve ratio).

KeynesiansChanges in interest rates do affect the supplyand demand for money. They prefer interest rate changes butwill also support selling/buying of bonds to change the supply ofmoney. Interest rate changes are used to supplement fiscal

policy tools (government spending, taxes, transfer payments).


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Further Analysis

When interest rates fall, borrowers are very happy. Interest

rates on mortgages and car loans fall which increases lendingactivity and new purchases.

Banks and other lenders receive lower income from lendingactivity as interest rates fall. However it is important to examinethe real rate of interest again. During a period of higher rates, abank may have been loaning money for mortgages at 9% wheninflation was at 6%; the real rate of interest is 3%. If bothnominal interest rates and the inflation rate falls, the bank may

be loaning money for mortgages at 5%, but if the rate ofinflation is only 2%, then the real rate of interest remains at 3%.


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Further Analysis

So is anyone not happy about lower interest rates? Well the

banks and other lenders may not be if the real interest rate hasfallen. Their profits are likely to be lower.

Individuals who have investments in savings account, CDs,money market accounts, and Treasury bills will receive lowerrates of interest on their savings and investments. Theirincomes will be lower as a result.


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macro presentation 15 top 5 revised

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