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Monetary Policy Chapter 15(30)

THIRD EDITION

ECONOMICS and

MACROECONOMICS Paul Krugman | Robin Wells

•  What the money demand curve is •  Why the liquidity preference model

determines the interest rate in the short run

•  How the Federal Reserve can implement monetary policy moving the interest rate to affect aggregate output

•  Why monetary policy is the main tool for stabilizing the economy

•  How the behavior of the Federal Reserve compares with that of other central banks

•  Why economists believe in monetary neutrality — that monetary policy affects only the price level, not aggregate output, in the long run

WHAT YOU WILL LEARN IN THIS CHAPTER

M

QuanQty of money

Interest rate, r

Nominal Money supply

curve, MS

M1 = C + D = (R+C) * Multiplier

Money supply chosen by the Fed

The Money Market – Money Supply

M

QuanQty of money

Interest rate, r


curve, MS




Monetary Base

M

QuanQty of money

Interest rate, r


curve, MS




Monetary Base

M1 Money Multiplier 1 + k _______________ rr + er + k

M1 M2

QuanQty of money

Interest rate, r Increase in the Nominal

Money supply M1 = C + D = ( ñR+C) *

The Money Market – Money Supply Increase

•  Open Market Purchase Monetary Base •  Discount Rate

1 + k ____________ êrr + er + k

r1

•  Required Reserve Ratio Multiplier

1 2

M2 M1

QuanQty of money

Interest rate, r Decrease in the

Nominal Money supply M1 = C + D = ( êR+C) *

The Money Market – Money Supply Decrease

•  Open Market Sale Monetary Base •  Discount Rate

1 + k ____________ ñrr + er + k

r1

•  Required Reserve Ratio Multiplier

1 2

r

MD(Y)

QuanQty of money

Interest rate, r

Money Demand – in 5 minutes Keynes: Three MoQves for Liquidity Preference •  TransacQons MoQve: to bridge the gap between income receipts and payment commitments •  PrecauQonary: the desire for security as a future cash equivalent of total resources •  SpeculaQve: the object of securing a profit from knowing beaer than the market what the

future will bring

Md = L1 ( Y ) + L2 ( r ) + −

Money and Interest Rates

•  According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money.

•  The money supply curve shows how the nominal quanNty of money supplied varies with the interest rate.

M

r H

r E

r L

L E

MD

M H M L

H

QuanQty of money

Interest rate, r

Equilibrium interest rate

Money supply curve, MS

Equilibrium


Equilibrium in the Money Market

M

r H

r E

r L

L E

MD

M L

H

QuanQty of money

Interest rate, r

Equilibrium interest rate


Equilibrium



Md < Ms Buy Bonds; éP bonds è êr

Md > Ms Sell Bonds; êP bonds è ér

M

r H

r E

r L

L E

MD

M H M L

H

QuanQty of money

Interest rate, r


Equilibrium



1

M2

2

MS2

An increase in the money

supply . . .

r1

MS1

MD

M1 Quantity of money

Interest rate, r

. . . leads to a fall in the

interest rate.

Increase

r2 3

1.  Ms = Md Equilibrium Shock : Increase in the Ms at r1

2.  Ms > Md Disequilibrium at r1 Excess Liquidity

Buy Bonds è éP bonds è êr

3.  From 1 to 3 a movement down along the Md curve to new equilibrium at point 3

Bonds

Bd1

Bd2 P 1

P 2bonds

3

M1

2

MS1

A Decrease in the money

supply . . .

r2

MS2

MD

M2 Quantity of money

Interest rate, r

. . . leads to A rise in the

interest rate.

Decrease

r1 1

1.  Ms = Md Equilibrium Shock : Decrease in the Ms at r1

2.  Ms < Md Disequilibrium at r1 Illiquid

Sell Bonds è êP bonds è ér

3.  From 1 to 3 a movement up along the Md curve to new equilibrium at point 3

Bonds

Bd

P 2

P 1bonds

Bs Bs ‘

Pi^alls

The Target versus the Market

•  A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works.

•  You’ll someNmes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate.

Pi^alls

The Target versus the Market

•  In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money.

•  The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate.

•  It’s important not to confuse a change in the Fed’s operaNng procedure with a change in the way the economy works.

Se_ng the Federal Funds Rate

Pushing the Interest Rate Down to the Target Rate

The target federal funds rate is the Federal Reserve’s

desired federal funds rate.

M

r 1 r

E 1

MS 1

MD

M 1 Quantity of money

Interest rate, r

E 2

2

MS 2

An open-market purchase . . .

T

. . . drives the interest rate

down.

Se_ng the Federal Funds Rate

Pushing the Interest Rate Up to the Target Rate

M 1

r 1 E 1

E

MD

MS 1

Quantity of money

Interest rate, r

2

MS 2

M 2

An open-market sale . . .

r T . . . drives the interest rate

up.

•  Long-‐term interest rates don’t necessarily move with short-‐term interest rates.

•  If investors expect short-‐term interest rates to rise, investors may buy short-‐term bonds.

•  In pracNce, long-‐term interest rates reflect the average expectaNon in the market about what’s going to happen to short-‐term rates in the future.

Long-‐Term Interest Rates

ECONOMICS IN ACTION

The Fed Reverses Course

•  On August 7, 2007, the Federal Open Market Commiaee decided to stand pat, making no change in its interest rate policy.

•  On September 18, the Fed cut the target federal funds rate “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disrupNons in financial markets.”

ECONOMICS IN ACTION


•  Given the increases in interest rates prior to 2007, this was a reversal of previous policy: previously, the Fed had generally been raising rates, not reducing them, out of concern that inflaNon might become a problem (more on that later in this chapter).

•  StarNng in September 2007, fighNng the financial crisis took priority.

The Fed Moves Interest Rates

Monetary Policy and Aggregate Demand

§  Expansionary monetary policy is monetary policy that increases aggregate demand.

§  ContracQonary monetary policy is monetary policy that reduces aggregate demand.

Expansionary and ContracQonary Monetary Policy

Monetary Policy and Aggregate Demand

AD 1 AD 1 AD 2

AD 3

Real GDP Real GDP

Aggregate price level

(a) Expansionary Monetary Policy (b) Contractionary Monetary Policy


Expansionary and ContracQonary Monetary Policy in the Income-‐Expenditure Model

Y 1

AE 1

Y 1

AE 1

Real GDP

Planned aggregate spending

Real GDP

Planned aggregate spending

(a) Expansionary Monetary Policy (b) Contractionary Monetary Policy

45-degree line 45-degree line

Y 2

AE 2

Y 2

AE 2

Expansionary Monetary Policy to Fight a Recessionary Gap

ContracQonary Monetary Policy to Fight an InflaQonary Gap

Monetary Policy and the MulQplier

Tracking Monetary Policy

Tracking Monetary Policy

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Federal funds rate

Year

Federal funds rate (Taylor rule)

InflaQon TargeQng

•  InflaQon targeQng occurs when the central bank sets an explicit target for the inflaNon rate and sets monetary policy to hit that target.

GLOBAL COMPARISON: InflaQon Targets

ECONOMICS IN ACTION

What the Fed Wants, the Fed Gets

•  ContracNonary monetary policy is someNmes used to eliminate inflaNon that has become embedded in the economy.

•  In this case, the Fed needs to create a recessionary gap—not just eliminate an inflaNonary gap—to wring embedded inflaNon out of the economy.

ECONOMICS IN ACTION

What the Fed Wants, the Fed Gets

•  In four of the five cases that ChrisNna Romer and David Romer examined, the decision to contract the economy was followed, aser a modest lag, by a rise in the unemployment rate.

•  On average, they found that the unemployment rate rises by 2 percentage points aser the Fed decides that unemployment needs to go up. §  So, the Fed gets what it wants.

ECONOMICS IN ACTION

When the Fed Wants a Recession

Money, Output, and Prices in the Long Run

S R

S R AS 1

L R AS

Y 1

E 3

E 1 P 1


Real GDP

Potential output

AS 2

P 3 . . . but the eventual rise in nominal wages

leads to a fall in short-run aggregate

supply and aggregate output falls back to

potential output.

Y 2

E 2 P 2

AD 2

An increase in the money supply reduces

the interest rate and increases aggregate

demand . . .

AD 1

Monetary Neutrality

•  In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate.

•  In fact, there is monetary neutrality: changes in the money supply have no real effect on the economy. So, monetary policy is ineffectual in the long run.

The Long-‐Run DeterminaQon of the Interest Rate

QuanQty of money

r 1

MD 1

MS 1

M 1

E 3 E 1

Interest rate, r

r 2

E 2

MS 2

M 2

An increase in the money supply lowers the interest rate in the

short run…

MD 2

…but in the long run higher prices lead to greater money demand, raising the interest

rate to its original level.

ECONOMICS IN ACTION

InternaQonal Evidence of Monetary Neutrality

•  All of the major central banks try to keep the aggregate price level roughly stable.

•  However, if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. §  Between 1970 and the present, the money supply rose only a few percent per year in some countries.

ECONOMICS IN ACTION

InternaQonal Evidence of Monetary Neutrality

•  The figure on the next slide shows the annual percentage increases in the money supply and average annual increases in the aggregate price.

•  The scaaer of points clearly lies close to a 45-‐degree line, showing a more or less proporNonal relaNonship between money and the aggregate price level. §  The data support the concept of monetary neutrality in the long run.

The Long-‐Run RelaQonship Between Money and InflaQon

1.  The money demand curve arises from a trade-‐off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short-‐term interest rates, not long-‐term interest rates. Changes in the aggregate price level, real GDP, technology, and insNtuNons shis the money demand curve.

Summary

2.  According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shising the money supply curve. In pracNce, the Fed uses open-‐market operaNons to achieve a target federal funds rate, which other short-‐term interest rates generally track.

Summary

3.   Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. ContracQonary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run.

Summary

4.  The Federal Reserve and other central banks try to stabilize the economy, limiNng fluctuaNons of actual output around potenNal output, while also keeping inflaNon low but posiNve. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflaNon, or a posiNve output gap, or both; the target interest rate falls when inflaNon is low or negaNve, or when the output gap is negaNve, or both.

Summary

4.  (Cont.) Some central banks engage in inflaQon targeQng, which is a forward-‐looking policy rule, whereas the Taylor rule is a backward-‐looking policy rule. In pracNce, the Fed appears to operate on a loosely defined version of the Taylor rule. Because monetary policy is subject to fewer implementaNon lags than fiscal policy, it is the preferred policy tool for stabilizing the economy.

Summary

5.  In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run.

Summary

•  Short-‐term interest rates •  Long-‐term interest rates •  Money demand curve •  Liquidity preference model

of the interest rate •  Money supply curve •  Target federal funds rate •  Expansionary monetary

policy •  ContracNonary monetary

policy

•  Taylor rule for monetary policy

•  InflaNon targeNng •  Monetary neutrality

Key Terms

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