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econ ch14: Modern Macro & Monetary Policy
Terms in this set (81)
DEMAND & SUPPLY OF MONEY
1950's, erratic monetary policy was primary source of economic instability & inflation
changes in money supply short run= big influence
changes in money supply long run=only affects price level
"Role of Monetary Policy" 1967;
"Every major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation episode has been produced by monetary expansion"
1976 Nobel Prize; most influential spokesman for free market economy; developed modern view of monetary policy
Milton Freidman on Great Depression
Monetary History of the United States (1963) with Anna Schwartz:
result of perverse monetary policy rather than a defective market economies
precautionary motive for money holding
unexpected expenses; accidents, etc
Do higher or lower interest rates make it more costly to hold money?
10% interest rate when money doesn't earn interest
will cost $100 per year to hold an additional $1,000 of non-interest-earning money
1% interest rate when money doesn't earn interest
will cost $10 annually to hold $1,000
opportunity cost of holding money is directly related to...
nominal interest rate
demand for money
A curve that indicates the relationship between the interest rate and the quantity of money people want to hold. Because higher interest rates increase the opportunity cost of holding money, the quantity of money demanded will be inversely related to the interest rate.
as interest rates rise...
individuals/businesses will try to manage their affairs with smaller money balances
high interest rates make it more costly to hold money, as opposed to holding...
interest earning assets (saving deposits, treasury securities)
Who is the monetary authority?
the Fed; controls through open market operations, extension of loans, and reserve requirements
demand for money balance increases when...
nominal value of transactions increases;
as wages increase, prices increase, so people need more money for regular life
prices remain constant but quantity of goods bought and sold increases...
larger money balance needed
NOMINAL GDP INCREASE
(result of either higher prices or growth of real output)
shifts curve to right;
demand for money increases
NOMINAL GDP DECREASE
shifts curve to left;
decreases demand for money
credit cards & short term loans...
shifts entire curve to left because people don't need as much money to make transactions
changes in the interest rate (do/do not) alter the Fed's ability to determine the money supply
vertical supply curve reflects that
the quantity of money is determined by Fed policy, and the Fed's ability to set the money supply is unaffected by the interest rate.
EQUILIBRIUM BETWEEN MONEY DEMAND & MONEY SUPPLY
money interest rate moves toward equilibrium when...
quantity of money demanded by households and business will equal the quantity of money supplied by the Fed
higher bond prices implies (higher/lower) interest rates
above equilibrium money interest rate=
people don't want to hold as much money --> people try to reduce money balances by buying bonds -->increases demand for bonds -->bond prices go up and interest rates go down ---------->
money interest rate will move toward equilibrium
below equilibrium money interest rate=
people want to hold more money, so excess demand for money will be present--> people sell some of their bonds to get money --> this reduces bond prices & puts upward pressure (rates move up) on interest rates --> interest rates will move toward equilibrium
HOW DOES MONETARY POLICY AFFECT THE ECONOMY
expansionary monetary policy
A shift in monetary policy designed to stimulate aggregate demand. Injection of additional bank reserves, lower short-term interest rates, and acceleration in the growth rate of the money supply are indicators of a more expansionary monetary policy.
How does Fed shift to a more expansionary monetary policy?
buy bonds issued by the U.S. Treasury or a financial institution. The Fed will pay for the bonds by writing a check on itself, thereby creating money out of thin air; and as the check clears, it will also make additional reserves available to the banks.
when the money interest rate is equal to the real interest rate...
rate of inflation is zero
Fed shifts to expansionary monetary policy...
Fed buys bonds-->this supplies banking system with additional reserves----->
both the bond purchases and the banks use of the additional reserves to extend new loans will INCREASE the supply of loanable funds & move interest rates down...
as interest rates fall, aggregate demand will increase--->since the expansion was unanticipated, the AD expansion will increase current output and inflation (higher prices) in the short run
How will the Fed's bond purchases, the creation of additional bank reserves, and a lower real interest rate influence the demand for goods and services?
aggregate demand will increase (curve shifts outward)
What factors contribute to this increase in AD?
1. The lower real interest rate will make current investment and consumption cheaper.
2. The lower interest rate will tend to cause financial capital to move abroad, the foreign exchange rate of the dollar to depreciate, and net exports to expand.
3. The lower interest rate will tend to increase asset prices—for example, the prices of stocks and houses—which will also increase aggregate demand.
interest rate transmission mechanism of monetary policy (number 3 above)
when the Fed purchases bonds and expands the availability of bank reserves the real interest rate will decline -->leads to an increase in investment & consumption, depreciation in foreign exchange value of dollar, and high asset prices---->
this all stimulates AD, output, and employment
EFFECTS OF AN UNANTICIPATED EXPANSIONARY MONETARY POLICY
If people do not anticipate the increase in aggregate demand accompanying an expansionary monetary policy, the prices of products will...
rise more quickly than the costs of producing them in the short run-->so, profit margins of businesses will improve, who will respond by expanding their output
expansionary monetary policy (aka increase in AD) when economy is operating below capacity (output less than full employment)
helps direct economy to long-run full employment equilibrium, curve shifts right, this is long term
expansionary monetary policy (aka increase in AD) when economy is operating at capacity (output is at full employment)
inflation; excess demand & higher product prices, output temporarily increases, BUT IN THE LONG RUN resource prices will move up --> shifting short run aggregate supply curve to the left, price level will rise, and output will recede from its temporary high
How will an expansion of the money supply by the Fed influence the price level and output if the economy is already at full employment?
* temporarily increases output, but only leads to higher prices in the long run
an unanticipated shift to a more expansionary monetary policy will increase aggregate demand, causing the prices of products to rise relative to the costs of making them;
real output will initially increase beyond the economies long run capacity-->new agreements will be made to reflect new stronger demand--> resource costs will rise which will push up product costs-->this will shift short SRAS curve up & left-->new long run equilibrium will be established at higher price level (move up), output will fall (shift left)
EFFECTS OF AN UNANTICIPATED RESTRICTIVE MONETARY POLICY
restrictive monetary policy
A shift in monetary policy designed to reduce aggregate demand and put downward pressure on the general level of prices (or the rate of inflation). A reduction in bank reserves, higher short-term interest rates, and a reduction in the growth rate of the money supply are indicators of a more restrictive monetary policy.
how restrictive monetary policy works:
all of these reduce aggregate demand >
Fed sells bonds, this reduces supply of money & reserves of banks-->selling bonds increases their supply & lowers their prices, drains reserves from banking system, which makes loans from banks less available-->since supply of loanable funds fall, interest rates rise-->high interest rate reduces spending on investments, causes inflow of capital form abroad, appreciation in exchange rate of dollar-->appreciation of dollar means more imports and less exports
short run effects of unanticipated restrictive monetary policy
price level declines (shifts down)
output will fall (shift left, or in)
AD curve shifts left;
lowers prices, squeezes profit margins, reduces output
which policy is best to fight against inflation when there is an upward pressure on prices due to strong demand?
restrictive monetary policy (reduces/increases) aggregate demand
restrictive policy to control inflation
(economy operating above employment)
if economy is operating above full employment, the policy can limit or even prevent inflation;
shifts AD curve down, shifts all curves down, in, or left
restrictive policy that causes a recession
(economy operating at full employment)
if economy is operating at full employment; reduces output, reduces AD-->causes economy to fall below full employment and enter recession
MONETARY POLICY IN THE LONG RUN
QUANTITY THEORY OF MONEY
"quantity theory of money"
Alfred Marshall and American Irving Fisher
increase in the money supply will cause a proportional increase in the price level;
excessive money growth leads to inflation
GDP = PY
AD-AS model of GDP
GDP= economies nominal gdp
P= price, or price level
Y= output, or real income/real gdp
GDP = MV
GDP= economies nominal gdp
M= money stock
V= velocity of money
"quantity theory equation"
"MV = PY"
rate of inflation + growth rate of real output = growth rate of money supply + growth rate of velocity
equation of exchange; reflects monetary & real side of each final product exchange
Velocity of Money, V
average number of times a dollar is used to purchase a final good/service;
rate of money exchange
increase in velocity of money
demand for money declines; each specific dollar is being used more often
reduction in velocity of money
increase in demand for money
Y (real output, labor force, technology) & V (velocity, determined by institution factors) were constant because they were unrelated to changes in money supply, MAYBE changing in small amounts of periods of 2, 3, 4 years
since MV=PY is constant...
an increase in the money supply (M) will lead to a proportional increase in the price level (P). Correspondingly, an increase in the growth rate of the money supply can be expected to cause a similar increase in the rate of inflation.
LONG-RUN IMPACT OF MONETARY POLICY: THE MODERN VIEW
following examples based on economy where:
2) real GDP is growing by 3% annually
b) velocity is constant
c) conditions a and b imply that:
3% annual increase in demand for money, so zero inflation
d) assume economys' real interest rate os 4%, so nominal rate of interest is also 4%
long-run effects of rapid expansion in money supply: goods & service market
AD & AS shift upward, leading to higher prices & sustained inflation
increases AD (shifts out); at first, real output may expand beyond economies potential, but low unemployment & strong demand will raise wages and other resource prices, which will shift AS upward-->price level increases
long-run effects of rapid expansion in money supply: loanable funds market
*higher expected rate of inflation increases money interest rate
if real rate is 4%:
rapid expansion leads to long-term 5% inflation rate, borrowers & lends will add this into their decision making, so
-->real 4% rate + 5% inflationary premium leads to a nominal interest rate of 9%
^affect on supply of loanable funds
curve shifts vertically by expected rate of inflation (5%)
*borrowers who were willing to pay 4% interest on their loans when stable prices were expected will be willing to pay 9% when they expect prices to increase by 5% annually, so...
-demand for loanable funds will increase (shift vertically) by 5%
-equilibrium money interest rate will be 9%
-so, 4% interest rate in long run will emerge
^SO....long run expansionary...
1) will NOT reduce real interest rates
2) nominal interest rates will rise (to reflect higher expected rate of inflation)
3) real interest rates will be unchanged
real interested rate=
money interest rate- expected rate of inflation
permanent increase of growth rate of money supply from 3-8% annually:
short run: reduces real interest rate and stimulates aggregate demand-->real output will exceed economy potential-->wages and resource prices increase-->costs & profit margins fall back to normal levels AND higher prices reduce aggregate supply
as growth continues more...
AD and AS shift upward, leads to higher price level, aka sustained inflation
if long-run rate of inflation is fully anticipated
will not reduce wages or improve profit margins, output will recede to its long-run potential, unemployment will return to its natural rate
MONEY & INFLATION
as money growth increases (expansionary)
inflation increases by close to same amount!
TIME LAGS, MONETARY SHIFTS, AND ECONOMIC STABILITY
-takes 6-18 months for a shift in monetary policy to exert a major impact on AG and real output
-12-30 months before significant impact on price level and inflation rate
expansionary monetary policy will first lower interest rates, V will decline,
eventually leads to increasing aggregate demand (cause interest rates are low) and RISING interest rates -->this leads to rising nominal interest rates & upward pressure on prices, V will increase
restrictive monetary policy will first raise interest rates, people will want to hold less money, V will increase,
higher interest rates will eventually reduce aggregate demand
POTENTIAL & LIMITATIONS OF MONETARY POLICY
How can the Fed best achieve price stability?
1. establish an inflation target (i.e. between 0-2%)
2. target a nominal GDP growth (i.e. keep it close to 5%)
^ people support these ideas for two reasons:
2) provides insight to which policy may be coming up ,provides stability because we know if out of this target, it will be predictable and fixable
b) they are real percentages, and monetary policy cannot control real variables (i.e. GDP, employment, etc)
RECENT MONETARY POLICY OF THE UNITED STATES
Low (and declining) short-term interest rates coupled with more rapid growth of the M2 money supply is indicative of a more
rising short-term rates and slow growth of M2 imply a more
monetary policy indicators
federal funds interest rate and growth rate of the M2 money supply
when Fed achieves price stability
strong growth and high employment
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