Transcript Monetary Policy

Ch. 15: Monetary Policy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
The Demand for Money
• The price of holding money balances is the
interest rate.
• The interest rate is the opportunity cost of
holding money.
• As the interest rate increases, the
opportunity cost of holding money
increases, and people choose to hold less
money.
Supply and Demand for Money
Equilibrium in the Money Supply
• The money supply is not
exclusively determined by
the Fed because both the
banks and the public are
important players the
money supply process.
• Equilibrium in the money
market exists when the
quantity demanded of
money equals the quantity
supplied.
Transmission Mechanisms
The impact that changes in
the money market have
on the goods and services
market and whether that
impact is direct or
indirect; and the routes
and ripple effects created
in the money market travel
to affect the goods and
services market are known
as the transmission
mechanism.
The Keynesian Transmission
Mechanism
• The Money Market
• The Investment Goods Market
• The Goods and Services Market (AD-AS
Framework)
• When the money supply increases, the Keynesian
transmission mechanism works as follows: an
increase in the money supply lowers the interest
rate, which causes investment to rise and the AD
curve to shift rightward. Real GDP increases and
the unemployment rate drops.
The Keynesian Transmission
Mechanism: Indirect
The Keynesian Mechanism May
Get Blocked
• Some Keynesian economists believe that
investment is not always responsive to interest
rates. The Keynesian transmission mechanism
would be short-circuited in the investment goods
market, and the link between the money market
and the goods and services market would be
broken.
• Keynesians have sometimes argued that the
demand curve for money could become horizontal
at some low interest rate. This is called the
Liquidity Trap.
Keynesian Transmission
Mechanisms
Because the Keynesian transmission mechanism is indirect,
both interest insensitive investment demand and the liquidity
trap may occur.
The Keynesian View of Monetary Policy
Bond Prices and Interest Rates
• As the price of a bond decreases, the actual
interest rate return, or simply the interest rate,
increases.
• The market interest rate is inversely related to the
price of old or existing bonds.
• Consider the Liquidity Trap: the reason an
increase in the money supply does not result in an
excess supply of money at a low interest rate is
that individuals believe bond prices are so high
that an investment in bonds is likely to turn out to
be a bad deal.
The Monetarist Transmission
Mechanism: Direct
• In the Monetarist theory, there is a direct link
between the money market and the goods and
services market.
• An increase in the money supply means increased
Aggregate Demand, Increased Real GDP,
increased Prices and a decrease in unemployment.
• A decrease in the money supply means decreased
Aggregate Demand, Decreased Real GDP,
decreased Prices and an increase in
unemployment.
The Monetarist Transmission
Mechanism: Direct
Q&A
• Explain the inverse relationship between bond
prices and interest rates.
• “According to the Keynesian transmission
mechanism, as the money supply rises, there is a
direct impact on the goods and services market.”
Do you agree or disagree with this statement.
Explain your answer.
• Explain how the monetarist transmission
mechanism works when the money supply rises.
Monetary Policy and the Problem of
Inflationary and Recessionary Gaps
Monetary Policy and an
Inflationary Gap
Keynesians, Recession, and
Inflation
• Most Keynesians believe that the natural forces of
the market economy work much faster and more
assuredly at eliminating an inflationary gap than a
recessionary gap.
• Keynesians are more likely to advocate
expansionary monetary policy to eliminate a
stubborn recessionary gap than contractionary
monetary policy to eliminate a not-so-stubborn
inflationary gap.
• It has been argued that Keynesian monetary policy
has an inflationary bias.
Monetary Policy and the
Activist–Nonactivist Debate
• Activists argue that
monetary and fiscal policies
should be deliberately used
to smooth out the business
cycle.
• They are in favor of
economic fine-tuning, which
is the frequent use of
monetary and fiscal policies
to counteract even small
undesirable movements in
economic activity.
• Nonactivists argue against
the use of deliberate fiscal
and monetary policies.
• They believe the
discretionary policies should
be replaced by a stable and
permanent monetary and
fiscal framework and the
rules should be established
in place of activist policies.
The Case for Activist Monetary
Policy
1. The economy does not always equilibrate
quickly enough at Natural Real GDP.
2. Activist monetary policy works; it is
effective at smoothing out the business
cycle.
3. Activist monetary policy is flexible;
nonactivist monetary policy, which is
based on rules, is not.
The Case for Nonactivist
Monetary Policy
1. In modern economies, wages and prices are
sufficiently flexible to allow the economy to
equilibrate at reasonable speed at Natural Real
GDP.
2. Activist monetary policies may not work.
3. Activist monetary policies are likely to be
destabilizing rather than stabilizing; they are
likely to make matters worse rather than better.
Expansionary Monetary Policy
and No Change in the Real GDP
If expansionary monetary
policy is anticipated,
workers may bargain for
and receive higher wage
rates. It is possible that
the SRAS curve will shift
leftward to the degree that
expansionary monetary
policy shifts the AD curve
rightward. Result: no
change in Real GDP.
Monetary Policy May Destabilize
In this scenario, the
the Economy
SRAS curve is shifting
rightward, but Fed
officials do not realize
this is happening.
They implement
expansionary
monetary policy, and
the AD curve ends up
intersecting SRAS2 at
point 2 instead of
SRAS1 at point 1’.
Fed officials end up
moving the economy
into an inflationary
gap and thus
destabilizing the
economy
Q&A
• Why are Keynesians more likely to advocate
expansionary monetary policy to eliminate a
recessionary gap than contractionary monetary
policy to eliminate an inflationary gap?
• How might monetary policy destabilize the
economy?
• If the economy is stuck in a recessionary gap, does
this make the case for activist monetary policy
stronger or weaker? Explain your answer.
Nonactivist Monetary Proposals
• A monetary rule describes monetary policy that is based on
a predetermined steady growth rate in the money supply.
• Some economists would like the monetary rule to read as
follows: The annual money supply growth rate will be
constant at the average annual growth rate of the Real
GDP.
• Others would like the monetary rule to read: The annual
growth rate in the money supply will be equal to the average
annual growth rate in Real GDP minus the growth rate in
velocity.
• Some Monetary rule proponents claim that even if a
monetary rule does not adjust for changes in velocity, there
is little cause for concern.
A Gold Standard
• The money supply would be tied to the stock of
gold.
• The government sets the price of gold at some
dollar amount.
• The government promises to buy and sell gold at
the official price.
• Critics charge that a gold standard is no guarantee
against inflation.
• Critics also charge that a reduction in national
output and an increase in unemployment will
result if prices do not fall in the same proportion
when the gold-backed money supply is reduced.
A Gold Standard
The Fed and The Taylor Rule
• There may be a middle ground between
activist and nonactivist monetary policy.
• The Taylor Rule specifies how policy
makers should set the target for the federal
funds rate.
Federal funds rate target = Inflation +
Equilibrium real federal funds rate +
½ (Inflation Gap) + ½ (Output Gap)
Q&A
• Would a monetary rule
produce price
stability? Explain
your answer.
• How would the gold
standard (described in
the text) work?