Transcript Interest Rates and Monetary Policy in the Short Run

Interest Rates and Monetary
Policy in the Short Run and the
Long Run
Unit 4 Lesson 6
Activity 41 & 42
Goodman, Rae Jean B.. U.S. Naval Academy
Advanced Placement Economics Teacher Resource Manual.
National Council on Economic Education, New York, N.Y
Objectives
Define the real interest rate and the nominal
interest rate
Explain the relationship among the real interest
rate, the nominal interest rate and the inflation
rate. This is also known as the Fisher Equation.
Explain the Fisher Effect, or how changes in the
money supply are transmitted to the nominal
interest rate in the long run.
Explain the effects of monetary policy to the
short run and the subsequent changes in the
model as the economy moves to the long run.
Define neutrality of money.
Introduction and Description
This lesson explores the relationship between
the nominal interest rate and the real interest
rate, the implications for monetary policy, and
the short-run and long-run effects of monetary
policy on real output and the price level.
You need to understand the relationship
between real and nominal interest rates because
the real interest rate determines the level of
investment, whereas the nominal interest rate
determines the demand for money.
The Fisher Effect demonstrates how
changes in the money supply affect the
nominal interest rate in the long run. The
discussion of the short-run and long-run
effects on interest rates leads to the
discussion of the effects of monetary
policy in the short-run and long-run.
Understanding of the dynamics of the
macroeconomic model over time is
essential to explaining the effects of
monetary policy on the economy.
Activity 41 will help you gain an understanding of
the difference between nominal interest rates
and real interest rates, and the effect of
monetary policy on both in the short and long
run.
Activity 42 is designed to bring the dynamic
macroeconomic model together with monetary
policy actions and to help you integrate the
effects of monetary policy in the short and long
run with your understanding of how the economy
works.
This will help you analyze current monetary
policy and understand monetary policy
discussions.
Nominal and Real Interest Rates
The nominal interest rate is the rate that
appears on the financial pages of
newspapers and on the signs and ads of
financial institutions.
The real interest rate is the increase in
purchasing power the lender wants to
receive to forego consumption now for
consumption in the future.
Nominal vs. Real Interest Rates
There are two relationships between the
real and nominal interest rates.


The ex ante real interest rate, which is the
expected interest rate and equals the nominal
interest rate minus the expected inflation rate.
The ex poste real interest rate, which is the
real interest rate actually received and equals
the nominal interest rate minus the actual rate
of inflation.
Nominal vs. Real Interest Rates
The ex poste real interest rate will equal the ex
ante interest rate, if people accurately anticipate
the inflation rate.
The relationship between the real and nominal
interest rate is called the Fisher Equation.
Fisher Effect: The direct relationship between
inflation and interest rates. Increasing
inflationary expectations result in increasing
interest rates
Looking at the equation of exchange – the
changes in the money supply – holding
velocity and real output constant – led to
changes in the price level. These changes
in the price level change the nominal
interest rate once they are anticipated.
Complete Activity 41.
Real Interest Rates and Nominal
Interest Rates
If you bought a one-year bond for $1,000
and the bond paid an interest rate of 10%
at the end of the year, would you be 10%
wealthier?
You will certainly have 10% more money
than you did a year earlier, but can you
buy 10% more?

If the price level has risen, the answer is that
you cannot buy 10% more.
If the inflation rate were 8%, then you could buy
only 2% more, if the inflation rate were 12%, you
would be able to buy 2% less!
The nominal interest rate is the rate the bank
pays you on your savings or the rate that
appears on your bond or car loan.
The actual real interest rate represents the
change in your purchasing power.
The expected real interest rate represents the
amount you need to receive in real terms to
forgo consumption now for consumption in the
future.
The relationship between the nominal interest
rate, the real interest rate and the inflation rate
can be written as:
r=I-π



r = real interest rate,
I = nominal interest rate
π = inflation rate (Yes, it is the ‘pi” sign, but it is only a symbol!)
This relationship is called the Fisher Equation
 In the example on the previous slide with the
10% bond, if the inflation rate were 6%, then
you real interest rate (the increase in your
purchasing power) would be 4%.
Obviously banks and customers do not know
what inflation is going to be, so the interest
rates on loans, bonds, etc. are set based on
expected inflation. The expected real interest
rate is
re = i – π e

π e = expected inflation rate the quotation
can be written as:
i = re + π e
A bank sets nominal interest rate equal to
its expected real interest rate plus the
expected inflation rate. However, the real
interest rate it actually receives may be
different if inflation is not equal to the
bank’s expected inflation rate.
The equation of exchange is MV = PQ.
If we assume that velocity (V) is constant,
then changes in money supply (M) result
in changes in the nominal output (PQ).
The equation of exchange can be rewritten
in terms of percentage change to be
percentage change in money supply + percentage
change in velocity =
percentage change in price level + percentage
change in real output
The first term, percentage change in the
money supply, is controlled by the
monetary authority (Federal Reserve).
Assuming that velocity is constant, the
second term is zero.
The third term is the inflation rate and the
fourth term is the growth in real output.
Output (Q) is determined by the factors of
production, technology and the production
function.
Output can be taken as given. Therefore,
the percentage change in the money
supply results in an equal percentage
change in the price level.
Increases in the money supply by the
Federal Reserve will result in increase in
the price level, or inflation.
Using the Fisher Equation, the increase in
inflation would result in an increase in the
nominal interest rate or a decrease in the
real interest rate or in some combination.
This is known as the Fisher Effect, or
Fisher Hypothesis.
Evidence indicates that increases in the
inflation rate result in increases in the
nominal interest rate in the long run.
Increases in the money supply are
translated into increases in the price level
and increase in the nominal interest rate in
the long run.
We know that:
 In the short run, increase in the money
supply decrease the nominal interest
rate and real interest rate
 In the long run, increases in the money
supply will result in an increase in the
price level and the nominal interest rate.
Activity 41
1. Fig. 41.1 provides the nominal interest
rates and inflation rates for the years
1991 through 2001.
A.
Compute the actual real interest rates
for 1991 through 2001.
B.
Graph the nominal interest rates and
the actual real interest rates on Fig.
41.2
Year
Nominal
Interest Rate
Inflation
Rate
1991
5.41%
3.12%
1992
3.46
2.30
1993
3.02
2.42
Real Interest Rate
2.29%
1.16
0.60
2.22
1994
4.27
2.05
1995
5.51
2.12
1996
5.02
1.87
3.15
1997
5.07
1.85
3.22
1998
4.78
1.14
3.64
1999
4.64
1.56
3.08
2000
5.82
2.29
3.53
2001
3.39
1.96
1.43
3.39
0
Year
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
Interest rates
Fig. 41.2 Real Nominal Interest Rates
7%
6
5
4
3
2
1
C. Has the actual real interest rate stayed
No
constant? ____
D. If it has not, explain why you think the real rate
has not been constant.
The actual real interest rate has not been constant
because the inflation rate has changed often. The
money supply growth rate has also changed during the
period shown in the graph
E. For what years has the actual real interest rate
remained nearly constant?
During the 1995 to 2000 period, the actual real interest
rate fluctuated within a small range. The result is
probably because of the reasonably steady inflation
rate and the announced desire by the Fed to control
inflation.
2. Frequently, economists argue that the
monetary authorities should try to maintain
a steady real interest rate. Explain why
you think a steady real rate of interest is
important to the economy.
My interest rate is important to induce firms
to invest and expand the capital stock.
Fig. 41.3 Expansionary Monetary Policy
SRAS
Price Level
LRAS
AD
Real GDP
3. Suppose that initially
the economy is at the
intersection of AD and
SRAS as shown.
Now the Fed decides
to implement
expansionary
monetary policy to
increase the level of
employment.
A. In the short run, what happens to real
output? Explain why.
Real output should increase. With the decrease in
interest rates because of the expansionary
monetary policy, the interest rates sensitive
components of AD (Consumption and investment)
will increase, thereby increasing output.
B. In the short run, what happen to the price
level? Explain why.
The price level increases because the increase in
demand can only be met if firms have the
incentive to produce more. An increasing price
level provides this incentive.
C. In the short run, what happens to
employment and nominal wages? Explain
why.
Employment increases and nominal wages
remain the same. Employment increases
because firms now have to produce more goods
and services and they need people to this.
Nominal wages stay the same because people
do not realize that the average price level has
increased.
D. In the short run, what happens to nominal
interest rates and real interest rates?
In the short run, the nominal and real interest
rates decrease.
E. In the long-run, what happens to real
output? Explain why.
In the long-run, the real output will be at the full
employment level. So real output will fall relative
in to the level of output in the short-run. An
employment increases, nominal wages increase,
which raises the costs of production and the
SRAS curve shifts to the left. The price level
increases, and real output will fall back toward
the original level.
F. In the long-run, what happens to the
price level? Explain why.
The price level rises in the long-run because the
SRAS curve shifted to the left in response to an
increase in nominal wages.
G. In the long-run, what happens to
employment and nominal wages?
Explain why.
Employment is at full employment and nominal
wages have risen so that the real income of
people has remained the same. To induce labor
to work at the new higher level firms must
increase the nominal wage.
H. In the long-run, what happens to the
nominal interest rate and the real interest
rate?
In the long run, the real interest rate goes to the
long-run level and the nominal interest rate is the
real interest rate plus the inflation rate. In the
United States, the long-run real interest rate is
about 2% to 3%.
Monetary Policy
Activity 42
You should be able to explain why the
curves shift by now.
Changes in the money supply over time
result in changes in the price level and no
change in the output level.
Monetary policy is neutral.
REVIEW!
Factors that shift the AD curve:





Changes in autonomous consumption
Changes in autonomous investment
Changes in government spending
Changes in taxes
Changes in the money supply
Factors that shift the SRAS:




Changes in resource prices
Changes in technology
Changes in capital stock
Changes in expectations
Do you remember what happens after the
initial effects in the AD and AS model?
From the Short run to the Long Run
LRAS
SRAS₁
SRAS
Price Level
p₂
Initially the economy is at Y*,
potential GDP and P.
Aggregate demand increases
from AD to AD1 and the
economy to Y1 and p1
p₁
p
AD₁
AD
Y*
Y*1
Real GDP
The final equilibrium is Y*
and p2
LRAS
Long Run Adjustment
SRAS1
SRAS
AD
AD1
p2
Price Level
The economy is initially at full
employment output: Y*
There is an increase in
aggregate demand:
p1
p
AD1
Output increases to Y1, and
the price level increases to P1
AD
Y*
Y*1
Real GDP
The increase in the price level means that real wages have
fallen. Labor will push for higher nominal wages to
compensate for the higher price level. The increase in
nominal wages will shift the aggregate supply curve to the
left. Eventually, the economy will return to the potential
output level, Y*, but at a higher price level p. This is the
process of adjustment over the long run.
Monetary Policy
Re-read and STUDY the Appendix to
Lesson 4 from Unit 4 with Activity 24!
We our now going to bring together all of
the pieces of the process by which
monetary policy is transmitted in the
economy, and we examine both the shortrun and the long-run effects of monetary
policy.
Effects of Monetary Policy
Fig. 42.1
LRAS
Price Level
SRAS
AD
Real GDP
1. Suppose the initially the economy is at the intersection
of AD and SRAS in Fig. 42.1
A.
What monetary policy should the fed implement to
move the economy to full-employment output?
Expansion Monetary Policy
________________________
B.
If the Fed is going to use open market operations, it
should (buy / sell) Treasury securities.
C. What is the effect on Treasury security
(bond) prices?
Bond prices should rise.
D. In the short-run, what is the effect on
nominal interest rates? Explain.
Nominal interest rates should fall because financial
institutions have more funds to lend out because
people have sold their Treasury to the Fed.
E. In the short-run, what happens to real
output? Explain how the Fed’s action
results in a change in real output.
Real output should increase. With the decrease in
interest rates, the increase interest-rate sensitive
components of AD (C & I) will increase, thereby
increasing output.
F. In the short-run, what happens to the
price level? Explain how the Fed’s action
results in a change to the price level.
The average price level increase because the
increase in demand can be met only if firms have
the incentive to produce more. An increasing
price level provides this incentive.
Moving to Full Employment Fig. 42.2
LRAS
Price Level
SRAS
AD
Real GDP
2.
Suppose that initially the economy is at the intersection of
AD and SRAS.
A.
What monetary policy should the fed implement to move
the economy to full-employment output?
Contractionary Monetary Policy
_______________________________
B.
If the Fed is going to use open market operations, it
should (buy / sell) Treasury securities.
C. What is the effect on Treasury security
(bond) prices?
Bond prices will decline.
D. In the short-run, what is the effect on
nominal interest rates? Explain.
In the short-run, nominal interest rates will
increase. When the public buys bonds, they pay for
them by reducing their demand deposits,
decreasing the supply of money, which means the
interest rate will increase.
E. In the short-run, what happens to real
output? Explain how the Fed’s action
results in a change in real output.
As a result of the Fed’s actions interest rates have
increased; therefore, the interest sensitive
components of AD (C & I) will decrease and thus,
decrease AD. With a reduced AD, firms will
experience an increase in inventories, which in
turn leads to a decrease in production. Output ↓
F. In the short-run, what happens to the
price level? Explain how the Fed’s action
results in a change to the price level.
The price level will fall as firms attempt to clear
out inventory by reducing prices, having a sale.
Fig.42.3
Expansionary Monetary Policy
PL
LRAS
SRAS
p
AD
Y*
Real GDP
3. Suppose that in the situation shown in the above fig.,
the AS and demand curves are represented by LRAS,
SRAS and AD. The monetary authorities decide to
maintain the level of employment represented by the
output level Y1 by using expansionary monetary policy.
PL
LRAS
SRAS
p1
p
AD1
AD
Y* Y1
Real GDP
A. Explain the effect of the expansionary
monetary policy on the price level and
output in the short-run.
In the short-run, the monetary authorities (the Fed)
will expand the money supply, which in turn
increases the AD curve to AD1. The price level
and output increase.
PL
LRAS
SRAS1
SRAS
p2
p1
p
AD2
AD1
AD
Y* Y1
Real GDP
B. Explain the effect on the price level and output
in the long-run.
The SRAS will shift leftward, leading to a decrease in output and
an increase in price level. Given the Fed’s desire to remain at Y1,
the Fed will continue to expand the money supply, shifting AD to
AD2. With the decrease in SRAS, the economy might be at a
point like the intersection of AD2 and SRAS1. Thus, the price
level will continue to rise and the economy will experience
inflation.
C. Explain what you think will happen to the
nominal rate of interest and the real rate
of interest in the short run as the Fed
continues to increase the money supply.
Explain why.
In the short run, both the nominal interest rate
and the real interest rate will decline.
Consumers and financial intermediaries will
not have correctly anticipated the inflation,
and both interest rates will decline. As
consumers and producers recognize that the
price level is increasing, they will take steps
to maintain their real income. Nominal wages
will rise, and the nominal and real interest
rates will start to rise.
D. Explain what you think will happen to the
nominal rate of interest and the real rate
of interest in the long run. Explain why.
In the long-run, the real interest rate will
return to its long-run equilibrium, and the
nominal interest rate will be the real interest
plus inflation. Since inflation is increasing,
the nominal interest rate will increase as well.
Producers and consumers will adjust
expectations to match reality.
4. Many economists think that moving from
short-run equilibrium to long-run
equilibrium may take several years. List
three reasons why the economy might
not immediately move to long-run
equilibrium.
Wages will adjust slowly to changes in prices
(inflation) because of wage contracts.
Prices adjust slowly because business is
slow to change prices to maintain customer
loyalty.
Both labor and firms have inaccurate
expectations about inflation
5. In a short paragraph, summarize the
long-run impact of an expansionary
monetary policy on the economy.
In the long-run, increases in the money
supply translates into increases in the PL and
no long-term increase in output. This is
known as the neutrality of money.
In the short-run, nominal and real interest
rates decline. In the long-run, nominal
interest rates follow the Fisher Equation and
equal the real rate plus the inflation rate. Real
interest rates return to their long-run level;
the rate people require to forgo consumption
now for consumption in the future.