Transcript Chapter 17
Chapter 17 Domestic and International Dimensions of Monetary Policy Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Effects of an Increase in The Money Supply • What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter? • People pick up the money and put it in their pockets, but how do they dispose of the new money? 17-2 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Effects of an Increase in The Money Supply (cont'd) • Direct effect – Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services. 17-3 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Effects of an Increase in The Money Supply (cont'd) • Indirect effect – Not everybody will necessarily spend the newfound money on goods and services. – Some of the money gets deposited, so banks have higher reserves (and they lend the excess out). 17-4 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Effects of an Increase in The Money Supply (cont'd) • Indirect effect – Banks lower rates to induce borrowing. • Businesses engage in investment. • Individuals consume durable goods (like housing and autos). – Increased loans generate an increase in aggregate demand. • More people are involved in more spending (even those who didn’t get money from the helicopter!). 17-5 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Effects of an Increase in The Money Supply (cont'd) Graphing the Effects of an Expansionary Monetary Policy • Assume the economy is operating at less than full employment – Expansionary monetary policy can close the recessionary gap. – Direct and indirect effects cause the aggregate demand curve to shift outward. 17-6 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Figure 17-1 Expansionary Monetary Policy with Underutilized Resources • The recessionary gap is due to insufficient AD • To increase AD, use expansionary monetary policy • AD increases and real GDP increases to full employment 17-7 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Effects of an Increase in The Money Supply (cont'd) Graphing the Effects of Contractionary Monetary Policy • Assume there is an inflationary gap – Contractionary monetary policy can eliminate this inflationary gap. – Direct and indirect effects cause the aggregate demand curve to shift inward. 17-8 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Figure 17-2 Contractionary Monetary Policy with Overutilized Resources • The inflationary gap is shown • To decrease AD, use contractionary monetary policy • AD decreases and real GDP decreases 17-9 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Open Economy Transmission of Monetary Policy • So far we have discussed monetary policy in a closed economy. • When we move to an open economy, monetary policy becomes more complex. 17-10 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Open Economy Transmission of Monetary Policy (cont'd) • The net export effect of contractionary monetary policy • Boosts the market interest rate • Higher rates attract foreign investment • International price of dollar rises • Appreciation of dollar reduces net exports • Negative net export effect 17-11 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Open Economy Transmission of Monetary Policy (cont'd) • The net export effect of expansionary monetary policy • Lower interest rates • Financial capital flows out of the United States • Demand for dollars will decrease • International price of dollar goes down • Foreign goods look more expensive in United States • Net exports increase (imports fall) 17-12 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Monetary Policy in Action: The Transmission Mechanism • Recall we talked about the direct and indirect effects of monetary policy – Direct effect: implies increase in money supply causes people to have excess money balances. – Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up. 17-13 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Figure 17-4 The Interest-Rate-Based Money Transmission Mechanism 17-14 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a and b) At lower rates, a larger quantity of money will be demanded The decrease in the interest rate stimulates investment 17-15 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c) The increase in investment shifts the AD curve to the right 17-16 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.