Transcript Economics: Explore and Apply 1/e by Ayers and Collinge Chapter

MACROECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
Chapter 14
“Monetary Policy and
Price Stability”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
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Learning Objectives
1. State the goals of monetary policy.
2. Explain the significance of the money
market and the motives for holding
money.
3. Recite the equation of exchange and its
role in the conduct of monetary policy.
4. Discuss the monetarist school of thought
and its implications for monetary policy.
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Learning Objectives
5. Interpret the relationship between
monetary policy and interest rates.
6. (E&A) Address the importance of
central banks staying independent of
political pressures.
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14.1
A FIRST LOOK AT MONETARY
POLICY
The Federal Reserve Act of 1913 established
the Fed and it was viewed at that time to be
a lender of last resort for troubled banks.
Today, the Fed’s role has expanded greatly.
The 1977 amendment to the act spells out
the objective of monetary policy as..
“ to promote effectively the goals of maximum
employment, stable prices, and moderate longterm interest rates.”
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Monetary Policy
Federal Reserve monetary policy
encompasses three macro goals.
High employment
Low inflation (price stability)
Economic growth
Many economist argue that price stability
should be the Fed’s primary goal.
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Economic Growth and Inflation
in the 1960’s
12
Rate
10
8
6
4
2
0
69
19
68
19
67
19
66
19
65
19
64
19
63
19
62
19
61
19
Year
Growth Rate in GDP
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Inflation Rate
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Monetary Policy
There are sometimes conflicts and/or tradeoffs
involved in pursuing a particular monetary
policy.
Bringing down inflation can lead to high
higher interest rates and unemployment.
The Fed develops monetary policy surrounded
by a whirlpool of considerations.
Debates over appropriate Fed policy can be
intense.
Unemployment and inflation exact a toll in
human suffering.
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Monetary Policy
• There are two monetary policy instruments
that the Fed can influence as part of
monetary policy.
– By increasing or decreasing the growth rate of
the money supply the Fed can attempt to
stimulate or slow down the economy.
– The Fed can also manipulate short-term interest
rates to stimulate or slow down the economy
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Money and the Macroeconomy
To maintain full employment, the quantity of
money must rise to keep pace with the
economy’s productive potential.
The Fed strongly influences the money
supply buy conducting open market
operation, changing the discount rate, and
changing the reserve requirement.
An overwhelming amount of evidence shows
excessive growth in the money supply to be
the root cause of inflation.
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Money and the Macroeconomy
 The quantity of money affects aggregate
demand.
 An increase in the money supply is associated
with expansionary monetary policy (looser
monetary policy).
 An increase in the money supply shifts
aggregate demand to the right, thus allowing
more aggregate output to be purchased at each
possible price level.
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Expansionary Monetary Policy
Price
level
Aggregate
demand
A larger money supply shifts aggregate
demand because it allows more to be
purchased at each price level.
Same
price
level
More
purchasing power
©2004 Prentice Hall Publishing
Real GDP
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Contractionary Monetary Policy
A contractionary monetary policy would
have the effect of drying up liquidity and
tightening up the economy’s purse strings,
and is thus called a tighter monetary
policy.
The effect of tighter monetary policy
would be just the opposite of the
expansionary policy shown in the previous
figure.
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14.2
THE MONEY MARKET
The demand for money is the quantities of money
that people would prefer to hold at various
nominal interest rates, ceteris paribus.
The nominal interest reflects the opportunity cost
of holding money.
Three motives make people willing to pay the price
of holding money.
The transactions motive.
The precautionary motive.
The speculative motive.
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The Money Market and the Demand
for Money
The transactions motive: money is held because of
the everyday need to buy goods and services.
The precautionary motive: unforeseen circumstances
motivate people to hold more money than called for
by their transactions demands.
The speculative motive: People may speculate with
some of their money in the sense that they prefer to
hold money rather than invest it when financial
investments seem unattractive.
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The Demand for Money
Nominal
interest rates
When the interest
rate falls, money
holdings rise.
Lower
interest
rates
More money
holdings
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Money
holdings
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Money Market Equilibrium
The money market is characterized by demand
and supply.
The money supply curve is drawn as a vertical
line because we are assuming that this is the
quantity of money supplied to the economy by
the Fed.
A vertical money supply curve implies that the
money supply is independent of the interest
rate.
The intersection of demand and supply
establishes the money market equilibrium.
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Money Market Equilibrium
Nominal
interest rates
Excess
supply
Too high
Money supply
Money market
equilibrium
Equilibrium
Interest rate
Too low
Money demand
Excess demand
Money
holdings
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The Substitutability of
Money and Bonds
The market interest rate will adjust to the
equilibrium interest rate.
A market interest rate that is above the
equilibrium interest rate will fall until the
equilibrium interest rate is reached.
A market interest rate that is below the
equilibrium interest rate will rise until the
equilibrium interest rate is reached.
The key to understanding interest rate changes is
to realize that money, bonds, and other
investments are substitutes for each other.
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The Substitutability of
Money and Bonds
If the
interest is
Quantity of Quantity of
money
money
demanded paying asset
is
demand is
(1) At
equilibrium
Equal to
Qs of
money
(2) Above
equilibrium
Less than
Qs of
money
(3) Below
equilibrium
Greater
than Qs of
money
©2004 Prentice Hall Publishing
Public’s
Response
Interest Rate
response to
Public’s Action
Equal to Qs
of interest
paying
assets
Greater
than the Qs
of interest
paying
assets
No change in
holdings of money
or bonds
Interest rate
decreases
Increase the
holdings of bonds
and decrease the
holdings of money
Interest rate
decrease
Less the Qs
of interest
paying
assets
Decrease holdings
of bonds and
increase holdings
of money
Interest rate
increases
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14.3
GUIDING MONETARY POLICY
 The Fed maintains confidentiality when it comes to
what economic variables determine monetary.
 Transcripts of meetings of the Federal Open
Market Committee are not released to the public
until five years after those meetings take place.
 In recent years observers have speculated that the
Fed has followed price rule by which it conducts
monetary policy with the aim of keeping price
increases among certain basic commodities within a
low range.
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The Equation of Exchange
o The equation of exchange reveals that the
amount of money people spend must
equal the market value of what they
purchase…
MxV=PxQ
M = Qs
V= velocity of money,
which is the average
Number of times money
Changes hands in a year.
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Price index
Aggregate out of
goods and services
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The Equation of Exchange
• The total amount of spending in an economy is
equivalent to the economy’s nominal GDP.
• Thus the equation of exchange says that
aggregate spending on the left side of the
equation, equals nominal GDP on the right
side.
• Because the value of what is bought is always
equal to value of what is sold, the equation of
exchange is always true.
M x V [total spending] = P x Q [nominal GDP]
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The Quantity Theory of Money
The equation of exchange forms the basis of
the quantity theory of money.
The quantity theory assumes…
The velocity of money is independent of the
quantity of money in the long run. V, in the
equation is a constant value.
Aggregate output, Q, is also independent of the
quantity of money in the long run. Q, in the
equation can also be treated as a constant.
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The Quantity Theory
Aggregate supply
Price
level
The aggregate demand
curve moves higher in
response to a money supply
increase.
Higher
price
level
Aggregate
Demand
Full
employment
GDP
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Real GDP
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The Monetarist Prescription
Monetarism is a school of thought
associated with Nobel-winning economist
Milton Freidman (1912-).
Monetarist readily agree with the original
quantity theory.
However, unlike the original quantity
theory, monetarism acknowledges the
existence of the short-run.
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The Monetarist Prescription
According to the monetarist view, the quantity
of money may indeed affect velocity and
aggregate output in the short run.
Neither V nor Q in the equation of exchange is
viewed as constant by monetarist.
A reduction in the growth rate of the money
supply may cause a reduction in aggregate
output, Q.
The velocity of money can change because of
changes in people’s need to hold money, V.
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The Monetarist Prescription
Expansionary (Looser) Monetary Policy
Increase in the quantity of Money
Increased aggregate spending
Increased nominal GDP
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
Increased aggregate spending
Increased nominal GDP
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Velocity
Year Velocity
Year Velocity
Year Velocity
1979
1980
1981
1982
1.742
1.748
1.784
1.706
1988
1989
1990
1991
1.706
1.738
1.771
1.773
1997
1998
1999
2000
2.06
2.00
1.99
2.00
1983
1984
1985
1.662
1.703
1.688
1992
1993
1994
1.842
1.907
2.017
2001
1.87
1986
1987
1.630
1.675
1995
1996
2.033
2.05
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Velocity
2.5
2
1.5
1
0.5
0
79
9
1
81
9
1
83
9
1
85
9
1
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87
9
1
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1
93
9
1
95
9
1
97
9
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9
1
01
0
2
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Velocity
To avoid the recession that could result
from too little money, or the inflation that
could result from too much money, the
monetarist policy recommendation is for
the Fed to increase the money supply at a
steady rate, equal to or slightly greater
than the long-run growth rate in
aggregate output.
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Monetarist Policy
 Monetarist recommend growth in the Money
supply that just matched the growth in longrun aggregate supply.
 To monitor the Fed, the monetarist have
established a Shadow Open Market Committee.
 The Fed controls the money base.
 Consumer pessimism or optimism about the
economy can greatly effect the money
multiplier, which relates the monetary base to
the money supply.
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Complications in Conducting
Monetary Policy
There are a number of possible difficulties the Fed
could face in designing an effective monetary policy.
 Large unpredictable shifts in the demand for
money.
Interest rate insensitivity among consumers and
business.
An unresponsive interest rate caused by a
liquidity trap.
Lags in the effects of monetary policy
Differential effects of monetary policy.
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The Monetarist Prescription
Expansionary (Looser) Monetary Policy
Increase in the quantity of Money
Increased borrowing
Lower interest rates
Increased aggregate spending
Increased nominal GDP
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
Decreased borrowing
Higher interest rates
Decreased aggregate spending
Decreased nominal GDP
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14.4
THE FEDERAL FUNDS RATE AND
MARKET INTEREST RATES
Fed Action
Bank Reserves
Open Market
Decrease (reserves
sale of securities
go to the Fed to
to banks
pay for securities)
Open market
purchase of
securities from
banks
Increase (reserves
are received from
the Fed in
payment for
securities
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Federal Funds
Rate
Short-term
Interest Rates
Increases, as
reserves leave
the banking
system
Increase
Decreases, as
reserves are
pumped into the
banking system
Decrease
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14.5 EXPLORE & APPLY
How Independent Should a Central Bank be?
o The Fed is relatively independent from
political interference from the President
and Congress.
o The Fed board members serve 14 year
non-renewable terms.
o The Fed funds itself with interest earned
on loans to banks and on holdings of
treasury securities.
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Terms Along the Way
 expansionary
monetary policy
 contractionary
monetary policy
 monetary policy
instruments
 demand for money
 transactions motive
 precautionary
motive
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 speculative motive
 money market
 price rule
 equation of exchange
 velocity of money
 quantity theory of
money
 monetarism
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Test Yourself
1. Conflicts in meeting the goals of Fed
policymaking
a. never occur.
b. occur, but are ignored by the Fed.
c. occur, and are considered by the Fed in
choosing monetary policy actions.
d. occur only when the President and Congress
disagree about the proper course of monetary
policy.
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Test Yourself
2. The demand for money represents the
a.
b.
c.
d.
quantities of money that people want to
hold
for transaction purposes only.
at different income levels.
at various interest rates.
at banks.
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Test Yourself
3. The speculative demand for money
occurs because
a. people want to make purchases.
b. of the need to save for a rainy day.
c. money that is stolen must be replaced.
d. sometimes investments are not
attractive to people and so they hold
money instead.
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Test Yourself
4. The equation of exchange says that the
quantity of money multiplied by
_____________ equals total spending.
a. the price level.
b. velocity.
c. GDP.
d. the equilibrium interest rate.
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Test Yourself
5. The quantity theory of money assumes
that aggregate output is
a. never at the full-employment level.
b. always at the full-employment level.
c. equal to one minus velocity.
d. unpredictable and unexplainable.
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Test Yourself
6. Monetarism recommends that
monetary policy
a. focus on low interest rates.
b. focus on the stock market, aiming to
increase stock prices.
c. expand the money supply at a steady
rate.
d. be turned over to Congress.
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The End!
Next Chapter 15
“Into The
International
Marketplace”
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