Transcript target interest rate

1
Macro
McEachern
ECON 2010-2011
16
CHAPTER
Monetary Theory and Policy
Designed by
Amy McGuire, B-books, Ltd.
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The Demand for Money


Demand for money

Interest rate

How much money people
to hold
People demand money


LO1
want
Pay for purchases
Money

Carry out economic transactions

Easily

Efficiently
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The Demand for Money


More active economy

More goods and services
exchanged

More money demanded
The higher the price level


LO1
Greater the demand for money
Money

Medium of exchange

Store of value

Liquidity
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The Demand for Money

Opportunity cost of holding money


Quantity of money demanded


Interest forgone
Inversely: market interest rate
Money demand curve

Downward slope

The lower interest rate

LO1
The lower opportunity
of holding money
cost
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LO1
Exhibit 1
Demand for Money
Interest rate
The money demand, Dm, slopes
downward. As the interest rate falls,
other things constant, so does the
opportunity cost of holding money; the
quantity of money demanded
increases.
Dm
0
Quantity of money
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The Supply of Money


Supply of money

Stock of money

In economy

A particular time
Determine by the Fed

Vertical line

LO1
Independent of
interest rate
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The Supply of Money


Equilibrium interest rate

Demand for money

Supply of money
Interest rates

Above equilibrium


Below equilibrium

LO1
Higher opportunity cost
of holding money
Lower opportunity cost
of holding money
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The Supply of Money

Given money demand curve

Increase money supply


Decrease money supply

LO1
Lower interest rate
Higher interest rate
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LO1
Exhibit 2
Interest
rate
Effect of an Increase in the Money Supply
Sm
Because the money supply is
determined by the Federal Reserve,
it can be represented by a vertical
line.
S’m
At point a, the intersection of the
money supply, Sm, and the money
demand, Dm, determines the market
interest rate, i.
a
i
b
i’
Dm
0
M
M’
Quantity of
money
Following an increase in the money
supply to S’m, the quantity of money
supplied exceeds the quantity
demanded at the original interest
rate, i.
People attempt to exchange money for bonds or other financial assets. In
doing so, they push down the interest rate to i’, where quantity demanded
equals quantity supplied. This new equilibrium occurs at point b.
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Money and Aggregate Demand
in the Short Run
 Short run: Money affects the economy
 Through changes in interest rate
 The Fed: stimulate output; employment
 Open-market purchases
 Money supply – increase
 Interest rate – reduce
 Investment – stimulate
 Aggregate demand – increase
 Real GDP – increase
LO2
Exhibit 3
LO2
a
i
i
b
i’
(b) Demand for
investment
(c) Aggregate demand
Price level
(a) Supply and demand
for money
Sm
S’m
Interest rate
Interest rate
Effects of an Increase in the Money Supply on Interest Rates,
Investment, and Aggregate Demand
a
P
b
i’
b
a
AD’
Dm
AD
DI
0
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M
M’ Money
An increase in the money
supply drives the interest
rate down to i'.
0
I I’
Investment
With the cost of borrowing
lower, the amount invested
increases from I to I‘.
0
Y
Y’
Real GDP
This sets off the spending
multiplier process, so the
aggregate output demanded at
price level P increases from Y to
Y‘
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Money and Aggregate Demand
in the Short Run
 The Fed: cool down the economy
 Open-market sale
 Money supply – decrease
 Interest rate – increase
 Investment – reduce
 Aggregate demand – decrease
 Real GDP - decrease
LO2
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Adding the Short-Run Aggregate
Supply Curve
 Contractionary gap
 Output < potential
 Price level < expected
 Wages > negotiated
 The Fed: expansionary
monetary policy
 Stimulate AD
 Increase money supply
 Equilibrium
LO2
LO2
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Exhibit 4
Expansionary Monetary Policy to Correct a Contractionary Gap
Price
level
Potential output
LRAS
At a, the economy is producing less
than its potential in the short run,
resulting in a contractionary gap of
$0.2 trillion.
SRAS130
b
130
a
125
AD’
AD
0
13.8
14.0
Real GDP
(trillions of dollars)
Contractionary gap
If the Federal Reserve increases
the money supply by just the right
amount, the aggregate demand
curve shifts rightward from AD to
AD’. A short-run and long-run
equilibrium is established at b, with
the pride level at 130 and output at
the potential level of $14.0 trillion
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Money and Aggregate Demand in the
Long Run
 Equation of exchange
Buyer: exchanges money for goods
Seller: exchanges goods for money
 M – quantity of money in economy
 V – velocity of money
 P – average price level
 Y – real GDP
LO3
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Targets for Monetary Policy



Short-run

Long-run

Price level
Money market: equilibrium
 Increase money demand curve
 The Fed – target money supply

LO4
Interest rate


Does nothing
Increase interest rate

Increase money supply
The Fed – target interest rate
LO4
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Exhibit 7
Targeting Interest Rates Versus Targeting
the Money Supply
Interest rate
Sm
S’m
If the Federal Reserve holds the money
supply at Sm, the interest rate rises from i (at
point e) to i ' (at point e').
e’
i’
i
An increase in the price level or in real GDP,
with velocity stable, shifts rightward the
money demand curve from Dm to D'm.
e’’
e
D’m
Dm
0
M
M’
Alternatively, the Fed could hold the
interest rate constant by increasing
the supply of money to S'm. The Fed
may choose any point along the
money demand curve D'm.
Quantity of money
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Targets for Monetary Policy

LO4
Targets before 1982
 Stabilize interest rates
 October 1979: target money
aggregates
 Volatile interest rates
 Sharp reduction in money
growth, 1981
 Recession, 1982
 Declining inflation
 Rising unemployment