Transcript Chapter 16: Monetary Policy and Inflation

CHAPTER
16
Monetary Policy
and Inflation
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Investment: A Plunge Into the Unknown



An investment is an action today that
costs today but provides benefits in the
future.
The hope of future payoffs is uncertain;
and the trade-off between costs today
and (uncertain) future gains is an
important aspect of investment.
Financial markets make it easier for
economies to invest in the future.
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The Volatility of Investment Spending



John Maynard Keynes referred to the
volatility of investment spending as “animal
spirits.”
Although it is a much smaller component of
GDP than consumption, investment is a much
more volatile component of GDP.
The volatility of investment is associated with
fluctuations in GDP. Projections of the future
and investors’ current animal spirits, both are
likely to move in conjunction with real GDP
growth.
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The Accelerator Theory
The accelerator theory emphasizes the
role of expected growth in real GDP
on investment spending.
 When real GDP growth is expected to
be high, firms anticipate that their
investments in plant and equipment
will be profitable and therefore
increase their total investment
spending.

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The Accelerator Theory

In his multiplier-accelerator theory,
Nobel laureate Paul Samuelson
explained how a downturn in real
GDP leads to a sharp fall in
investment, which further reduces
GDP through the multiplier for
investment spending.
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Investment Spending as a Share of
U.S. GDP, 1970-1998

Investment is highly procyclical.
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Nominal and Real Interest Rates


Nominal interest rates are the rates
actually charged in the market—the
rates that individuals and firms pay or
receive when they borrow or lend money.
Real interest rates are nominal rates
adjusted for inflation—by subtracting
the inflation rate. This is a concept
associated with the reality principle.
Reality PRINCIPLE
What matters to people is the real value or purchasing
power of money or income, not its face value.
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Nominal and Real Interest Rates
Impact of Inflation for
lenders
Nominal interest rate
minus the inflation rate
= real rate of interest
Impact of Inflation for
borrowers
6%
4%
2%
Nominal interest rate
minus the inflation rate
= real rate of interest
10%
6%
4%
Investor lends
$100
Individual borrows
$100
Receives one year
later ($100 x 1.06)
$106
pays back after one
year ($100 x 1.1)
minus impact of
inflation (100 x 0.06)
= actual cost to
borrower
$110
minus impact of
inflation (100 x 0.04)
-$4
= actual real gain
$2
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-$6
$4
8
The Expected Real Interest Rate


Before individuals lend or borrow,
they must form an expectation of
the inflation rate in the future.
For a given nominal interest rate,
the expected real interest rate is the
nominal interest rate minus the
expected inflation rate.
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Investment Spending and Interest Rates

The decision to invest is based on the principle
of opportunity cost.
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what you
sacrifice to get it.


The interest rate prevailing in the economy
provides a measure of the opportunity cost of
investment.
If the net return from an investment exceeds the
opportunity cost of the funds, the investment
should be undertaken.
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Returns on Investment
Investment

Cost Return
A
$100
$101
B
100
103
C
100
105
D
100
107
E
100
109
As market interest
rates rise, there will
be fewer profitable
investments.
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

A firm has a menu of
investment projects it
would like to undertake.
At a market interest rate
of 2% per year, for
example, only investment
A is unprofitable. All the
other investments have a
return greater than the
opportunity cost of the
funds.
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Interest Rates and Investment
There is a negative relationship
between real investment spending
and the real interest rate. As the
real rate of interest rises, fewer
investment projects will be
profitable.
Nominal rates of interest are not a good indicator of
the true cost of investing.
The firm makes its investment decisions by
comparing its expected real net return from
investment projects to the real rate of interest.



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Model of the Money Market

The model of the money market
combines the supply of money,
determined by the Fed, with the
demand for money, determined by
the public, to see how interest rates
are determined in the short run.
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The Demand for Money



Money is simply a part of your wealth. You
can hold assets such as stocks or bonds, or
hold wealth in the form of money.
Holding wealth in currency or checking
deposits that pay little or no interest means
that you sacrifice the potential income from
interest and dividends earned on stocks and
bonds.
So why hold money? Because it makes it
easier to conduct transactions.
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The Demand for Money

The transactions demand for money is based
on the principle of opportunity cost:
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what you
sacrifice to get it.

The opportunity cost of holding money is the
return that you could have earned by holding
your wealth in other assets.

The market rate of interest is a measure of the
opportunity cost of holding money.
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The Demand for Money

As interest rates increase,
the opportunity cost of
holding money increases,
and the public will
demand less money.

Conversely, the demand
for money will decrease
with an increase in
interest rates—or an
equivalent increase in the
opportunity cost of
holding money.
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The Demand for Money
Factors That
Increase the
Demand for
Money
Factors That
Decrease the
Demand for
Money
An increase in A decrease in
the price level the price level
An increase in A decrease in
real GDP
real GDP
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The Demand for Money

The liquidity demand for money refers to the desire
of individuals to hold assets that can be easily
transferable into the medium of exchange, such as
currency or checking accounts, so they can make
transactions on quick notice.

Individuals also demand some types of money
found in M2, such as a savings account, in order
to avoid the risk of falling stock or bond prices.
This demand for money that is safer than other
assets is called speculative demand for money.

In practice, the demand for money is the sum of
transactions, liquidity, and speculative demands.
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Money Market Equilibrium



The supply of money is
determined by the Fed, so
we assume that it is
independent of the interest
rate.
In the model of the money
market, the money supply
is a vertical supply curve.
Combining the supply of
money with the demand
for money yields the
equilibrium interest rate.
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Money Market Equilibrium

At the equilibrium interest
rate, r0, the quantity of
money supplied equals the
quantity demanded.

A higher interest rate yields
an excess supply of money.
The interest rate will tend
to fall.
A lower interest rate causes
an excess demand for
money. The interest rate
will tend to rise.

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Interest Rate Intervention



An increase in the money
supply, through an open
market purchase of bonds,
causes the money supply to
shift rightward.
The increase in the money
supply leads to a lower
interest rate.
On the other hand, if the
Fed sells bonds in the open
market, the money supply
decreases and interest rates
will increase.
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Interest rates
Interest Rates, Investment, & Output
Ms
r*
r*
Md
I
I*
Money

Investment
The supply and demand for money determine the
equilibrium interest rate. At the equilibrium
interest rate, the level of investment in the
economy will be given by I*.
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Monetary Policy

The Federal Reserve can change the level
of output in the short run:

An open market purchase of government
bonds increases the supply of money, which
in return, causes interest rates to fall;

With the decrease in interest rates,
investment spending goes up;

The increase in investment spending will
shift AD to the right, causing both output
and prices to rise in the short run.
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Monetary Policy
The sequence of the two main events for an open market
operation by the Federal reserve is as follows:
Open
Market
sale
decrease
in money
supply
Rise in
interest
rate
Fall in
Investment
spending
Decrease
In
GDP
increase in
Investment
spending
increase
In
GDP
or
Open
Market
purchase
increase
in money
supply
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Decrease
in interest
rate
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Interest rates
Monetary Policy
M0s
r0
r1
M 1s
Md
I
I0
Money

I1
Investment
As the money supply increases, equilibrium
interest rates fall from r0 to r1. Investment
spending increases from I0 to I1.
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Monetary Policy in an Open Economy

When we take into account the effect
of international trade, monetary
policy operates through an
additional route.

International trade or movements of
financial funds across countries are
affected by interest rates and
exchange rates.
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The Exchange Rate


The exchange rate is the rate at which one
currency trades for another currency.
Supply and demand for a currency
determine the exchange rate. In effect, the
exchange rate is the price of a given
currency in the foreign exchange market.
A decrease in the value of a currency is
called depreciation, while an increase in the
exchange rate is called appreciation.
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Interest Rates and Exchange Rates



There is a direct relationship between a country’s
interest rates and its exchange rate.
Higher interest rates in the United States cause an
increase in the demand for dollars as foreign
investors seek higher returns in United States banks.
A higher demand for dollars leads to a higher
exchange rate of the dollar against foreign currencies.
The dollar appreciates.
Lower U.S. interest rates induce investors to sell their
dollars and buy the foreign currency of a more
attractive country in which to invest. A higher supply
of dollars leads to dollar depreciation.
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Exchange Rates and Net Exports


As the dollar appreciates, U.S. goods become
more expensive on world markets. U.S.
exports decline. Meanwhile, a higher value
of the dollar makes it cheaper for U.S.
residents to buy foreign goods. U.S. imports
rise. Lower exports combined with higher
imports result in a decrease in net exports.
Conversely, dollar depreciation leads to an
increase in net exports. If the economy were
in a recession, dollar depreciation could help
increase GDP through higher net exports.
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Monetary Policy in an Open Economy

The effect of interest rates on net exports
accentuates the effect of monetary policy.
Monetary policy is even more powerful in an open
economy than in a closed economy. Take the case
of a decision by the Fed to adopt expansionary
monetary policy:
Open
market
purchase
Money
supply
increases
Interest
rates
fall
Exchange
rate falls
Net
exports
increase
GDP
increases
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Monetary Policy in an Open Economy

The case of a decision by the Fed to adopt
contractionary monetary policy:
Open
market
sale
Money
supply
decreases
Interest
rates
rise
Exchange
rate rises
Net
exports
decrease
GDP
decreases
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Money & Inflation in the Long Run


What is the relationship between
money growth, inflation and interest
rates?
Economists believe that, in the long
run, changes in the supply of money
have no effect on any real variables
in the economy, such as
employment, output, or real interest
rates.
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Long-run Neutrality of Money


The assertion that, in the long run,
changes in the money supply are
“neutral” with respect to real
variables in the economy, is known as
the long run neutrality of money.
Money is, however, not neutral in the
short run. In the short run, changes in
the money supply affect interest rates,
investment spending, and output.
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Long-run Neutrality of Money

Monetary expansion that initially leads to
output above full employment, higher
prices and wages, and higher demand for
money, eventually results in higher interest
rates, lower investment, and a return to full
employment.
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Long-run Neutrality of Money

If every green dollar was replaced by two blue
dollars, then:
 Everyone would have twice as many blue
dollars as they formerly had of green
dollars.
 Prices and wages quoted in the blue
currency would simply be twice as high as
for the green dollars.
 The purchasing power of blue money
would be the same as it was for green
money, therefore, real wages would be the
same as before.
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Long-run Neutrality of Money


In the long run, the currency
conversion has no effect on the real
economy, and will be neutral. Prices
adjust to the amount of nominal
money available.
Whether the money comes from an
open market purchase or a currency
conversion, it will be neutral in the
long run.
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Money & Inflation in the Long Run




In the short run, changes in money growth
affect real output, or real GDP.
In the long run, changes in the money supply
do not affect real variables in the economy.
In the long run, the rate of money growth
determines the rate of inflation and not real
GDP.
In the long run, money is neutral. If nominal
wages and prices rise at the same rate, say 5%
per year, then real wages remain constant.
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Money & Inflation in the Long Run

Continued inflation has a tendency to
become the normal state of affairs in an
economy.

For example, when producers hold their
expectations of inflation at 5%, they will
on average expect input prices and wages
to be 5% higher next year. Expectations
of inflation become ingrained in decisions
made in all aspects of life.
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Money & Inflation in the Long Run

Workers would understand that a 5%
increase in wages would be matched by
a 5% increase in the prices of the
goods they buy.

When workers fail to recognize that
the only reason why nominal wages
rise by 5% is because of a general 5%
inflation, we say that they suffer from
money illusion.
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Money & Inflation in the Long Run

When the public holds expectations of inflation,
real and nominal rates of interest will differ.
Nominal rate of
interest

Real rate of
= interest
Expected rate
+ of inflation
In the long run, changes in the money supply do
not affect real variables, including the real interest
rate. But nominal rates, which depend on the rate
of inflation, will be affected by the growth of the
money supply.
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Money & Inflation in the Long Run

Because of inflation, countries with
higher money growth typically have
higher nominal interest rates than the
nominal interest rates in countries with
lower money growth rates.

Money demand is also affected by
expectations of inflation. Inflation
increases the demand for money to match
the expected increase in inflation.
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