Transcript Monetary Policy

The Quantity Theory of Money
Connecting Money and Prices: Irving Fisher’s Quantity Equation
M×V=P×Y
V = Velocity of money The average number of times each dollar in the money
supply is used to purchase goods and services included in GDP.
P xY
V
M
We can transform the quantity equation from
M xV  P x Y
to:
Growth rate of the money supply + Growth rate of velocity
=
Growth rate of the price level (inflation rate) + Growth rate of real output
The Quantity Theory of Money
The growth rate of the price level is just the inflation rate
•we can rewrite the quantity equation to help us understand the factors
that determine inflation:
Inflation rate = Growth rate of the money supply
+ Growth rate of velocity
− Growth rate of real output
If velocity is constant,
Inflation rate = Growth rate of the money supply
− Growth rate of real output
• If money supply grows at a faster rate than real GDP  inflation.
• If money supply grows at a slower rate than real GDP,  deflation.
Very high rates of inflation—in excess of hundreds or thousands of percentage
points per year—are known as hyperinflation.
Economies suffering from high inflation usually also suffer from very slow
growth, if not severe recession.
What Is Monetary Policy?
The Goals of Monetary Policy: Price Stability
The Inflation Rate, 1952–2006
Other Goals of Monetary Policy
High Employment
Economic Growth
•Policymakers aim to encourage stable economic growth
•Stable growth allows households and firms to plan accurately
and encourages the long-run investment sustains growth.
Stability of Financial Markets and Institutions
•The Fed can’t control unemployment or inflation rates directly
•The Fed uses monetary policy targets, that it can control, that
in turn, affect variables closely related to its policy goals—real
GDP, employment, and the price level.
•These monetary policy targets include the growth rate of the
money supply and, most importantly now, the federal funds
interest rate
The Money Market and the Fed’s Choice
of Monetary Policy Targets
The Demand for Money
The Demand for Money
The Money Market and the Fed’s Choice
of Monetary Policy Targets
Shifts in the Money Demand Curve
Shifts in the Money
Demand Curve
The Money Market and the Fed’s Choice
of Monetary Policy Targets
How the Fed Manages the Money Supply: A Quick Review
Equilibrium in the Money Market
The Impact on the Interest Rate When
the Fed Increases the Money Supply
The Relationship between Treasury Bill Prices and Their Interest Rates
What is the price of a Treasury bill that pays
$1,000 in one year, if its interest rate is 4
percent?
 $1,000  P 

 x 100  4
P


When the price paid for a bond rises,
the interest rate earned on the bond falls
Monetary Policy and Economic Activity
How Interest Rates Affect Aggregate Demand
Changes in interest rates will not affect government purchases, but they
will affect the other three components of aggregate demand in the
following ways:
• Consumption: lower rate  save less, spend more
• Investment: lower rate finance more capital investment
• Net exports: lower rate  $ depreciation  NX increase
The Importance of the Federal Funds Rate
Federal funds rate The interest rate banks
charge each other for overnight loans.
Monetary Policy and Economic Activity
The Effects of Monetary Policy on Real GDP and
the Price Level: An Initial Look
Expansionary monetary policy The Federal
Reserve’s increasing the money supply and
decreasing interest rates to increase real GDP.
Contractionary monetary policy The Federal
Reserve’s adjusting the money supply to
increase interest rates to reduce inflation.
Monetary Policy and Economic Activity
The Effects of Monetary Policy on Real GDP and
the Price Level: An Initial Look
Monetary Policy
Monetary Policy and Economic Activity
A Summary of How Monetary Policy Works
Expansionary and Contractionary
Monetary Policies
Making
the
Connection
The Fed Responds to the Terrorist
Attacks of September 11, 2001
The day after the terrorist attacks of
September 11, 2001, the Fed made
massive discount loans to banks and
succeeded in preventing a financial
panic. Alan Greenspan, pictured here,
was the chairman of the Fed at the time
of the attacks.
Reserves Deposits that a bank keeps as cash in its vault or on deposit with
the Federal Reserve.
Required reserves Reserves that a bank is legally required to hold, based on
its checking account deposits.
Required reserve ratio The minimum fraction of deposits banks are required
by law to keep as reserves.
Excess reserves Reserves that banks hold over and above the legal
requirement.
Making
the
Connection
The Inflation and Deflation of the
Housing Market “Bubble”
Monetary Policy and Economic Activity
Can the Fed Get the Timing Right?
The Effect of a Poorly
Timed Monetary Policy
on the Economy
Don’t Let This Happen to YOU!
Remember That with Monetary Policy, It’s the
Interest Rates—Not the Money—That Counts
Why Doesn’t the Fed Target Both the Money Supply
and the Interest Rate?
Some economists have
argued that rather than
use an interest rate as its
monetary policy target,
the Fed should use the
money supply.
Milton Friedman and his
monetarist followers
favored replacing
monetary policy with a
monetary growth rule.
The Fed Can’t Target
Both the Money Supply
and the Interest Rate
A Closer Look at the Fed’s Setting
of Monetary Policy Targets
Should the Fed Target Inflation?
The Taylor Rule
Taylor rule A rule developed by John Taylor that
links the Fed’s target for the federal funds rate
to economic variables.
Federal funds target rate =
Current inflation rate
+ Real equilibrium federal funds rate
+ (1/2) x Inflation gap
+ (1/2) x Output gap
Making
the
Connection
How Does the Fed Measure Inflation?
Is the Independence of the
Federal Reserve a Good Idea?
The Case for Fed Independence
FIGURE 14.12
The More Independent the
Central Bank, the Lower the
Inflation Rate
Is the Independence of the
Federal Reserve a Good Idea?
The Case against Fed Independence
In democracies, elected representatives usually decide
important policy matters. In the United States, however,
monetary policy is not decided by elected officials.
Instead, it is decided by the unelected FOMC.
Because those deciding monetary policy do not have to
run for election, they are not accountable for their actions
to the ultimate authorities in a democracy: the voters.
Key Terms
Contractionary monetary policy
Expansionary monetary policy
Federal funds rate
Inflation targeting
Monetary policy
Taylor rule