Transcript Chapter 28: Monetary Policy in the Short Run

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Monetary Policy
in the Short Run
Prepared by:
Fernando Quijano and Yvonn Quijano
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Monetary Policy in the Short Run
• In the short run, when prices don’t have enough
time to change, the Federal Reserve can
influence the level of interest rates in the
economy.
• In the short run, interest rates are determined by
the supply and demand for money. The Fed
can change the interest rate level because it
controls the supply of money.
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Monetary Policy in the Short Run
• To change the money supply, the Fed uses
open market operations—buying and selling
bonds in the open market.
• Actions by the Fed to influence the level of GDP
are known as monetary policy.
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Monetary Policy in the Short Run
• When the Fed lowers interest rates, investment
spending and GDP increase.
Open
market
purchase
Money
supply
increases
Interest
rates fall
Investment
spending
increases
GDP
increases
• However, there are limits to the extent to which
the Fed can control the economy. In the long
run, changes in the money supply affect only
prices, not the level of output.
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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 you
can hold wealth in the form of money.
• Holding wealth in currency or checking
deposits 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 desire to facilitate transactions.
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.
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The Demand for Money
• The market rate of
interest is a measure of
the opportunity cost of
holding money.
• As interest rates
increase, the opportunity
cost of holding money
increases, and the public
will demand less money.
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The Demand for Money
• The liquidity demand for money is the demand for
money that represents the needs or desires of
individuals or firms to make purchases on short notice
without incurring excessive costs.
• The speculative demand for money is the demand for
money that reflects that holding money over short
periods is less risky than holding stocks or bonds.
• In practice, the demand for money is the sum of
transactions, liquidity, and speculative demands.
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The Demand for Money
Factors That
Increase the
Demand for
Money
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Factors That
Decrease the
Demand for
Money
An increase in
the price level
A decrease in
the price level
An increase in
real GDP
A decrease in
real GDP
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The Demand for Money
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Interest Rate Determination
• The supply of money is
determined by the Fed, so
we assume that it is
independent of the interest
rate.
• 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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Federal Reserve and Interest Rates
• An increase in the
money supply leads to a
lower interest rate.
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•
A decrease in the money
supply leads to a higher
interest rate.
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Bond Prices and Interest Rates
• Bonds are promises to pay money in the future. The
price of a bond one year from now is the promised
payment divided by 1 plus the interest rate.
• For example, a bond that promises to pay $106 a year,
with an interest rate is 6% per year, would cost today:
$106
price of bond 
1  $100
(1  0.06)
• In other words, if you can invest at 6% per year, you
would be willing to pay $100 today for a $106 promised
payment next year.
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Interest Rates and Bond Prices
• Bond prices change in the opposite direction from
changes in interest rates:
Promised
Payment
Interest
Rate
Promised
Payment
Interest Rate
$106
6%
$106
4%
price of bond 
$106
1  $100
(1  0.06)
price of bond 
$106
1  $101.92
(1  0.04)
• When the interest rate falls from 6% to 4%, you have to
pay $101.92 today to have $106 next year. And if the
interest rate rose to 8%, for example, you would pay
only $98.15.
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Interest Rates and Bond Prices
• When interest rates rise, investors need less money to
obtain the same promised payments in the future, so
the price of bonds falls.
• An alternative explanation of the relationship between
bond prices and interest rates deals with the supply and
demand for bonds.
• When the Fed buys bonds, in order to lower interest rates, it is
increasing the demand for bonds, thus the price of bonds tends
to rise.
• An open market sale increases the supply of bonds,
causing bond prices to fall and interest rates to rise.
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Why Is Good News for the Economy
Bad News for the Bond Market?
•
An increase in real GDP causes the demand for money to
rise, putting upward pressure on interest rates.
Consequently, bond prices will fall.
•
Also, higher GDP growth leads to higher expectations of
inflation which tend to push up nominal interest rates,
leading to lower bond prices.
•
Stock prices can also fall despite good economic news.
As bond prices fall, bonds become more attractive than
stocks, resulting in lower demand for stocks, and lower
stock prices.
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Interest Rates, Investment, and Output
•
The supply and demand for money determine the
interest rate, which is consistent with particular levels of
investment and output in the economy.
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Interest Rates, Investment, and Output
Open
market
purchase
Money
supply
increases
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Interest
rates fall
Investment
spending
rises
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GDP
increases
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Monetary Policy
• Monetary policy is the range of actions taken
by the Federal Reserve to influence the level
of GDP or the rate of inflation.
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The Exchange Rate
• International trade and movements of financial
funds across countries are affected by interest
rates and exchange rates.
• The exchange rate is the rate at which one
currency trades for another in the market.
• Supply and demand for a currency determine
the exchange rate.
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The Exchange Rate
• 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.
A higher demand for dollars leads to a higher
exchange rate of the dollar against foreign
currencies. The dollar appreciates.
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Interest Rates and Exchange Rates
• There is a direct relationship between a
country’s interest rates and its exchange
rate:
• 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
• There is an inverse relationship between a
country’s net exports and its exchange
rate:
• As the dollar appreciates, U.S. goods become
more expensive on world markets. U.S.
exports decline. A higher value of the dollar
also 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.
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Exchange Rates and Net Exports
• There is an inverse relationship between a
country’s net exports and its exchange
rate:
• 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
• 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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Stabilization Policy and Its Limitations
• The government has two different types of tools
to change the level of GDP in the short run:
• Fiscal policy: the use of government spending and
taxation to influence the level of GDP.
• Monetary policy: changes in the money supply
which lead to changes in interest rates and the level
of GDP.
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Stabilization Policy and Its Limitations
• Fiscal and monetary policies that are used to
change the level of GDP can be:
• Expansionary policies: policies such as tax cuts,
increased government spending, or increased
money supply that aim to increase the level of GDP.
• Contractionary policies: policies that aim to
decrease the level of GDP back to full employment,
or potential output.
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Stabilization Policy and Its Limitations
• Stabilization policies are intended to move
the economy closer to full employment or
potential output. In practice, however, it is very
difficult to accomplish this goal for two reasons:
• Lags: delays in stabilization policy caused by
failure to recognize a problem and respond in a
timely manner to changes in the economy.
• Insufficient knowledge: economists do not know
enough about the economy to be accurate in all
their forecasts.
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Problems Caused by Lags
• Successful stabilization
policies can reduce the
magnitude of economic
fluctuations.
• Ill-timed policies, on the
other hand, can
magnify economic
fluctuations.
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Inside Lags
• Inside lags are lags in implementing policy
which occur for two reasons:
1. It takes time to identify and recognize a problem.
2. It still takes time before any actions can be taken.
This problem is most severe for fiscal policy in the
United States because it is difficult to obtain a
consensus for tax and spending changes in a timely
manner.
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Outside Lags
•
Outside lags refer to the time it takes for policy to
work.
•
Econometric models are mathematical computerbased models that economists build to capture the
actual dynamics of the economy.
•
Econometric models have been used to estimate
outside lags in monetary policy, which are longer than
outside lags for fiscal policy (although fiscal policy
has a much longer inside lag).
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Forecasting Uncertainties
• Economists are not very accurate in
forecasting what will happen in the economy.
• For example, knowing whether a slowdown is
temporary or permanent is a classical problem
policymakers face when the economy appears
to be slowing down.
• Today, most policymakers understand these
limitations and are cautious in using activist
policies to smooth out economic fluctuations.
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