Chapter 14

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Chapter 14Monetary Policy and Price Stability
MACROECONOMICS EXPLORE APPLYby Ayers and
Collinge
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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

1. Interpret the relationship between monetary
   policy and interest rates.
2. (EA) Address the importance of central banks
   staying independent of political pressures.

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14.1A 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 Feds 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 long-term
  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 Feds primary goal.

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Economic Growth and Inflationin the 1960s
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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 economys
  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
Same price level
Real GDP
More purchasing power
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Contractionary Monetary Policy

• A contractionary monetary policy would have the
  effect of drying up liquidity and tightening up
  the economys 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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14.2THE 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
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
Money supply
Nominal interest rates
Equilibrium Interest rate
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 money demanded is Quantity of money paying asset demand is Publics Response Interest Rate response to Publics Action
(1) At equilibrium Equal to Qs of money Equal to Qs of interest paying assets No change in holdings of money or bonds Interest rate decreases
(2) Above equilibrium Less than Qs of money Greater than the Qs of interest paying assets Increase the holdings of bonds and decrease the holdings of money Interest rate decrease
(3) Below equilibrium Greater than Qs of money Less the Qs of interest paying assets Decrease holdings of bonds and increase holdings of money Interest rate increases
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14.3GUIDING 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

• The equation of exchange reveals that the amount
  of money people spend must equal the market value
  of what they purchase
• M x V P x Q

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The Equation of Exchange

• The total amount of spending in an economy is
  equivalent to the economys 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
Aggregate Demand
Full employment GDP
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 peoples need to hold money, V.

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The Monetarist Prescription
Expansionary (Looser) Monetary Policy
Increase in the quantity of Money
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
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Velocity
Year Velocity
1979 1.742
1980 1.748
1981 1.784
1982 1.706
1983 1.662
1984 1.703
1985 1.688
1986 1.630
1987 1.675
Year Velocity
1988 1.706
1989 1.738
1990 1.771
1991 1.773
1992 1.842
1993 1.907
1994 2.017
1995 2.033
1996 2.05
Year Velocity
1997 2.06
1998 2.00
1999 1.99
2000 2.00
2001 1.87




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Velocity
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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 long-run
  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
Contractionary (Tighter) Monetary Policy
Decrease in the quantity of Money
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14.4THE FEDERAL FUNDS RATE AND MARKET INTEREST
RATES
Fed Action Bank Reserves Federal Funds Rate Short-term Interest Rates
Open Market sale of securities to banks Decrease (reserves go to the Fed to pay for securities) Increases, as reserves leave the banking system Increase
Open market purchase of securities from banks Increase (reserves are received from the Fed in payment for securities Decreases, as reserves are pumped into the banking system Decrease
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14.5 EXPLORE APPLYHow Independent Should a
Central Bank be?

• The Fed is relatively independent from political
  interference from the President and Congress.
• The Fed board members serve 14 year non-renewable
  terms.
• 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

• speculative motive
• money market
• price rule
• equation of exchange
• velocity of money
• quantity theory of money
• monetarism

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Test Yourself

• Conflicts in meeting the goals of Fed
  policymaking
• never occur.
• occur, but are ignored by the Fed.
• occur, and are considered by the Fed in choosing
  monetary policy actions.
• 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 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
• people want to make purchases.
• of the need to save for a rainy day.
• money that is stolen must be replaced.
• 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.
• the price level.
• velocity.
• GDP.
• the equilibrium interest rate.

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Test Yourself

• 5. The quantity theory of money assumes that
  aggregate output is
• never at the full-employment level.
• always at the full-employment level.
• equal to one minus velocity.
• unpredictable and unexplainable.

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Test Yourself

• 6. Monetarism recommends that monetary policy
• focus on low interest rates.
• focus on the stock market, aiming to increase
  stock prices.
• expand the money supply at a steady rate.
• be turned over to Congress.

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The End! Next Chapter 15 Into The International
Marketplace