Macroeconomics

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Macroeconomics

• Unit 15
• Monetary Policy and Theory
• The Top Five Concepts

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Introduction

• This unit discusses another economic policy tool
  called monetary theory. Similar to fiscal policy
  or Keynesian theory it focuses on demand.
  However, its main emphasis is controlling the
  demand for money by consumers and businesses.
• In the United States, monetary policy and the
  tools used to control the supply of money are
  controlled and implemented by the Federal Reserve.

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Concept 1 The Money Market

• Money is confronted with its own demand and
  supply curve. The demand and supply of money is
  controlled through the interest rate.
• The interest rate in this case is the price paid
  for the use of money. The amount of money
  demanded is based upon the interest rate. Think
  of the interest rate as the cost of money. When
  interest rates are low, borrowing money to buy a
  home or car is less expensive. When interest
  rates are higher, your cost (and monthly payment)
  increases.
• There are three types of demand for money
  transactions, precautionary, and speculative.

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Concept 1 Money Demand

• Transactions demand This is money that is being
  held for the purpose of making everyday market
  purchases.
• Examples of routine market purchases include
  paying for gas, buying lunch, shopping for
  clothes, buying a home.
• Payments are made using cash, check, debit card,
  credit card, and loans.
• Think about the money that you have in your
  wallet or purse, and in your checking account.
  Chances are this money is for your routine
  transactions that occur every day.

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Concept 1 Money Demand

• Precautionary demand This is money held in
  reserve for unexpected needs or purchases, and
  emergencies.
• Examples include money held in certificates of
  deposit, extra cash kept in a checking account,
  and extra cash kept in a money market account or
  a savings account.
• Uses of money for precautionary demand included
  unexpected illnesses, a great deal on some new
  electronic equipment, or the unexpected loss of a
  car or home not adequately covered by insurance.
  Most people think of this money as their
  emergency money although it can also be used to
  take advantage of a great bargain.

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Concept 1 Money Demand

• Speculative demand This is the money you keep
  in reserve for later financial opportunities or
  speculation.
• For example, extra cash in the bank reserved for
  when stocks fall to a certain price. Its also
  the extra cash being held to buy some property
  when the price falls enough. Or, it could be the
  extra cash you use to invest in a friends
  business.

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Concept 1 Money Demand

• The three different types of demand affect the
  market demand for money.
• The market demand curve for money indicates that
  as the price of money falls (the cost in terms of
  the interest rate), the demand for money will
  increase.
• The supply of money is fixed by current monetary
  policy initiated and controlled by the Federal
  Reserve. So in regards to the money supply, the
  supply curve is vertical, while the demand for
  money is a downward sloping curve.

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The Demand For Money
The amount of money demanded (held) depends on
interest rates
Equilibrium
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Concept 2 Money Equilibrium

• At the equilibrium point the demand and supply of
  money intersect indicating that people are
  willing to hold as much money as is available.
• If interest rates increase, then money will be
  transferred to other markets, like the bond
  market. The demand for money falls.
• The equilibrium point represents the equilibrium
  rate of interest indicating the interest rate at
  which the demand and supply of money are equal.

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Concept 2 Changes to Equilibrium

• Federal Reserve policy can have an impact on the
  equilibrium rate of interest.
• The Federal Reserve can increase the supply of
  money by
• lowering the reserve requirement
• lowering the discount rate
• buying bonds in the open market
• The increase in the supply of money causes the
  equilibrium rate of interest to fall.

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Changing Interest Rates
When rates drop from 7 to 6, there is movement
along the demand curve to the right. The demand
for money increases.
E1
Interest Rate(percent per year)
7
E2
Demand for money
6
0
Quantity Of Money (billions of dollars)
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Economic Effects

• Federal Reserve policy changes have an effect on
  aggregate demand.
• Monetary stimulus is achieved by the Federal
  Reserve through
• Increasing the supply of money.
• Reducing interest rates.
• Buying bonds in the market.
• As a rule, a 1/10 point reduction in long-term
  interest rates can produce 10 billion dollars in
  fiscal stimulus according to Alan Greenspan,
  former chair of the Federal Reserve.

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Economic Effects

• Federal Reserve policy can also be used to
  restrain the economy.
• To reduce aggregate demand, the Federal Reserve
  can
• Decrease the money supply.
• Increase interest rates.
• Sell more bonds at attractive prices.
• All three policy changes will cause a leftward
  shift in aggregate demand.

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Concept 3 Policy Constraints

• Changes in short-term interest rates (federal
  funds rates, 6 month Treasury bonds) need to
  produce changes in long-term interest rates.
  Long-term interest rates are the rates on home
  mortgages, installment loans, 10 year Treasury
  bonds, etc.
• Most Federal Reserve Open Market operations focus
  on short-term rates.
• In order to have a lasting effect on the economy,
  long-term rates need to change as well as
  short-term rates. The success of Federal Reserve
  policy changes is often measured by changes in
  long-term interest rates.

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Concept 3 Policy Constraints

• Long-term rates may not change as fast or as much
  due to the following
• Reluctant Lenders Private banks may not be
  willing to increase their lending activity. They
  may be concerned about consumer or business
  credit quality and/or general economic
  conditions.
• Liquidity Trap If interest rates are already
  low, people may continue to hold money waiting
  for better investment options, and not seek loans
  or conduct additional spending. At this point
  the demand curve is horizontal and increases in
  the supply of money do not push rates lower.

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Concept 3 Policy Constraints

• Long-term rates also may not change due to low
  expectations. If businesses do not believe that
  the demand for goods and services will increase,
  they may curtail investment spending until
  economic conditions improve.
• Any further interest rate reductions may not
  produce an increase in demand at this point
  demand is inelastic until expectations change.
  The U.S. economy during 2002 2003 had some of
  the lowest interest rates in the last 40 years.
  Expectations of future growth remained
  pessimistic until consumer and business spending
  increased significantly during the third and
  fourth quarters of 2003.

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Concept 4 Monetarists

• Keynes believed changes in the money supply can
  affect aggregate demand. Changes in the supply
  of money occur when interest rates change.
• Monetarists believe that changes in short-term
  interest rates (like the discount rate and
  federal funds rate) do not have a significant
  effect on the supply of money. They believe the
  changes in these rates affect the price of money.
• Monetarists believe that monetary policy is not
  effective for recessionary problems, but is
  effective against inflation.

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Concept 4 Monetarists

• Monetary policy can be viewed as a relationship
  between four variables according to Monetarists.
  The relationship is expressed by the equation of
  exchange.
• The equation of exchange shows the relationship
  between four variables that affect monetary
  policy.
• MV PQ is the equation of exchange.
• M quantity of money in circulation
• V the velocity of money in circulation
• P average price of goods
• Q quantity of goods purchased

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Concept 4 Equation of Exchange

• V indicates the number of times per year, on
  average, a dollar is used to purchase final goods
  and services.
• Monetarists believe that V is stable and does not
  change over the long run.
• M X V P X Q
• Any change that occurs in M indicates a change
  will also occur in P and/or Q. The equation must
  remain in balance.
• Monetarists believe that any change in the supply
  of money (M) will alter total spending (PQ), even
  if interest rates change.

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Concept 5 Monetary Theory

• Monetarists believe that Federal Reserve policy
  should be directed at increasing/decreasing the
  supply of money, not at changing interest rates.
• Expanding upon the basic theories of monetarists,
  some believe that Q is stable too. Under this
  theory, a natural rate of unemployment exists
  within the economy that is not affected by short
  term monetary policy changes.
• If this is true, then some monetarists believe
  that changes in M will lead to changes only in P.

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Concept 5 Monetary Theory

• In regards to interest rates, the real rate of
  interest is important to Monetarists. The real
  interest rate is the nominal interest rate minus
  anticipated inflation.
• For example, if the nominal or current rate of
  interest is 4 and the anticipated inflation rate
  is 2, the real rate of interest 4 - 2 2.
• The real rate of interest tells you if, after a
  year, you actually gained or lost money. For
  example, if a bank wishes to receive a 5 return
  (profit) on a loan when the inflation rate is 3,
  then the bank should charge an interest rate of
  8. This nominal rate of 8 has a real rate of
  interest of 5 after inflation.

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Concept 5 Monetary Theory

• Monetarists believe that the real rate of
  interest is stable and that changes in nominal
  interest rates are caused by changes in the
  anticipated rate of inflation.
• If inflation exists, monetarists believe that a
  reduction in the supply of money will lessen
  inflation. As the supply of money is gradually
  reduced by the Federal Reserve through open
  market operations and/or changes in the reserve
  ratio, nominal interest rates will fall.
• Keynesians believe that increasing interest rates
  (discount and federal funds rate) is an effective
  method to lessen inflation.

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Concept 5 Monetary Policy

• For recessionary problems, monetarists believe
  that increasing the supply of money or reducing
  interest rates is not an effective way to end
  recessions.
• Keynesians believe that lowering rates and
  increasing the supply of money (M) can help
  eliminate a recession, along with fiscal policy
  changes.
• Monetarists believe that increasing the supply of
  money (M) could cause an increase in prices (P).
  Rising prices and interest rates would stall any
  economic recovery.

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Monetarists KeynesiansComparison

• Monetarists Changes in interest rates do not
  affect the supply of money. To change the money
  supply, you need to change bond prices through
  the buying and selling of bonds by the Federal
  Reserve, or change the bank reserve requirements
  (reserve ratio).
• Keynesians Changes in interest rates do affect
  the supply and demand for money. They prefer
  interest rate changes but will also support
  selling/buying of bonds to change the supply of
  money. Interest rate changes are used to
  supplement fiscal policy tools (government
  spending, taxes, transfer payments).

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Further Analysis

• When interest rates fall, borrowers are very
  happy. Interest rates on mortgages and car loans
  fall which increases lending activity and new
  purchases.
• Banks and other lenders receive lower income from
  lending activity as interest rates fall. However
  it is important to examine the real rate of
  interest again. During a period of higher rates,
  a bank may have been loaning money for mortgages
  at 9 when inflation was at 6 the real rate of
  interest is 3. If both nominal interest rates
  and the inflation rate falls, the bank may be
  loaning money for mortgages at 5, but if the
  rate of inflation is only 2, then the real rate
  of interest remains at 3.

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Further Analysis

• So is anyone not happy about lower interest
  rates? Well the banks and other lenders may not
  be if the real interest rate has fallen. Their
  profits are likely to be lower.
• Individuals who have investments in savings
  account, CDs, money market accounts, and Treasury
  bills will receive lower rates of interest on
  their savings and investments. Their incomes
  will be lower as a result.

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Summary

• Demand for money (3).
• Equilibrium rate of interest.
• Monetary stimulus and constraints.
• Real interest rate.
• Equation of Exchange.
• Keynesian view of monetary policy.
• Monetarist view of monetary policy.