Monetary Policy PERSON OF THE YEAR CHAPTER 15 WHAT YOU WILL LEARN IN THIS CHAPTER

Transcription

1 CHAPTER 15 Monetary Policy PERSON OF THE YEAR WHAT YOU WILL LEARN IN THIS CHAPTER Dan Winters As Fed chair irman n, Ben Ber nan anke has more influencence ov er the economy s ups and downs than the presi dent. What the money demand dcurveis Why the liquidity preference model determines the interest rate in the short run How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output Why monetary policy is the main tool for stabilizing the economy How the behavior of the Federal Reserve compares to that of other central banks Why economists believe in monetary neutrality that monetary policy affects only the price level, not aggregate output, in the long run A BALD MAN WITH A GRAY beard and tired eyes is sitting in his oversize Washington office, talking about the economy. He doesn t have a commanding presence. He isn t a mesmerizing speaker. He has none of the look-at-me swagger or listen-tome charisma so common among men with oversize Washington offices. His arguments aren t partisan or ideological; they re methodical, grounded in data and the latest academic literature. When he doesn t know something, he doesn t bluster or bluff. He s professorial, which makes sense, because he spent most of his career as a professor. So began Time magazine s profile of Ben Bernanke, whom the magazine named Person of the Year for Who is this mild-mannered man, and why does he matter so much? The answer is that Bernanke is the chairman of the Board of Governors of the Federal Reserve System the body that controls monetary policy. People sometimes say that Bernanke decides how much money to print. That s not quite true: for one thing, the Fed doesn t literally print money, and beyond that, monetary decisions are actually made by a committee rather than by one man. But as we learned in Chapter 14, the Federal Reserve can use openmarket operations and other actions, such as changes in reserve requirements, to alter the money supply and Ben Bernanke has more influence over these actions than anyone else in America. And these actions matter a lot. Roughly half of the recessions the United States has experienced since World War II can be attributed, at least in part, to the decisions of the Federal Reserve to tighten policy to fight inflation. In a number of other cases, the Fed has played a key role in fighting slumps and promoting recovery. The financial crisis of 2008 put the Fed at center stage. Bernanke s aggressive response to the crisis, which, as we saw in Chapter 14, included a tripling of the monetary base, inspired both praise (including his designation as Person of the Year) and condemnation. In this chapter we ll learn how monetary policy works how actions by the Federal Reserve can have a powerful effect on the economy. We ll start by looking at the demand for money from households and firms. Then we ll see how the Fed s ability to change the supply of money allows it to move interest rates in the short run and thereby affect real GDP. We ll look at U.S. monetary policy in practice and compare it to the monetary policy of other central banks. We ll conclude by examining the long-run effects of monetary policy. 447 KrugWellsEC3e_Macro_CH15_15A.indd 447

2 448 PART 6 STABILIZATION POLICY Big Cheese Photo/SuperStock The Demand for Money In Chapter 14 we learned about the various types of monetary aggregates: M1, the most commonly used definition of the money supply, consists of currency in circulation (cash), plus checkable bank deposits, plus traveler s checks; and M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. We also learned why people hold money to make it easier to purchase goods and services. Now we ll go deeper, examining what determines how much money individuals and firms want to hold at any given time. The Opportunity Cost of Holding Money Most economic decisions involve trade-offs at the margin. That is, individuals decide how much of a good to consume by determining whether the benefit they d gain from consuming a bit more of any given good is worth the cost. The same decision process is used when deciding how much money to hold. Individuals and firms find it useful to hold some of their assets in the form of money because of the convenience money provides: money can be used to make purchases directly, but other assets can t. But there is a price to be paid for that convenience: money normally yields a lower rate of return than nonmonetary assets. As an example of how convenience makes it worth incurring some opportunity costs, consider the fact that even today with the prevalence of credit cards, debit cards, and ATMs people continue to keep cash in their wallets rather than leave the funds in an interestbearing account. They do this because they don t want to have to go to an ATM to withdraw money every time they want to buy lunch from a place that doesn t accept credit cards or won t accept them for small amounts because of the processing fee. In other words, the There is a price to be paid for the convenience of hold- convenience of keeping some cash in your wallet is more valuable ing money. than the interest you would earn by keeping that money in the bank. Even holding money in a checking account involves a trade-off between convenience and earning interest. That s because you can earn a higher interest rate by putting your money in assets other than a checking account. For example, many banks offer certificates of deposit, or CDs, which pay a higher interest rate than ordinary bank accounts. But CDs also carry a penalty if you withdraw the funds before a certain amount of time say, six months has elapsed. An individual who keeps funds in a checking account is forgoing the higher interest rate those funds would have earned if placed in a CD in return for the convenience of having cash readily available when needed. So making sense of the demand for money is about understanding how individuals and firms trade off the benefit of holding cash that provides convenience but no interest versus the benefit of holding interest-bearing nonmonetary assets that provide interest but not convenience. And that trade-off is affected by the interest rate. (As before, when we say the interest rate it is with the understanding that we mean a nominal interest rate that is, it s unadjusted for inflation.) Next, we ll examine how that trade-off changed dramatically from June 2007 to June 2008, when there was a big fall in interest rates. TABLE 15-1 Selected Interest Rates, June 2007 One-month certificates of deposit (CDs) 5.30% Interest-bearing demand deposits 2.30% Currency 0 Source: Federal Reserve Bank of St. Louis. Table 15-1 illustrates the opportunity cost of holding money in a specific month, June The first row shows the interest rate on onemonth certificates of deposit that is, the interest rate individuals could get if they were willing to tie their funds up for one month. In June 2007, one-month CDs yielded 5.30%. The second row shows the interest rate on interest-bearing demand deposits (specifically, those included in M2, minus small time deposits). Funds in these accounts were more accessible than those in CDs, but the price of that convenience was a KrugWellsEC3e_Macro_CH15_15A.indd 448

3 CHAPTER 15 MONETARY POLICY 449 much lower interest rate, only 2.30%. Finally, the last row shows the interest rate on currency cash in your wallet which was, of course, zero. Table 15-1 shows the opportunity cost of holding money at one point in time, but the opportunity cost of holding money changes when the overall level of interest rates changes. Specifically, when the overall level of interest rates falls, the opportunity cost of holding money falls, too. Table 15-2 illustrates this point by showing how selected interest rates changed between June 2007 and June 2008, a period when the Federal Reserve was slashing rates in an (unsuccessful) effort to fight off a rapidly worsening recession. A comparison between interest rates in June 2007 and June 2008 illustrates what happens when the opportunity cost of holding money falls sharply. Between June 2007 and June 2008, the federal funds rate, which is the rate the Fed controls most directly, fell by 3.25 percentage points. The interest rate on one-month CDs fell almost as much, 2.8 percentage points. These interest rates are short-term interest rates rates on financial assets that come due, or mature, within less than a year. As short-term interest rates fell between June 2007 and June 2008, the interest rates on money didn t fall by the same amount. The interest rate on currency, of course, remained at zero. The interest rate paid on demand deposits did fall, but by much less than short-term interest rates. As a comparison of the two columns of Table 15-2 shows, the opportunity cost of holding money fell. The last two rows of Table 15-2 summarize this comparison: they give the differences between the interest rates on demand deposits and on currency and the interest rate on CDs. These differences the opportunity cost of holding money rather than interest-bearing assets declined sharply between June 2007 and June This reflects a general result: The higher the short-term interest rate, the higher the opportunity cost of holding money; the lower the shortterm interest rate, the lower the opportunity cost of holding money. The fact that the federal funds rate in Table 15-2 and the interest rate on one-month CDs fell by almost the same percentage is not an accident: all short-term interest rates tend to move together, with rare exceptions. The reason shortterm interest rates tend to move together is that CDs and other short-term assets (like one-month and three-month U.S. Treasury bills) are in effect competing for the same business. Any short-term asset that offers a lower-than-average interest rate will be sold by investors, who will move their wealth into a higher-yielding short-term asset. The selling of the asset, in turn, forces its interest rate up, because investors must be rewarded with a higher rate in order to induce them to buy it. Conversely, investors will move their wealth into any short-term financial asset that offers an above-average interest rate. The purchase of the asset drives its interest rate down when sellers find they can lower the rate of return on the asset and still find willing buyers. So interest rates on short-term financial assets tend to be roughly the same because no asset will consistently offer a higherthan-average or a lower-than-average interest rate. Table 15-2 contains only short-term interest rates. At any given moment, longterm interest rates rates of interest on financial assets that mature, or come due, a number of years into the future may be different from short-term interest rates. The difference between short-term and long-term interest rates is sometimes important as a practical matter. Moreover, it s short-term rates rather than long-term rates that affect money demand, because the decision to hold money involves trading off the convenience of holding cash versus the payoff from holding assets that mature in the short term a year or less. For the moment, however, let s ignore the distinction between short-term and long-term rates and assume that there is only one interest rate. TABLE 15-2 Interest Rates and the Opportunity Cost of Holding Money June 2007 June 2008 Federal funds rate 5.25% 2.00% One-month certificates of deposit (CDs) 5.30% 2.50% Interest-bearing demand deposits 2.30% 1.24% Currency 0 0 CDs minus interest-bearing demand deposits (percentage points) CDs minus currency (percentage points) Source: Federal Reserve Bank of St. Louis. Short-term interest rates are the interest rates on financial assets that mature within less than a year. Long-term interest rates are interest rates on financial assets that mature a number of years in the future. KrugWellsEC3e_Macro_CH15_15A.indd 449

4 450 PART 6 STABILIZATION POLICY The money demand curve shows the relationship between the interest rate and the quantity of money demanded. The Money Demand Curve Because the overall level of interest rates affects the opportunity cost of holding money, the quantity of money individuals and firms want to hold is, other things equal, negatively related to the interest rate. In Figure 15-1, the horizontal axis shows the quantity of money demanded and the vertical axis shows the interest rate, r, which you can think of as a representative short-term interest rate such as the rate on one-month CDs. (As we discussed in Chapter 10, it is the nominal interest rate, not the real interest rate, that influences people s money allocation decisions. Hence, r in Figure 15-1 and all subsequent figures is the nominal interest rate.) The relationship between the interest rate and the quantity of money demanded by the public is illustrated by the money demand curve, MD, in Figure The money demand curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money, leading the public to reduce the quantity of money it demands. For example, if the interest rate is very low say, 1% the interest forgone by holding money is relatively small. As a result, individuals and firms will tend to hold relatively large amounts of money to avoid the cost and nuisance of converting other assets into money when making purchases. By contrast, if the interest rate is relatively high say, 15%, a level it reached in the United States in the early 1980s the opportunity cost of holding money is high. People will respond by keeping only small amounts in cash and deposits, converting assets into money only when needed. You might ask why we draw the money demand curve with the interest rate as opposed to rates of return on other assets, such as stocks or real estate on the vertical axis. The answer is that for most people the relevant question in deciding how much money to hold is whether to put the funds in the form of other assets that can be turned fairly quickly and easily into money. Stocks don t fit that definition because there are significant transaction fees when you sell stock (which is why stock market investors are advised not to buy and sell too often). Real estate doesn t fit the definition either because selling real estate involves even larger fees and can take a long time as well. So the relevant comparison is with assets that are close to money fairly liquid assets like CDs. And as we ve already seen, the interest rates on all these assets normally move closely together The Money Demand Curve The money demand curve illustrates the relationship between the interest rate and the quantity of money demanded. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. Correspondingly, a lower interest rate reduces the opportunity cost of holding money and increases the quantity of money demanded. Interest rate, r Money demand curve, MD Quantity of money KrugWellsEC3e_Macro_CH15_15A.indd 450

5 CHAPTER 15 MONETARY POLICY 451 Shifts of the Money Demand Curve A number of factors other than the interest rate affect the demand for money. When one of these factors changes, the money demand curve shifts. Figure 15-2 shows shifts of the money demand curve: an increase in the demand for money corresponds to a rightward shift of the MD curve, raising the quantity of money demanded at any given interest rate; a decrease in the demand for money corresponds to a leftward shift of the MD curve, reducing the quantity of money demanded at any given interest rate. The most important factors causing the money demand curve to shift are changes in the aggregate price level, changes in real GDP, changes in credit markets and banking technology, and changes in institutions. Changes in the Aggregate Price Level Americans keep a lot more cash in their wallets and funds in their checking accounts today than they did in the 1950s. One reason is that they have to if they want to be able to buy anything: almost everything costs more now than it did when you could get a burger, fries, and a drink at McDonald s for 45 cents and a gallon of gasoline for 29 cents. So, other things equal, higher prices increase the demand for money (a rightward shift of the MD curve), and lower prices decrease the demand for money (a leftward shift of the MD curve). We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, such as r 1 in Figure 15-2, also rises by 20% the movement from M 1 to M 2. Why? Because if the price of everything rises by 20%, it takes 20% more money to buy the same basket of goods and services. And if the aggregate price level falls by 20%, at any given interest rate the quantity of money demanded falls by 20% shown by the movement from M 1 to M 3 at the interest rate r 1. As we ll see later, the fact that money demand is proportional to the price level has important implications for the long-run effects of monetary policy. Changes in Real GDP Households and firms hold money as a way to facilitate purchases of goods and services. The larger the quantity of goods and services they buy, the larger the quantity of money they will want to hold at any given interest rate. So an increase in real GDP the total quantity of goods and services produced and sold in the economy shifts the money demand curve rightward. A fall in real GDP shifts the money demand curve leftward Increases and Decreases in the Demand for Money The demand curve for money shifts when non-interest rate factors that affect the demand for money change. An increase in money demand shifts the money demand curve to the right, from MD 1 to MD 2, and the quantity of money demanded rises at any given interest rate. A decrease in money demand shifts the money demand curve to the left, from MD 1 to MD 3, and the quantity of money demanded falls at any given interest rate. Interest rate, r r 1 A decrease in money demand shifts the money demand curve to the left. An increase in money demand shifts the money demand curve to the right. MD 1 MD 2 M 3 M 1 M 2 MD 3 Quantity of money KrugWellsEC3e_Macro_CH15_15A.indd 451

6 452 PART 6 STABILIZATION POLICY Changes in Credit Markets and Banking Technology Credit cards are everywhere in American life today, but it wasn t always so. The first credit card that allowed customers to carry a balance from month to month (called a revolving balance ) was issued in Before then, people had to either pay for purchases in cash or pay off their balance every month. The invention of revolving-balance credit cards allowed people to hold less money in order to fund their purchases and decreased the demand for money. In addition, changes in banking technology that made credit cards widely available and widely accepted magnified the effect, making it easier for people to make purchases without having to convert funds from their interest-bearing assets, further reducing the demand for money. Changes in Institutions Changes in institutions can increase or decrease the demand for money. For example, until Regulation Q was eliminated in 1980, U.S. banks weren t allowed to offer interest on checking accounts. So the interest you would forgo by holding funds in a checking account instead of an interest-bearing asset made the opportunity cost of holding funds in checking accounts very high. When banking regulations changed, allowing banks to pay interest on checking account funds, the demand for money rose and shifted the money demand curve to the right. Ton Koene/AgeFotostock No matter what they are shopping for, Japanese con- sumers tend to pay with cash rather than plastic. Quick Review Money offers a lower rate of return than other financial assets. We usually compare the rate of return on money with short-term, not longterm, interest rates. Holding money provides liquidity but incurs an opportunity cost that rises with the interest rate, leading to the downward slope of the money demand curve. Changes in the aggregate price level, real GDP, credit markets and banking technology, and institutions shift the money demand curve. An increase in the demand for money shifts the money demand curve rightward; a decrease in the demand for money shifts the money demand curve leftward. ECONOMICS IN ACTION A YEN FOR CASH Japan, say financial experts, is still a cash society. Visitors from the United States or Europe are surprised at how little use the Japanese make of credit cards and how much cash they carry around in their wallets. Yet Japan is an economically and technologically advanced country and, according to some measures, ahead of the United States in the use of telecommunications and information technology. So why do the citizens of this economic powerhouse still do business the way Americans and Europeans did a generation ago? The answer highlights the factors affecting the demand for money. One reason the Japanese use cash so much is that their institutions never made the switch to heavy reliance on plastic. For complex reasons, Japan s retail sector is still dominated by small mom-and-pop stores, which are reluctant to invest in credit card technology. Japan s banks have also been slow about pushing transaction technology; visitors are often surprised to find that ATMs close early in the evening rather than staying open all night. But there s another reason the Japanese hold so much cash: there s little opportunity cost to doing so. Short-term interest rates in Japan have been below 1% since the mid-1990s. It also helps that the Japanese crime rate is quite low, so you are unlikely to have your wallet full of cash stolen. So why not hold cash? CHECK YOUR UNDERSTANDING Explain how each of the following would affect the quantity of money demanded. Does the change cause a movement along the money demand curve or a shift of the money demand curve? a. Short-term interest rates rise from 5% to 30%. b. All prices fall by 10%. c. New wireless technology automatically charges supermarket purchases to credit cards, eliminating the need to stop at the cash register. d. In order to avoid paying a sharp increase in taxes, residents of Laguria shift their assets into overseas bank accounts. These accounts are harder for tax authorities to trace but also harder for their owners to tap and convert funds into cash. KrugWellsEC3e_Macro_CH15_15A.indd 452

7 CHAPTER 15 MONETARY POLICY Which of the following will increase the opportunity cost of holding cash? Reduce it? Have no effect? Explain. a. Merchants charge a 1% fee on debit/credit card transactions for purchases of less than $50. b. To attract more deposits, banks raise the interest paid on six-month CDs. c. It s the holiday shopping season and retailers have temporarily slashed prices to unexpectedly low levels. d. The cost of food rises significantly. Solutions appear at back of book. According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money. The money supply curve shows how the quantity of money supplied varies with the interest rate. Money and Interest Rates The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2¼ percent. Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters. So read the beginning of a press release from the Federal Reserve issued on March 18, (A basis point is equal to 0.01 percentage point. So the statement implies that the Fed lowered the target from 3% to 2.25%.) We learned about the federal funds rate in Chapter 14: it s the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight-times-a-year meetings, a group called the Federal Open Market Committee sets a target value for the federal funds rate. It s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells short-term U.S. government debt, known as Treasury bills, to achieve that target. As we ve already seen, other short-term interest rates, such as the rates on CDs, move with the federal funds rate. So when the Fed reduced its target for the federal funds rate from 3% to 2.25% in March 2008, many other short-term interest rates also fell by about three-quarters of a percentage point. How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all? The Equilibrium Interest Rate Recall that, for simplicity, we re assuming there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 15-3, which illustrates the liquidity preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 15-3 combines the money demand curve, MD, with the money supply curve, MS, which shows how the quantity of money supplied by the Federal Reserve varies with the interest rate. In Chapter 14 we learned how the Federal Reserve can increase or decrease the money supply: it usually does this through open-market operations, buying or selling Treasury bills, but it can also lend via the discount window or change reserve requirements. Let s assume for simplicity that the Fed, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, MS in Figure 15-3, with a horizontal intercept corresponding to the money supply chosen by the Fed, M. The money market equilibrium is at E, where MS and MD cross. At this point the quantity of money demanded equals the money supply, M, leading to an equilibrium interest rate of r E. KrugWellsEC3e_Macro_CH15_15A.indd 453

8 454 PART 6 STABILIZATION POLICY 15-3 Equilibrium in the Money Market The money supply curve, MS, is vertical at the money supply chosen by the Federal Reserve, M. The money market is in equilibrium at the interest rate r E : the quantity of money demanded by the public is equal to M, the quantity of money supplied. At a point such as L, the interest rate, r L, is below r E and the corresponding quantity of money demanded, M L, exceeds the money supply, M. In an attempt to shift their wealth out of nonmoney interest-bearing financial assets and raise their money holdings, investors drive the interest rate up to r E. At a point such as H, the interest rate r H exceeds r E and the corresponding quantity of money demanded, M H, is less than the money supply, M. In an attempt to shift out of money holdings into nonmoney interest-bearing financial assets, investors drive the interest rate down to r E. Equilibrium interest rate Interest rate, r r H r E r L H M H Money supply curve, MS M E Money supply chosen by the Fed Equilibrium L MD M L Quantity of money To understand why r E is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, r L, is below r E. At r L the public wants to hold the quantity of money M L, an amount larger than the actual money supply, M. This means that at point L, the public wants to shift some of its wealth out of interest-bearing assets such as CDs into money. This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of interestbearing money assets demanded is less than the quantity supplied. So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from r L until the public wants to hold the quantity of money that is actually available, M. That is, the interest rate will rise until it is equal to r E. Now consider what happens if the money market is at a point such as H in Figure 15-3, where the interest rate r H is above r E. In that case the quantity of money demanded, M H, is less than the quantity of money supplied, M. Correspondingly, the quantity of interest-bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from r H. It falls until the public wants to hold the quantity of money that is actually available, M. Again, the interest rate will end up at r E. Two Models of Interest Rates? You might have noticed that this is the second time we have discussed the determination of the interest rate. In Chapter 10 we studied the loanable funds model of the interest rate; according to that model, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market. Which of these models is correct? KrugWellsEC3e_Macro_CH15_15A.indd 454

9 CHAPTER 15 MONETARY POLICY 455 The answer is both. We explain how the models are consistent with each other in the appendix to this chapter. For now, let s put the loanable funds model to one side and concentrate on the liquidity preference model of the interest rate. The most important insight from this model is that it shows us how monetary policy actions by the Federal Reserve and other central banks works. Monetary Policy and the Interest Rate Let s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 15-4 shows what happens when the Fed increases the money supply from M 1 to M 2. The economy is originally in equilibrium at E 1, with an equilibrium interest rate of r 1 and money supply M 1. An increase in the money supply by the Fed to M 2 shifts the money supply curve to the right, from MS 1 to MS 2, and leads to a fall in the equilibrium interest rate to r 2. Why? Because r 2 is the only interest rate at which the public is willing to hold the quantity of money actually supplied, M 2. So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate. In practice, at each meeting the Federal Open Market Committee decides on the interest rate to prevail for the next six weeks, until its next meeting. The Fed sets a target federal funds rate, a desired level for the federal funds rate. This target is then enforced by the Open Market Desk of the Federal Reserve Bank of New York, which adjusts the money supply through the purchase and sale of Treasury bills until the actual federal funds rate equals the target rate. The other tools of monetary policy, lending through the discount window and changes in reserve requirements, aren t used on a regular basis (although the Fed used discount window lending in its efforts to address the 2008 financial crisis). Figure 15-5 shows how this works. In both panels, r T is the target federal funds rate. In panel (a), the initial money supply curve is MS 1 with money supply M 1, and the equilibrium interest rate, r 1, is above the target rate. To lower the interest rate to r T, the Fed makes an open-market The target federal funds rate is the Federal Reserve s desired federal funds rate. PITFALLS THE TARGET VERSUS THE MARKET Over the years, the Federal Reserve has changed the way in which monetary policy is implemented. In the late 1970s and early 1980s, it set a target level for the money supply and altered the monetary base to achieve that target. Under this operating procedure, the federal funds rate fluctuated freely. Today the Fed uses the reverse procedure, setting a target for the federal funds rate and allowing the money supply to fluctuate as it pursues that target. A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works. That is, you ll sometimes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate. In fact, the money market works the same way as always: the interest rate is determined by the supply and demand for money. The only difference is that now the Fed adjusts the supply of money to achieve its target interest rate. It s important not to confuse a change in the Fed s operating procedure with a change in the way the economy works The Effect of an Increase in the Money Supply on the Interest Rate The Federal Reserve can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r 1 to r 2 in response to an increase in the money supply from M 1 to M 2. In order to induce people to hold the larger quantity of money, the interest rate must fall from r 1 to r 2. Interest rate, r MS 1 An increase in the money supply... MS 2... leads to a fall in the interest rate. r 1 E 1 r 2 E 2 MD M 1 M 2 Quantity of money KrugWellsEC3e_Macro_CH15_15A.indd 455

10 456 PART 6 STABILIZATION POLICY 15-5 Setting the Federal Funds Rate Interest rate, r (a) Pushing the Interest Rate Down to the Target Rate An open-market purchase of Treasury bills... Interest rate, r (b) Pushing the Interest Rate Up to the Target Rate An open-market sale of Treasury bills... MS 1 MS 2 MS 2 MS 1... drives the interest rate down. r 1 r T E 1 E 2... drives the interest rate up. r T r 1 E 2 E 1 MD MD M 1 M 2 Quantity of money M 2 M 1 Quantity of money The Federal Reserve sets a target for the federal funds rate and uses open-market operations to achieve that target. In both panels the target rate is r T. In panel (a) the initial equilibrium interest rate, r 1, is above the target rate. The Fed increases the money supply by making an open-market purchase of Treasury bills, pushing the money supply curve rightward, from MS 1 to MS 2, and driving the interest rate down to r T. In panel (b) the initial equilibrium interest rate, r 1, is below the target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward, from MS 1 to MS 2, and driving the interest rate up to r T. purchase of Treasury bills. As we learned in Chapter 14, an open-market purchase of Treasury bills leads to an increase in the money supply via the money multiplier. This is illustrated in panel (a) by the rightward shift of the money supply curve from MS 1 to MS 2 and an increase in the money supply to M 2. This drives the equilibrium interest rate down to the target rate, r T. Panel (b) shows the opposite case. Again, the initial money supply curve is MS 1 with money supply M 1. But this time the equilibrium interest rate, r 1, is below the target federal funds rate, r T. In this case, the Fed will make an open-market sale of Treasury bills, leading to a fall in the money supply to M 2 via the money multiplier. The money supply curve shifts leftward from MS 1 to MS 2, driving the equilibrium interest rate up to the target federal funds rate, r T. Long-Term Interest Rates Earlier in this chapter we mentioned that long-term interest rates rates on bonds or loans that mature in several years don t necessarily move with short-term interest rates. How is that possible, and what does it say about monetary policy? Consider the case of Millie, who has already decided to place $10,000 in U.S. government bonds for the next two years. However, she hasn t decided whether to put the money in one-year bonds, at a 4% rate of interest, or two-year bonds, at a 5% rate of interest. If she buys the one-year bond, then in one year, Millie will receive the $10,000 she paid for the bond (the principal) plus interest earned. If instead she buys the two-year bond, Millie will have to wait until the end of the second year to receive her principal and her interest. You might think that the two-year bonds are a clearly better deal but they may not be. Suppose that Millie expects the rate of interest on one-year bonds to rise sharply next year. If she puts her funds in one-year bonds this year, she KrugWellsEC3e_Macro_CH15_15A.indd 456

11 CHAPTER 15 MONETARY POLICY 457 will be able to reinvest the money at a much higher rate next year. And this could give her a two-year rate of return that is higher than if she put her funds into the two-year bonds today. For example, if the rate of interest on one-year bonds rises from 4% this year to 8% next year, putting her funds in a one-year bond today and in another one-year bond a year from now will give her an annual rate of return over the next two years of about 6%, better than the 5% rate on two-year bonds. The same considerations apply to all investors deciding between shortterm and long-term bonds. If they expect short-term interest rates to rise, investors may buy short-term bonds even if long-term bonds bought today offer a higher interest rate today. If they expect short-term interest rates to fall, investors may buy long-term bonds even if short-term bonds bought today offer a higher interest rate today. As this example suggests, long-term interest rates largely reflect the average expectation in the market about what s going to happen to shortterm rates in the future. When long-term rates are higher than short-term rates, as they were in 2010, the market is signaling that it expects shortterm rates to rise in the future. This is not, however, the whole story: risk is also a factor. Return to the example of Millie, deciding whether to buy one-year or two-year bonds. Suppose that there is some chance she will need to cash in her investment after just one year say, to meet an emergency medical bill. If she buys two-year bonds, she would have to sell those bonds to meet the unexpected expense. But what price will she get for those bonds? It depends on what has happened to interest rates in the rest of the economy. As we learned in Chapter 10, bond prices and interest rates move in opposite directions: if interest rates rise, bond prices fall, and vice versa. This means that Millie will face extra risk if she buys two-year rather Advertising during the two world wars increased than one-year bonds, because if a year from now bond prices fall and the demand for government long-term bonds from she must sell her bonds in order to raise cash, she will lose money on the savers who might have been otherwise reluctant bonds. Owing to this risk factor, long-term interest rates are, on average, to tie up their funds for several years. higher than short-term rates in order to compensate long-term bond purchasers for the higher risk they face (although this relationship is reversed when short-term rates are unusually high). As we will see later in this chapter, the fact that long-term rates don t necessarily move with short-term rates is sometimes an important consideration for monetary policy. U.S. Department of Defense ECONOMICS IN ACTION THE FED REVERSES COURSE We began this section with the Fed s announcement of March 18, 2008, that it was cutting its target interest rate. This particular action was part of a larger story: a dramatic reversal of Fed policy that began in September Figure 15-6 shows two interest rates from the beginning of 2004 to mid-2011: the target federal funds rate, decided by the Federal Open Market Committee, and the effective, or actual, rate in the market. As you can see, the Fed raised its target rate in a series of steps from late 2004 until the middle of 2006; it did this to head off the possibility of an overheating economy and rising inflation (more on that later in this chapter). But the Fed dramatically reversed course beginning in September 2007, as falling housing prices triggered a growing 15-6 The Fed Reverses Course Federal funds rate 6% Target federal funds rate Source: Federal Reserve Bank of St. Louis Effective federal funds rate Year KrugWellsEC3e_Macro_CH15_15A.indd 457

12 458 PART 6 STABILIZATION POLICY Quick Review According to the liquidity preference model of the interest rate, the equilibrium interest rate is determined by the money demand curve and the money supply curve. The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate and uses open-market operations to achieve that target. Long-term interest rates reflect expectations about what s going to happen to short-term rates in the future. Because of risk, long-term interest rates tend to be higher than short-term rates. financial crisis and ultimately a severe recession. And in December 2008, the Fed decided to allow the federal funds rate to move inside a target band between 0% and 0.25%. From 2009 to mid-2011, the Fed funds rate was kept close to zero in response to a very weak economy and high unemployment. Figure 15-6 also shows that the Fed doesn t always hit its target. There were a number of days, especially in 2008, when the effective federal funds rate was significantly above or below the target rate. But these episodes didn t last long, and overall the Fed got what it wanted, at least as far as short-term interest rates were concerned. CHECK YOUR UNDERSTANDING Assume that there is an increase in the demand for money at every interest rate. Using a diagram, show what effect this will have on the equilibrium interest rate for a given money supply. 2. Now assume that the Fed is following a policy of targeting the federal funds rate. What will the Fed do in the situation described in Question 1 to keep the federal funds rate unchanged? Illustrate with a diagram. 3. Frannie must decide whether to buy a one-year bond today and another one a year from now, or buy a two-year bond today. In which of the following scenarios is she better off taking the first action? The second action? a. This year, the interest on a one-year bond is 4%; next year, it will be 10%. The interest rate on a two-year bond is 5%. b. This year, the interest rate on a one-year bond is 4%; next year, it will be 1%. The interest rate on a two-year bond is 3%. Solutions appear at back of book. Robert Mankoff/Cartoonbank.com I told you the Fed should have tightened. Expansionary monetary policy is monetary policy that increases aggregate demand. Contractionary monetary policy is monetary policy that decreases aggregate demand. Monetary Policy and Aggregate Demand In Chapter 13 we saw how fiscal policy can be used to stabilize the economy. Now we will see how monetary policy changes in the money supply, and the interest rate can play the same role. Expansionary and Contractionary Monetary Policy In Chapter 12 we learned that monetary policy shifts the aggregate demand curve. We can now explain how that works: through the effect of monetary policy on the interest rate. Figure 15-7 illustrates the process. Suppose, first, that the Federal Reserve wants to reduce interest rates, so it expands the money supply. As you can see in the top portion of the figure, a lower interest rate, in turn, will lead, other things equal, to more investment spending. This will in turn lead to higher consumer spending, through the multiplier process, and to an increase in aggregate output demanded. In the end, the total quantity of goods and services demanded at any given aggregate price level rises when the quantity of money increases, and the AD curve shifts to the right. Monetary policy that increases the demand for goods and services is known as expansionary monetary policy. Suppose, alternatively, that the Federal Reserve wants to increase interest rates, so it contracts the money supply. You can see this process illustrated in the bottom portion of the diagram. Contraction of the money supply leads to a higher interest rate. The higher interest rate leads to lower investment spending, then to lower consumer spending, and then to a decrease in aggregate output demanded. So the total quantity of goods and services demanded falls when the money supply is reduced, and the AD curve shifts to the left. Monetary policy that decreases the demand for goods and services is called contractionary monetary policy. KrugWellsEC3e_Macro_CH15_15A.indd 458

13 CHAPTER 15 MONETARY POLICY Expansionary and Contractionary Monetary Policy EXPANSIONARY Increase money supply Lower interest rate Higher investment spending raises income Higher consumer spending (via multiplier) Increase in aggregate demand and AD curve shifts to the right Aggregate price level AD 1 AD 2 Real GDP CONTRACTIONARY Decrease money supply Higher interest rate Lower investment spending reduces income Lower consumer spending (via multiplier) Decrease in aggregate demand and AD curve shifts to the left Aggregate price level AD 2 AD 1 Real GDP The top portion shows what happens when the Fed adopts an expansionary monetary policy and increases the money supply. Interest rates fall, leading to higher investment spending, which raises income, which, in turn, raises consumer spending and shifts the AD curve to the right. The bottom portion shows what happens when the Fed adopts a contractionary monetary policy and reduces the money supply. Interest rates rise, leading to lower investment spending and a reduction in income. This lowers consumer spending and shifts the AD curve to the left. Monetary Policy in Practice How does the Fed decide whether to use expansionary or contractionary monetary policy? And how does it decide how much is enough? In Chapter 6 we learned that policy makers try to fight recessions, as well as try to ensure price stability: low (though usually not zero) inflation. Actual monetary policy reflects a combination of these goals. In general, the Federal Reserve and other central banks tend to engage in expansionary monetary policy when actual real GDP is below potential output. Panel (a) of Figure 15-8 shows the U.S. output gap, which we defined in Chapter 12 as the percentage difference between actual real GDP and potential output, versus the federal funds rate since (Recall that the output gap is positive when actual real GDP exceeds potential output.) As you can see, the Fed has tended to raise interest rates when the output gap is rising that is, when the economy is developing an inflationary gap and cut rates when the output gap is falling. The big exception was the late 1990s, when the Fed left rates steady for several years even as the economy developed a positive output gap (which went along with a low unemployment rate). One reason the Fed was willing to keep interest rates low in the late 1990s was that inflation was low. Panel (b) of Figure 15-8 compares the inflation rate, measured as the rate of change in consumer prices excluding food and energy, with the federal funds rate. You can see how low inflation during the mid-1990s, the early 2000s, and the late 2000s helped encourage loose monetary policy in the late 1990s, in , and again beginning in The Taylor Rule Method of Setting Monetary Policy In 1993 Stanford economist John Taylor suggested that monetary policy should follow a simple rule that takes into account concerns about both the business cycle and inflation. He also suggested that actual monetary policy often looks as if the Federal Reserve was, in fact, more or less following the proposed rule. A Taylor rule for monetary policy is a rule for setting interest rates that takes A Taylor rule for monetary policy is a rule that sets the federal funds rate according to the level of the inflation rate and either the output gap or the unemployment rate. KrugWellsEC3e_Macro_CH15_15A.indd 459

14 460 PART 6 STABILIZATION POLICY 15-8 Tracking Monetary Policy Using the Output Gap and Inflation Output gap 8% (a) Output Gap vs. Federal Funds Rate Federal funds rate Output gap Year Federal funds rate 12% Inflation rate 6% (b) Inflation Rate vs. Federal Funds Rate Inflation rate Federal funds rate Year Federal funds rate 12% Panel (a) shows that the federal funds rate usually rises when the output gap is positive that is, when actual real GDP is above potential output and falls when the output gap is negative. Panel (b) illustrates that the federal funds rate tends to be high when inflation is high and low when inflation is low. Sources: Bureau of Labor Statistics; Congressional Budget Office; Federal Reserve Bank of St. Louis. into account the inflation rate and the output gap or, in some cases, the unemployment rate. A widely cited example of a Taylor rule is a relationship among Fed policy, inflation, and unemployment estimated by economists at the Federal Reserve Bank of San Francisco. These economists found that between 1988 and 2008 the Fed s behavior was well summarized by the following Taylor rule: Federal funds rate = inflation rate 1.95 unemployment gap where the inflation rate was measured by the change over the previous year in consumer prices excluding food and energy, and the unemployment gap was the difference between the actual unemployment rate and Congressional Budget Office estimates of the natural rate of unemployment. Figure 15-9 compares the federal funds rate predicted by this rule with the actual federal funds rate from 1985 to early As you can see, the Fed s decisions were quite close to those predicted by this particular Taylor rule from 1988 through the end of We ll talk about what happened after 2008 shortly. Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target. Inflation Targeting Until January 2012, the Fed did not explicitly commit itself to achieving a particular inflation rate. However, in January 2012, Bernanke announced that the Fed would set its policy to maintain an approximately 2% inflation rate per year. With that statement, the Fed joined a number of other central banks that have explicit inflation targets. So rather than using a Taylor rule to set monetary policy, they instead announce the inflation rate that they want to achieve the inflation target and set policy in an attempt to hit that target. This method of setting monetary policy, called inflation targeting, involves having the central bank announce the inflation rate it is trying to achieve and set policy in an attempt to KrugWellsEC3e_Macro_CH15_15A.indd 460

15 CHAPTER 15 MONETARY POLICY The Taylor Rule and the Federal Funds Rate The blue line shows the federal funds rate predicted by the San Francisco Fed s version of the Taylor rule, which relates the interest rate to the inflation rate and the unemployment rate. The red line shows the actual federal funds rate. The actual rate tracked the predicted rate quite closely through the end of After that, however, the Taylor rule called for negative interest rates, which aren t possible. Sources: Bureau of Labor Statistics; Congressional Budget Office; Federal Reserve Bank of St. Louis; Glenn D. Rudebusch, The Fed s Monetary Policy Response to the Current Crisis, FRBSF Economic Letter # (May 22, 2009). Federal funds rate 12% Federal funds rate Federal funds rate (Taylor rule) Year hit that target. The central bank of New Zealand, which was the first country to adopt inflation targeting, specified a range for that target of 1% to 3%. Other central banks commit themselves to achieving a specific number. For example, the Bank of England has committed to keeping inflation at 2%. In practice, there doesn t seem to be much difference between these versions: central banks with a target range for inflation seem to aim for the middle of that range, and central banks with a fixed target tend to give themselves considerable wiggle room. One major difference between inflation targeting and the Taylor rule method is that inflation targeting is forward-looking rather than backward-looking. That is, the Taylor rule method adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation. INFLATION TARGETS This figure shows the target inflation rates of six central banks that have adopted inflation targeting. The central bank of New Zealand introduced inflation targeting in Today it has an inflation target range of from 1% to 3%. The central banks of Canada and Sweden have the same target range but also specify 2% as the precise target. The central banks of Britain and Norway have specific targets for inflation, 2% and 2.5%, respectively. Neither states by how much they re prepared to miss those targets. Since 2012, the U.S. Federal Reserve also targets inflation at 2%. In practice, these differences in detail don t seem to lead to any significant difference in results. New Zealand aims for the middle of its range, at 2% inflation; Britain, Norway, and the United States allow themselves considerable wiggle room around their target inflation rates. Target inflation rate 3.5% New Zealand Canada Sweden Britain Norway United States KrugWellsEC3e_Macro_CH15_15A.indd 461

16 462 PART 6 STABILIZATION POLICY The zero lower bound for interest rates means that interest rates cannot fall below zero. Advocates of inflation targeting argue that it has two key advantages over a Taylor rule: transparency and accountability. First, economic uncertainty is reduced because the central bank s plan is transparent: the public knows the objective of an inflation-targeting central bank. Second, the central bank s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable. Critics of inflation targeting argue that it s too restrictive because there are times when other concerns like the stability of the financial system should take priority over achieving any particular inflation rate. Indeed, in late 2007 and early 2008 the Fed cut interest rates much more than either a Taylor rule or inflation targeting would have dictated because it feared that turmoil in the financial markets would lead to a major recession. (In fact, it did.) Many American macroeconomists have had positive things to say about inflation targeting including Ben Bernanke, the current chairman of the Federal Reserve. And in January 2012 the Fed declared that what it means by the price stability it seeks is 2 percent inflation, although there was no explicit commitment about when this inflation rate would be achieved. The Zero Lower Bound Problem As Figure 15-9 shows, a Taylor rule based on inflation and the unemployment rate does a good job of predicting Federal Reserve policy from 1988 through After that, however, things go awry, and for a simple reason: with very high unemployment and low inflation, the same Taylor rule called for an interest rate less than zero, which isn t possible. Why aren t negative interest rates possible? Because people always have the alternative of holding cash, which offers a zero interest rate. Nobody would ever buy a bond yielding an interest rate less than zero because holding cash would be a better alternative. The fact that interest rates can t go below zero called the zero lower bound for interest rates sets limits to the power of monetary policy. In 2009 and 2010, inflation was low and the economy was operating far below potential, so the Federal Reserve wanted to increase aggregate demand. Yet the normal way it does this open-market purchases of short-term government debt to expand the money supply had run out of room to operate because short-term interest rates were already at or near zero. In November 2010 the Fed began an attempt to circumvent this problem, which went by the somewhat obscure name quantitative easing. Instead of purchasing only short-term government debt, it began buying longer-term government debt five-year or six-year bonds, rather than three-month Treasury bills. As we have already pointed out, long-term interest rates don t exactly follow shortterm rates. At the time the Fed began this program, short-term rates were near zero, but rates on longer-term bonds were between 2% and 3%. The Fed hoped that direct purchases of these longer-term bonds would drive down interest rates on long-term debt, exerting an expansionary effect on the economy. This policy may have given the economy some boost in 2011, but as of early 2012, recovery remained painfully slow. ECONOMICS IN ACTION WHAT THE FED WANTS, THE FED GETS What s the evidence that the Fed can actually cause an economic contraction or expansion? You might think that finding such evidence is just a matter of looking at what happens to the economy when interest rates go up or down. But it turns out that there s a big problem with that approach: the Fed usually changes interest rates in an attempt to tame the business cycle, raising rates if the economy is expanding and reducing rates if the economy KrugWellsEC3e_Macro_CH15_15A.indd 462

17 CHAPTER 15 MONETARY POLICY 463 is slumping. So in the actual data, it often looks as if low interest rates go along with a weak economy and high rates go along with a strong economy. In a famous 1994 paper titled Monetary Policy Matters, the macroeconomists Christina Romer and David Romer solved this problem by focusing on episodes in which monetary policy wasn t a reaction to the business cycle. Specifically, they used minutes from the Federal Open Market Committee and other sources to identify episodes in which the Federal Reserve in effect decided to attempt to create a recession to reduce inflation. As we ll learn in Chapter 16, rather than just using monetary policy as a tool of macroeconomic stabilization, sometimes it is used to eliminate embedded inflation inflation that people believe will persist into the future. In such a case, the Fed needs to create a recessionary gap not just eliminate an inflationary gap to wring embedded inflation out of the economy. Figure shows the unemployment rate between 1952 and 1984 (orange) and also identifies five dates on which, according to Romer and Romer, the Fed decided that it wanted a recession (vertical red lines). In four out of the five cases, the decision to contract the economy was followed, after a modest lag, by a rise in the unemployment rate. On average, Romer and Romer found, the unemployment rate rises by 2 percentage points after the Fed decides that unemployment needs to go up. So yes, the Fed gets what it wants. CHECK YOUR UNDERSTANDING 15-3 Unemployment rate 12% 1. Suppose the economy is currently suffering from an output gap and the Federal Reserve uses an expansionary monetary policy to close that gap. Describe the short-run effect of this policy on the following. a. The money supply curve b. The equilibrium interest rate c. Investment spending d. Consumer spending e. Aggregate output 2. In setting monetary policy, which central bank one that operates according to a Taylor rule or one that operates by inflation targeting is likely to respond more directly to a financial crisis? Explain. Solutions appear at back of book. Money, Output, and Prices in the Long Run When the Fed Wants a Recession Through its expansionary and contractionary effects, monetary policy is generally the policy tool of choice to help stabilize the economy. However, not all actions by central banks are productive. In particular, as we ll see in the next chapter, central banks sometimes print money not to fight a recessionary gap but to help the government pay its bills, an action that typically destabilizes the economy Sources: Bureau of Labor Statistics; Christina D. Romer and David H. Romer, Monetary Policy Matters, Journal of Monetary Economics 34 (August 1994): Quick Review Year The Federal Reserve can use expansionary monetary policy to increase aggregate demand and contractionary monetary policy to reduce aggregate demand. The Federal Reserve and other central banks generally try to tame the business cycle while keeping the inflation rate low but positive. Under a Taylor rule for monetary policy, the target federal funds rate rises when there is high inflation and either a positive output gap or very low unemployment; it falls when there is low or negative inflation and either a negative output gap or high unemployment. In contrast, some central banks set monetary policy by inflation targeting, a forward-looking policy rule, rather than by using the Taylor rule, a backward-looking policy rule. Although inflation targeting has the benefits of transparency and accountability, some think it is too restrictive. Until 2008, the Fed followed a loosely defined Taylor rule. Starting in early 2012, it began inflation targeting with a target of 2% per year. There is a zero lower bound for interest rates they cannot fall below zero that limits the power of monetary policy. Because it is subject to fewer lags than fiscal policy, monetary policy is the main tool for macroeconomic stabilization. KrugWellsEC3e_Macro_CH15_15A.indd 463

18 464 PART 6 STABILIZATION POLICY What happens when a change in the money supply pushes the economy away from, rather than toward, long-run equilibrium? We learned in Chapter 12 that the economy is self-correcting in the long run: a demand shock has only a temporary effect on aggregate output. If the demand shock is the result of a change in the money supply, we can make a stronger statement: in the long run, changes in the quantity of money affect the aggregate price level, but they do not change real aggregate output or the interest rate. To see why, let s look at what happens if the central bank permanently increases the money supply. Short-Run and Long-Run Effects of an Increase in the Money Supply To analyze the long-run effects of monetary policy, it s helpful to think of the central bank as choosing a target for the money supply rather than the interest rate. In assessing the effects of an increase in the money supply, we return to the analysis of the long-run effects of an increase in aggregate demand, first introduced in Chapter 12. Figure shows the short-run and long-run effects of an increase in the money supply when the economy begins at potential output, Y 1. The initial short-run aggregate supply curve is SRAS 1, the long-run aggregate supply curve is LRAS, and the initial aggregate demand curve is AD 1. The economy s initial equilibrium is at E 1, a point of both short-run and long-run macroeconomic equilibrium because it is on both the short-run and the long-run aggregate supply curves. Real GDP is at potential output, Y 1. Now suppose there is an increase in the money supply. Other things equal, an increase in the money supply reduces the interest rate, which increases investment spending, which leads to a further rise in consumer spending, and so on. So an increase in the money supply increases the quantity of goods and services The Short-Run and Long-Run Effects of an Increase in the Money Supply When the economy is already at potential output, an increase in the money supply generates a positive short-run effect, but no long-run effect, on real GDP. Here, the economy begins at E 1, a point of short-run and long-run macroeconomic equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short-run macroeconomic equilibrium at E 2 and a new real GDP of Y 2. But E 2 is not a long-run equilibrium: Y 2 exceeds potential output, Y 1, leading over time to an increase in nominal wages. In the long run, the increase in nominal wages shifts the short-run aggregate supply curve leftward, to a new position at SRAS 2. The economy reaches a new short-run and long-run macroeconomic equilibrium at E 3 on the LRAS curve, and output falls back to potential output, Y 1. When the economy is already at potential output, the only long-run effect of an increase in the money supply is an increase in the aggregate price level from P 1 to P 3. Aggregate price level LRAS P 3 E 3 P 2 P 1 An increase in the money supply reduces the interest rate and increases aggregate demand... E 1 Y 1 Potential output AD 1 Y 2 E 2 AD 2 SRAS 2 SRAS 1... but the eventual rise in nominal wages leads to a fall in short-run aggregate supply and aggregate output falls back to potential output. Real GDP KrugWellsEC3e_Macro_CH15_15A.indd 464

19 CHAPTER 15 MONETARY POLICY 465 demanded, shifting the AD curve rightward, to AD 2. In the short run, the economy moves to a new short-run macroeconomic equilibrium at E 2. The price level rises from P 1 to P 2, and real GDP rises from Y 1 to Y 2. That is, both the aggregate price level and aggregate output increase in the short run. But the aggregate output level, Y 2, is above potential output. As a result, nominal wages will rise over time, causing the short-run aggregate supply curve to shift leftward. This process stops only when the SRAS curve ends up at SRAS 2 and the economy ends up at point E 3, a point of both short-run and long-run macroeconomic equilibrium. The long-run effect of an increase in the money supply, then, is that the aggregate price level has increased from P 1 to P 3, but aggregate output is back at potential output, Y 1. In the long run, a monetary expansion raises the aggregate price level but has no effect on real GDP. We won t describe the effects of a monetary contraction in detail, but the same logic applies. In the short run, a fall in the money supply leads to a fall in aggregate output as the economy moves down the short-run aggregate supply curve. In the long run, however, the monetary contraction reduces only the aggregate price level, and real GDP returns to potential output. According to the concept of monetary neutrality, changes in the money supply have no real effects on the economy. Monetary Neutrality How much does a change in the money supply change the aggregate price level in the long run? The answer is that a change in the money supply leads to an equal proportional change in the aggregate price level in the long run. For example, if the money supply falls 25%, the aggregate price level falls 25% in the long run; if the money supply rises 50%, the aggregate price level rises 50% in the long run. How do we know this? Consider the following thought experiment: Suppose all prices in the economy prices of final goods and services and also factor prices, such as nominal wage rates double. And suppose the money supply doubles at the same time. What difference does this make to the economy in real terms? The answer is none. All real variables in the economy such as real GDP and the real value of the money supply (the amount of goods and services it can buy) are unchanged. So there is no reason for anyone to behave any differently. We can state this argument in reverse: If the economy starts out in long-run macroeconomic equilibrium and the money supply changes, restoring long-run macroeconomic equilibrium requires restoring all real values to their original values. This includes restoring the real value of the money supply to its original level. So if the money supply falls 25%, the aggregate price level must fall 25%; if the money supply rises 50%, the price level must rise 50%; and so on. This analysis demonstrates the concept known as monetary neutrality, in which changes in the money supply have no real effects on the economy. In the long run, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage. Economists argue that money is neutral in the long run. This is, however, a good time to recall the dictum of John Maynard Keynes: In the long run we are all dead. In the long run, changes in the money supply don t have any effect on real GDP, interest rates, or anything else except the price level. But it would be foolish to conclude from this that the Fed is irrelevant. Monetary policy does have powerful real effects on the economy in the short run, often making the difference between recession and expansion. And that matters a lot for society s welfare. Changes in the Money Supply and the Interest Rate in the Long Run In the short run, an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don t affect the interest rate. KrugWellsEC3e_Macro_CH15_15A.indd 465

20 466 PART 6 STABILIZATION POLICY The Long-Run Determination of the Interest Rate In the short run, an increase in the money supply from M 1 to M 2 pushes the interest rate down from r 1 to r 2 and the economy moves to E 2, a short-run equilibrium. In the long run, however, the aggregate price level rises in proportion to the increase in the money supply, leading to an increase in money demand at any given interest rate in proportion to the increase in the aggregate price level, as shown by the shift from MD 1 to MD 2. The result is that the quantity of money demanded at any given interest rate rises by the same amount as the quantity of money supplied. The economy moves to long-run equilibrium at E 3 and the interest rate returns to r 1. Interest rate, r r 1 r 2 MS 1 MS 2 E 1 E 3 E 2 An increase in the money supply lowers the interest rate in the short run but in the long run higher prices lead to greater money demand, raising the interest rate to its original level. M 1 M 2 MD 1 MD 2 Quantity of money Figure shows why. It shows the money supply curve and the money demand curve before and after the Fed increases the money supply. We assume that the economy is initially at E 1, in long-run macroeconomic equilibrium at potential output, and with money supply M 1. The initial equilibrium interest rate, determined by the intersection of the money demand curve MD 1 and the money supply curve MS 1, is r 1. Now suppose the money supply increases from M 1 to M 2. In the short run, the economy moves from E 1 to E 2 and the interest rate falls from r 1 to r 2. Over time, however, the aggregate price level rises, and this raises money demand, shifting the money demand curve rightward from MD 1 to MD 2. The economy moves to a new long-run equilibrium at E 3, and the interest rate rises to its original level at r 1. And it turns out that the long-run equilibrium interest rate is the original interest rate, r 1. We know this for two reasons. First, due to monetary neutrality, in the long run the aggregate price level rises by the same proportion as the money supply; so if the money supply rises by, say, 50%, the price level will also rise by 50%. Second, the demand for money is, other things equal, proportional to the aggregate price level. So a 50% increase in the money supply raises the aggregate price level by 50%, which increases the quantity of money demanded at any given interest rate by 50%. As a result, the quantity of money demanded at the initial interest rate, r 1, rises exactly as much as the money supply so that r 1 is still the equilibrium interest rate. In the long run, then, changes in the money supply do not affect the interest rate. ECONOMICS IN ACTION INTERNATIONAL EVIDENCE OF MONETARY NEUTRALITY These days monetary policy is quite similar among wealthy countries. Each major nation (or, in the case of the euro, the euro area) has a central bank that is insulated from political pressure. All of these central banks try to keep the aggregate price level roughly stable, which usually means inflation of at most 2% to 3% per year. But if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. Between 1970 and KrugWellsEC3e_Macro_CH15_15A.indd 466

21 CHAPTER 15 MONETARY POLICY 467 the present, the money supply rose only a few percent per year in some countries, such as Switzerland and the United States, but rose much more rapidly in some poorer countries, such as South Africa. These differences allow us to see whether it is really true that increases in the money supply lead, in the long run, to equal percent rises in the aggregate price level. Figure shows the annual percentage increases in the money supply and average annual increases in the aggregate price level that is, the average rate of inflation for a sample of countries during the period , with each point representing a country. If the relationship between increases in the money supply and changes in the aggregate price level were exact, the points would lie precisely on a 45-degree line. In fact, the relationship isn t exact, because other factors besides money affect the aggregate price level. But the scatter of points clearly lies close to a 45-degree line, showing a more or less proportional relationship between money and the aggregate price level. That is, the data support the concept of monetary neutrality in the long run. CHECK YOUR UNDERSTANDING 15-4 Average annual increase in price level 25% Source: OECD Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short-run and long-run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the following. a. Aggregate output b. Aggregate price level c. Interest rate 2. Why does monetary policy affect the economy in the short run but not in the long run? Solutions appear at back of book The Long-Run Relationship Between Money and Inflation United States Switzerland 5 Japan 10 Canada India Australia South Africa Korea OECD-Europe 45-degree line Iceland % Average annual increase in money supply Quick Review According to the concept of monetary neutrality, changes in the money supply do not affect real GDP, only the aggregate price level. Economists believe that money is neutral in the long run. In the long run, the equilibrium interest rate in the economy is unaffected by changes in the money supply. KrugWellsEC3e_Macro_CH15_15A.indd 467

22 468 BUSINESS CASE PIMCO Bets on Cheap Money J. Emilio Flores/The New York Times/Redux Pictures Pacific Investment Management Company, generally known as PIMCO, is one of the world s largest investment companies. Among other things, it runs PIMCO Total Return, the world s largest mutual fund. Bill Gross, shown at left, who heads PIMCO, is legendary for his ability to predict trends in financial markets, especially bond markets, where PIMCO does much of its investing. In the fall of 2009, Gross decided to put more of PIMCO s assets into long-term U.S. government bonds. This amounted to a bet that long-term interest rates would fall. This bet was especially interesting because it was the opposite of the bet many other investors were making. For example, in November 2009 the investment bank Morgan Stanley told its clients to expect a sharp rise in long-term interest rates. What lay behind PIMCO s bet? Gross explained the firm s thinking in his September 2009 commentary. He suggested that unemployment was likely to stay high and inflation low. Global policy rates, he asserted meaning the federal funds rate and its equivalents in Europe and elsewhere will remain low for extended periods of time. PIMCO s view was in sharp contrast to those of other investors: Morgan Stanley expected long-term rates to rise in part because it expected the Fed to raise the federal funds rate in Who was right? PIMCO, mostly. As Figure shows, the federal funds rate stayed near zero, and long-term interest rates fell through much of 2010, although they rose somewhat very late in the year as investors became somewhat more optimistic about economic recovery. Morgan Stanley, which had bet on rising rates, actually apologized to investors for getting it so wrong. Interest rate 4% Bill Gross s foresight, however, was a lot less accurate in Anticipating a significantly stronger U.S. economy by mid-2011 that would result in inflation, Gross bet heavily against U.S. government bonds early that year. But this time he was wrong, as weak growth continued. By late summer 2011, Gross realized his mistake as U.S. bonds rose in value and the value of his funds sank. He admitted to the Wall Street Journal that he had lost sleep over his bet, and called it a mistake. QUESTIONS FOR THOUGHT Long-term interest rate 1. Why did PIMCO s view that unemployment would stay high and inflation low lead to a forecast that policy interest rates would remain low for an extended period? 2. Why would low policy rates suggest low long-term interest rates? 3. What might have caused long-term interest rates to rise in late 2010, even though the federal funds rate was still zero? 2010 Source: Federal Reserve Bank of St. Louis. The Federal Funds Rate and Long-Term Interest Rates, Federal funds rate 2011 Year KrugWellsEC3e_Macro_CH15_15A.indd 468