THIRD EDITION ECONOMICS. and. MACROECONOMICS Paul Krugman Robin Wells. Chapter 15(30) Monetary Policy
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1 THIRD EDITION ECONOMICS and MACROECONOMICS Paul Krugman Robin Wells Chapter 15(30) Monetary Policy
2 WHAT YOU WILL LEARN IN THIS CHAPTER What the money demand curve is Why the liquidity preference model determines the interest rate in the short run How the Federal Reserve can implement 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 with 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
3 The Money Market Money Supply Interest rate, r Nominal Money supply curve, MS M1 = C + D = (R+C) * Multiplier M Money supply chosen by the Fed QuanQty of money
4 The Money Market Money Supply Interest rate, r Nominal Money supply curve, MS M1 = C + D = (R+C) * Multiplier Monetary Base M Money supply chosen by the Fed QuanQty of money
5 The Money Market Money Supply Interest rate, r Nominal Money supply curve, MS M1 = C + D = (R+C) * Multiplier Monetary Base M1 Money Multiplier 1 + k rr + er + k M Money supply chosen by the Fed QuanQty of money
6 The Money Market Money Supply Increase Interest rate, r Increase in the Nominal Money supply M1 = C + D = ( ñ R+C) * 1 + k ê rr + er + k M 1 M 2 Open Market Purchase Monetary Base Discount Rate Required Reserve Ratio Multiplier r QuanQty of money
7 The Money Market Money Supply Decrease Interest rate, r Decrease in the Nominal Money supply M 2 M 1 M1 = C + D = ( ê R+C) * 1 + k ñ rr + er + k Open Market Sale Monetary Base Discount Rate Required Reserve Ratio Multiplier r QuanQty of money
8 Money Demand in 5 minutes Interest rate, r Keynes: Three MoQves for Liquidity Preference TransacQons MoQve: to bridge the gap between income receipts and payment commitments PrecauQonary: the desire for security as a future cash equivalent of total resources SpeculaQve: the object of securing a profit from knowing beaer than the market what the future will bring + M d = L 1 ( Y ) + L 2 ( r ) r MD (Y) QuanQty of money
9 Money and Interest Rates 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 nominal quannty of money supplied varies with the interest rate.
10 Equilibrium in the Money Market Interest rate, r Money supply curve, MS r H H Equilibrium Equilibrium interest rate r E r L E L MD M H M Money supply chosen by the Fed M L QuanQty of money
11 Equilibrium in the Money Market Interest rate, r Money supply curve, MS r H H M d < M s Buy Bonds; é P bonds è ê r Equilibrium Equilibrium interest rate r E r L E M d > M s Sell Bonds; ê P bonds è é r L MD M M L Money supply chosen by the Fed QuanQty of money
12 Equilibrium in the Money Market Interest rate, r Money supply curve, MS r H H Equilibrium r E r L E L MD M H M Money supply chosen by the Fed M L QuanQty of money
13 Increase Interest rate, r An increase in the money supply M s = M d Equilibrium Shock : Increase in the M s at r 1 MS 1 MS 2 2. M s > M d Disequilibrium at r 1 Excess Liquidity Buy Bonds è é P bonds è ê r... leads to a fall in the interest rate. r From 1 to 3 a movement down along the M d curve to new equilibrium at point 3 P 2 bonds P 1 B d 2 r 2 3 MD B d 1 Bonds M 1 M 2 Quantity of money
14 Interest rate, r Decrease A Decrease in the money supply M s = M d Equilibrium Shock : Decrease in the M s at r 1 MS 2 MS 1 2. M s < M d Disequilibrium at r 1 Illiquid Sell Bonds è ê P bonds è é r 3. From 1 to 3 a movement up along the M d curve to new equilibrium at point 3... leads to A rise in the interest rate. r 2 3 P 1 bonds P 2 B s B s r MD Bonds B d M 2 M 1 Quantity of money
15 Pi^alls The Target versus the Market A common mistake is to imagine that these changes in the way the Federal Reserve operates alter the way the money market works. You ll somenmes hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate.
16 Pi^alls The Target versus the Market 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 operanng procedure with a change in the way the economy works.
17 Se_ng the Federal Funds Rate Pushing the Interest Rate Down to the Target Rate Interest rate, r An open-market purchase... MS 1 MS 2 The target federal funds rate is the Federal Reserve s desired federal funds rate.... drives the interest rate down. r 1 r T E 1 E 2 MD M 1 M 2 Quantity of money
18 Se_ng the Federal Funds Rate Pushing the Interest Rate Up to the Target Rate Interest rate, r An open-market sale... MS 2 MS 1... drives the interest rate up. r E T 2 E r 1 1 MD M 2 M 1 Quantity of money
19 Long- Term Interest Rates Long- term interest rates don t necessarily move with short- term interest rates. If investors expect short- term interest rates to rise, investors may buy short- term bonds. In pracnce, long- term interest rates reflect the average expectanon in the market about what s going to happen to short- term rates in the future.
20 ECONOMICS IN ACTION The Fed Reverses Course On August 7, 2007, the Federal Open Market Commiaee decided to stand pat, making no change in its interest rate policy. On September 18, the Fed cut the target federal funds rate to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disrupnons in financial markets.
21 ECONOMICS IN ACTION The Fed Reverses Course Given the increases in interest rates prior to 2007, this was a reversal of previous policy: previously, the Fed had generally been raising rates, not reducing them, out of concern that inflanon might become a problem (more on that later in this chapter). StarNng in September 2007, fighnng the financial crisis took priority.
22 The Fed Reverses Course
23 The Fed Moves Interest Rates
24 Monetary Policy and Aggregate Demand Expansionary monetary policy is monetary policy that increases aggregate demand. ContracQonary monetary policy is monetary policy that reduces aggregate demand.
25 Expansionary and ContracQonary Monetary Policy
26 Monetary Policy and Aggregate Demand (a) Expansionary Monetary Policy (b) Contractionary Monetary Policy Aggregate price level Aggregate price level AD 1 AD 2 AD 3 AD 1 Real GDP Real GDP
27 Expansionary and ContracQonary Monetary Policy in the Income- Expenditure Model (a) Expansionary Monetary Policy Planned aggregate spending 45-degree line (b) Contractionary Monetary Policy Planned aggregate spending 45-degree line AE 2 AE 1 AE 1 AE 2 Y 1 Y 2 Real GDP Y 2 Y 1 Real GDP
28 Expansionary Monetary Policy to Fight a Recessionary Gap
29 ContracQonary Monetary Policy to Fight an InflaQonary Gap
30 Monetary Policy and the MulQplier
31 Tracking Monetary Policy
32 Tracking Monetary Policy Federal funds rate (Taylor rule) 12% 10% 8% 6% 4% Federal 2% funds rate 0% -2% -4% -6% -8% Year
33 InflaQon TargeQng InflaQon targeqng occurs when the central bank sets an explicit target for the inflanon rate and sets monetary policy to hit that target.
34 GLOBAL COMPARISON: InflaQon Targets
35 ECONOMICS IN ACTION What the Fed Wants, the Fed Gets ContracNonary monetary policy is somenmes used to eliminate inflanon that has become embedded in the economy. In this case, the Fed needs to create a recessionary gap not just eliminate an inflanonary gap to wring embedded inflanon out of the economy.
36 ECONOMICS IN ACTION What the Fed Wants, the Fed Gets In four of the five cases that ChrisNna Romer and David Romer examined, the decision to contract the economy was followed, aser a modest lag, by a rise in the unemployment rate. On average, they found that the unemployment rate rises by 2 percentage points aser the Fed decides that unemployment needs to go up. So, the Fed gets what it wants.
37 ECONOMICS IN ACTION When the Fed Wants a Recession
38 Money, Output, and Prices in the Long Run Aggregate price level An increase in the money supply reduces the interest rate and increases aggregate demand... L R AS S R AS 2 S R AS 1 E 3 P 3 P 2 P 1 E 1 AD 1 E 2 AD 2... but the eventual rise in nominal wages leads to a fall in short-run aggregate supply and aggregate output falls back to potential output. Y 1 Y 2 Real GDP Potential output
39 Monetary Neutrality In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. In fact, there is monetary neutrality: changes in the money supply have no real effect on the economy. So, monetary policy is ineffectual in the long run.
40 The Long- Run DeterminaQon of the Interest Rate Interest rate, r MS 1 MS 2 An increase in the money supply lowers the interest rate in the short run r 1 E 1 E 3 but in the long run higher prices lead to greater money demand, raising the interest rate to its original level. r 2 E 2 MD 1 MD 2 M 1 M 2 QuanQty of money
41 ECONOMICS IN ACTION InternaQonal Evidence of Monetary Neutrality All of the major central banks try to keep the aggregate price level roughly stable. However, 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 the present, the money supply rose only a few percent per year in some countries.
42 ECONOMICS IN ACTION InternaQonal Evidence of Monetary Neutrality The figure on the next slide shows the annual percentage increases in the money supply and average annual increases in the aggregate price. The scaaer of points clearly lies close to a 45- degree line, showing a more or less propornonal relanonship between money and the aggregate price level. The data support the concept of monetary neutrality in the long run.
43 The Long- Run RelaQonship Between Money and InflaQon
44 Summary 1. The money demand curve arises from a trade- off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short- term interest rates, not long- term interest rates. Changes in the aggregate price level, real GDP, technology, and insntunons shis the money demand curve.
45 Summary 2. According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shising the money supply curve. In pracnce, the Fed uses open- market operanons to achieve a target federal funds rate, which other short- term interest rates generally track.
46 Summary 3. Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. ContracQonary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run.
47 Summary 4. The Federal Reserve and other central banks try to stabilize the economy, liminng fluctuanons of actual output around potennal output, while also keeping inflanon low but posinve. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflanon, or a posinve output gap, or both; the target interest rate falls when inflanon is low or neganve, or when the output gap is neganve, or both.
48 Summary 4. (Cont.) Some central banks engage in inflaqon targeqng, which is a forward- looking policy rule, whereas the Taylor rule is a backward- looking policy rule. In pracnce, the Fed appears to operate on a loosely defined version of the Taylor rule. Because monetary policy is subject to fewer implementanon lags than fiscal policy, it is the preferred policy tool for stabilizing the economy.
49 Summary 5. In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run.
50 Key Terms Short- term interest rates Long- term interest rates Money demand curve Liquidity preference model of the interest rate Money supply curve Target federal funds rate Expansionary monetary policy ContracNonary monetary policy Taylor rule for monetary policy InflaNon targenng Monetary neutrality
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