Monetary Policy Ch-14

7/23/2019 Monetary Policy Ch-14

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Monetary Policy

Chapter 14



The Demand for Money

• The price of holding money balancesis the interest rate.

• The interest rate is the opportunity

cost of holding money.• As the interest rate increases, the

opportunity cost of holding money

increases, and people choose to holdless money.



Supply and Demand forMoney



Money Supply and

!uilibrium• The money supply is

not e"clusi#elydetermined by the

$ed because boththe ban%s and thepublic are importantplayers the moneysupply process.

• !uilibrium in themoney mar%et e"ists&hen the !uantitydemanded of moneye!uals the !uantity

supplied.



Transmission Mechanisms

The impact that changes in the money mar%etha#e on the goods and ser#ices mar%et and&hether that impact is direct or indirect' and theroutes and ripple e(ects created in the moneymar%et tra#el to a(ect the goods and ser#ices

mar%et are %no&n as the transmissionmechanism.



The )eynesian Transmission

Mechanism

• The Money Mar%et

• The *n#estment +oods Mar%et

• The +oods and Ser#ices Mar%et AD-AS

$rame&or%• /hen the money supply increases, the

)eynesian transmission mechanism &or%sas follo&s0 an increase in the money

supply lo&ers the interest rate, &hichcauses in#estment to rise and the ADcur#e to shift right&ard. eal +DPincreases and the unemployment rate

drops.



The )eynesian Transmission

Mechanism0 *ndirect



The )eynesian Mechanism May +et

2loc%ed

• Some )eynesian economists belie#e thatin#estment is not al&ays responsi#e tointerest rates. The )eynesian transmission

mechanism &ould be short-circuited in thein#estment goods mar%et, and the lin%bet&een the money mar%et and the goodsand ser#ices mar%et &ould be bro%en.

•

)eynesians ha#e sometimes argued thatthe demand cur#e for money couldbecome hori3ontal at some lo& interestrate.



)eynesian Transmission

Mechanisms2ecause the )eynesian transmission mechanism isindirect, both interest insensiti#e in#estment demandand the li!uidity trap may occur.



y & yPolicy



2ond Prices and *nterest

ates"planation of li!uidity trap0

• As the price of a bond decreases, the actual interestrate return, or simply the interest rate, increases.

• The mar%et interest rate is in#ersely related to the

price of old or e"isting bonds.• An increase in the money supply does not result in

an e"cess supply of money at a lo& interest ratebecause indi#iduals belie#e that bond prices are sohigh because lo& interest rates mean high bond

prices that an in#estment in bonds is li%ely to turnout to be a bad deal. As they belie#e bond pricesare so high that they ha#e no place to go but do&n.



The Monetarist Transmission

Mechanism0 Direct

• *n the Monetarist theory, there is a directlin% bet&een the money mar%et and thegoods and ser#ices mar%et.

•

An increase in the money supply meansincreased Aggregate Demand, *ncreasedeal +DP, increased Prices and a decreasein unemployment.

•

A decrease in the money supply meansdecreased Aggregate Demand, Decreasedeal +DP, decreased Prices and anincrease in unemployment.



The Monetarist TransmissionMechanism0 Direct



Monetary Policy and the Problem of

*n5ationary and ecessionary +aps



Monetary Policy and an *n5ationary+ap



)eynesians, ecession, and *n5ation

• Most )eynesians belie#e that the naturalforces of the mar%et economy &or% muchfaster and more assuredly at eliminatingan in5ationary gap than a recessionarygap.

• )eynesians are more li%ely to ad#ocatee"pansionary monetary policy to eliminatea stubborn recessionary gap thancontractionary monetary policy toeliminate a not-so-stubborn in5ationarygap.

• *t has been argued that )eynesianmonetary policy has an in5ationary bias.



Monetary Policy and the Acti#ist6

7onacti#ist Debate

• Acti#ists argue thatmonetary and 8scalpolicies should bedeliberately used tosmooth out the business

cycle.• They are in fa#or of

economic 8ne-tuning,&hich is the frequent useof monetary and 8scalpolicies to counteract e#en

small undesirablemo#ements in economicacti#ity.

• 7onacti#ists argueagainst the use of

deliberate 8scal and

monetary policies.• They belie#e the

discretionary policies

should be replaced by astable and permanent

monetary and 8scalframe&or% and the rulesshould be established inplace of acti#ist policies.



The Case for Acti#ist Monetary

Policy

1. The economy does not al&ayse!uilibrate !uic%ly enough at7atural eal +DP.

9. Acti#ist monetary policy &or%s' it ise(ecti#e at smoothing out thebusiness cycle.

:. Acti#ist monetary policy is 5e"ible.*t changes as the monetary needsof the economy changes.7nonacti#ist monetary policy, &hich

is based on rules or ;the same for<



The Case for 7onacti#ist Monetary

Policy

1. *n modern economies, &ages and pricesare su=ciently 5e"ible to allo& theeconomy to e!uilibrate at reasonable

speed at 7atural eal +DP.9. Acti#ist monetary policies may not &or%.

:. Acti#ist monetary policies are li%ely to bedestabili3ing rather than stabili3ing' theyare li%ely to ma%e matters &orse ratherthan better.



"pansionary Monetary Policy and7o Change in the eal +DP

*f e"pansionarymonetary policy isanticipated, &or%ers

may bargain for andrecei#e higher &agerates. *t is possible thatthe SAS cur#e &illshift left&ard to the

degree thate"pansionarymonetary policy shiftsthe AD cur#eright&ard. esult0 no

change in eal +DP.



Monetary Policy May Destabili3e theconomy

*n this scenario, theSAS cur#e is shiftingright&ard, but $edo=cials do not reali3ethis is happening. Theyimplement

e"pansionary monetarypolicy, and the AD cur#eends up intersectingSAS9 at point 9 insteadof SAS1 at point 1<.

$ed o=cials end upmo#ing the economyinto an in5ationary gapand thus destabili3ingthe economy



7onacti#ist MonetaryProposals

• Constant Money +ro&th ate ule0 The annualmoney supply gro&th rate &ill be constant at thea#erage annual gro&th rate of the eal +DP.

• Predetermined Money +ro&th rate0 The annualgro&th rate in the money supply &ill be e!ual tothe a#erage annual gro&th rate in eal +DP minusthe gro&th rate in #elocity.

> ?M @ > ? - > ?

The gro&th rate of money supply is not 8"ed. *t

can #ary year to year but it is predetermined inthat it is dependent on the gro&th rates of eal+DP and elocity.

if > ? is :> and > ? is 1>, then > ?Mshould be 9> to %eep the price le#el stable



The $ed and the Taylor ule

• Taylor rule is that there is some federal funds rate target

that is consistent &ith 6 1 stabili3ing in5ation around a lo&in5ation rate and 9 stabili3ing eal +DP around its fullemployment le#el.

Federal Funds rate target @ in5ation B !uilibrium realfederal funds rate B in5ation gap B utput gap

• *n5ation @ the current in5ation rate.• !uilibrium real federal funds rate @ the nominal federal

funds rate adEusted for in5ation. Taylor assumes that itshould be 9>.

• in5ation gap @ the di(erence bet&een the actual

in5ation rate and the target for in5ation. Taylor assumesthat target in5ation should be 9>.

• utput gap @ The percentage di(erence bet&een actualeal +DP and its natural le#el.



*n5ation Targeting

• *n5ation targeting re!uires the $ed to%eep the in5ation rate near apredetermined le#el.

Three maEor rele#ant issues0

a /hether the in5ation rate targetshould be a speci8c percentage rate

or a narro& range.

b /hat should the rate or the rangeF

c Should it be announced or not.



A +old Standard

• The money supply &ould be tied to the stoc% ofgold.

• The go#ernment sets the price of gold at somedollar amount.

• The go#ernment promises to buy and sell goldat the o=cial price.

• Critics charge that a gold standard is noguarantee against in5ation.

• Critics also charge that a reduction in nationaloutput and an increase in unemployment &illresult if prices do not fall in the same proportion&hen the gold-bac%ed money supply is reduced.



A +old Standard

Monetary Policy Ch-14

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