Foundations of Economics BSc Business Studies and Management Lecture 16 Professor Alec Chrystal A.Chrystal@city.ac.uk www.cass.city.ac.uk/faculty/a.

chrystal

Monetary policy and aggregate demand

CPI inflation projection based on market interest rate expectations and 200 billion asset purchases

Inflation Report, February 2011

GDP projection based on market interest rate expectations and 200 billion asset purchases

Inflation Report, February 2011

Projection of the level of GDP based on market interest rate expectations and 200 billion asset purchases

Inflation Report, February 2011

Outline of lecture

Money demand, supply and the interest rate Monetary policy changes and AD MPC view of how monetary policy works.

Simplified asset choice

For simplicity we assume that there are just two assets:
money, which is a medium of exchange, and bonds, which earn a higher interest return than money and can be sold at a price that is determined on the open market.

The price of existing bonds varies negatively with the rate of interest. A rise in the interest rate lowers the prices of all outstanding bonds. The longer a bonds term to maturity, the greater the change in its price will be for a given change in the interest rate.

Bond prices and interest rates

Suppose a perpetual bond is issued at price = 100 and a coupon of 5 per annum. This bond will pay out 5 each year for ever to whoever holds it (unless the issuer buys it back) At the market price of 100 the rate of interest on this bond is 5%. If the market price rose to 200 the interest rate would be 2.5% and vice versa If the market price fell to 50 the interest rate would be 10%. As market interest rates rise, the price of existing bonds falls and vice versa.

The Supply of Money and the Demand for Money

The value of money balances that the public wishes to hold is called the demand for money. It is a stock [not a flow], measured in the United Kingdom as so many millions of pounds. Money balances are held, despite the opportunity cost of bond interest forgone, because of the transactions, precautionary, and speculative motives. Transactions and precautionary motives are derived from role of money as a medium of exchange and provider of liquidity. Speculative role derives from role of money as a safe asset. The demand for money varies positively with real GDP, the price level, and wealth, and negatively with the nominal rate of interest. The nominal demand for money varies proportionally with the price level.

Equilibrium in money market

When there is an excess demand for money balances, people try to sell bonds. This pushes the price of bonds down and the interest rate up. When there is an excess supply of money balances, people try to buy bonds. This pushes the price of bonds up and the rate of interest down. Monetary equilibrium is established when people are willing to hold the existing stocks of money and bonds at the current rate of interest.

The Equilibrium Interest Rate

MS
MD

i0

E0

M
0

Quantity of Money

The Equilibrium Interest Rate

MS
MD

i0

E0

i1

M0

M1 Quantity of Money

The Equilibrium Interest Rate

MS
MD

i2

i0

E0

i1

M2

M0

M1 Quantity of Money

Interest Rates and Money Supply Changes

MS
MD

i0

E0

E1 i1

M0

M1 Quantity of Money

A change in interest rate leads to a change in spending

Standard textbook route is for the interest rate to affect investment:
Fewer projects profitable at higher interest rate on loans Also can get higher return on financial asset than real asset so why invest?

In reality interest rates also affect:

wealth, through asset valuations consumption, through mortgage and savings rates net trade, through the effect of interest rates on the exchange rate

The Effect of Changes in the Interest Rate on Investment Expenditure

MD

MS0

MS1

ID

i0

E0 i0 A

i1

E1
i1

I 0 0

M0

M1

I0 Investment expenditure

I1

Quantity of Money (i). Money Demand and Supply

(ii). The investment demand function

The Effects of Changes in the Interest Rate on Aggregate Demand

AE = Y
Desired Expenditure

E0 I

AE0

45o 0 AD1 Y0 Real GDP

(i). Shift in Aggregate Expenditure

E0 P0

(ii). Shift in Aggregate Demand

Y0
Real GDP

The Effects of Changes in the Interest Rate on Aggregate Demand

AE = Y
Desired Expenditure E1 E0 I AE1 AE0

45o 0 AD1 AD0 E0 P0 E1 Y0 Y1 Real GDP

(i). Shift in Aggregate Expenditure

(ii). Shift in Aggregate Demand

Y0

Y1 Real GDP

Demand-shock Inflation
SRAS1 SRAS0 SRAS0 E2 E1 P1 P0 Price Level Rises P2 P1 AD1 E0 AD1 Price Level Rises further E1

E0

Inflationary Gap Opens

AD0
Inflationary gap eliminated Y* Y1 Y* Real GDP Y1

AD0

Real GDP

[i]. Autonomous increase in aggregate demand

[ii]. Induced shift in aggregate supply

Summary of channels of policy Monetary policy:

lower interest rate higher investment spending shift AE line up and AD line to right (depending on initial position) some increase in P and Y If Y>Y* the price level rises further and reduces C or net trade. Economy ends up back at Y* on LRAS and change in P depends on initial position.

Fiscal policy:
Same, except starts with spending change via G or via C (if induced by tax change).

How does monetary policy work in reality

See: The transmission mechanism of monetary policy, April 1999 written for the UK Monetary Policy Committee (Reprinted as an appendix to Chapter 30 of 10th edition of Lipsey and Chrystal and available on the web at: http://www.bankofengland.co.uk/publications/other/monetary/montrans.pdf ). Change in interest rate affects, market rates, asset prices, expectations and confidence, exchange rate. Interest rate affects domestic spending Investment is affected by cost of borrowing Consumption affected by e.g. mortgage rates Net exports affected by exchange rate Inflation affected by AD relative to AS (i.e. the GDP gap) plus import prices.

Time lags in the impact of policy on target variables

Old monetarist rule of thumb was that a change in monetary policy took one year to affect output and two years to affect prices. The Bank of Englands own forecasting model shows similar time lags: peak effect on GDP after 5 quarters peak effect on inflation after 9 quarters Note that it takes 1 percentage point change in interest rate to have about 0.3 percentage point effect on GDP and inflation

Quantitative Easing What do you do when interest rates can go no lower? Bank of England has bought 200bn of bonds.mainly gilts. What effect might this have? Raises price of bonds and lowers long-term interest rates. Could lower cost of capital for firms. Gives cash to sellers of bonds and could encourage them to buy other assets, so probably helped stock market. Also gives banks more liquidity and meant to encourage lending. Raises money stock relative to where it might otherwise be. May need to be reversed rapidly if demand picks up quickly. BUT note it will only work if it raises some item in C+I+G+(X-IM) It may have helped C through higher asset prices (shares) and it may help I through cost of capital, but confidence and expectations matter here.