27 Monetary Policy and Interest Rates228 Chapter 10, ‘Opensmarket operations = Fed buys bonds to T money supply = T price of bonds 2 {interest rate = T consumption, investment, and government spending = T aggregate demand for goods and services = Keynesian multiplier process = T income Figure 10.3 The Transmission Mechanism “Monetary policy lowers the interest rate, increasing aggregate demand for goods and services and setting the Keynesian muliplier process in motion by consumers, firms, and local governments. The increase in spending leads to the familiar Keynesian multiplier process, moving the economy to a higher level of income, as illus- trated in figure 10.3. In this new story the impact of monetary policy is transmitted to economic activity through the intermediary of the interest rate. (See curiosity 10.3 for discussion of what happens when the interest rate falls to zero!) Most economists feel that this new transmis sion mechanism is the way in which monetary policy operates to influence economic activity; consequently we adopt it henceforth in this book. The monetarist view of the transmission mechanism, described in chapter 9 as the modern quantity theory, can be seen to be consistent with this mechanism, but the explanation is too advanced for inclusion in this book. We will simply view the chapter 9 story, in which people lower ‘excess cash balances by spending them, as supplementing this interest-rate transmission ‘mechanism, Sample Exam Question 10.4: “The decline in both the number of payroll jobs and hours worked surprised many analysts, who said the report put new pressure on the Fed to, ...” Complete this clipping 10.5 Monetary Policy versus Fiscal Policy ‘The view of discretionary monetary policy that has emerged from this chapter and the preceding two chapters is that through open-market operations the central bank can stimu late the economy by increasing the money supply, alternatively viewed as pushing down the interest rate, Ina longer run context, an eye must he kept on the rate of growth of the ‘money supply to ensure that inflation is not allowed to escalate, but in a noninflationary environment, discretionary use of monetary policy is a useful altemative or supplement to fiscal policy.Monetary Policy and Interest Rates Both fiscal and monetary policy shift the AD curve in the aggregate-supply/aggregate- demand diagram, Fiscal policy changes aggregate demand directly; monetary policy changes aggregate demand by changing the interest rate. Two marked differences between ‘monetary and fiscal policy, however, should be noted, 1. Timing considerations. Monetaty policy can be implemented much more quickly than fiscal policy, since it does not require congressional approval. Once implemented, however, it affects the economy more slowly than fiscal policy because it takes time for decision makers to react to lower interest rates. It has heen estimated, for example, that only about one-third of the impact of an interest rate change on aggregate demand foceurs within one year, and only about one-half within two years. Furthermore these lags are variable as well as long, making it quite difficult for monetary authorities to deduce the corsect timing for monetary policy. Therefore any temporary, discretionary, diversion from the monetarist rule must be undertaken with great cate 2. Discrimination considerations. Monetary policy affects the economy very broadly, allowing the impersonal forces of supply and demand to distribute its impact efficiently across the economy. Fiscal policy has this effect when it takes the form of tax changes, but not when it takes the form of government spending changes: the discriminatory effects of government spending could be either an advantage in that the spending could be directed at a depressed region or a disadvantage in that it may be directed by politi= cal whims. Despite the impersonality of monetary policy, however, itis discriminatory, ‘The components of aggregate demand that are more sensitive to interest-rate changes bear the costs of adjustment. The sector most strongly affected in this regard is the housing sector, which is notoriously sensitive (o interest-rate changes. A fall in the mortgage rate from 10 to 8 percent, for example, decreases the monthly payment on a thiry-year mortgage by more than 16 percent. This saving markedly increases the demand for residential construction. The export- and import-competing sectors ate also strongly affected. Interest-rate changes cause foreigners to change their demand for our currency to invest in our financial assets, altering the exchange rate and affecting the profitability of business in the international sector. ur discussion of monetary policy is not yet complete. The next chapter examines its role in an inflationary environment, providing further insight into the relationship between ‘monetary policy and interest rates. Chapter 14 looks at how monetary policy is affected by forces coming from the international sector of the economy. ‘Sample Exam Question 10.5: “Looking at the high correlation between recessions and housing slumps, some people have concluded that the Fed has been responsible for creating recessions.” What is the logic of these people?