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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 .

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

• A rise in the interest rate lowers the prices of all outstanding bonds. • The price of existing bonds varies negatively with the rate of interest. the greater the change in its price will be for a given change in the interest rate. which earn a higher interest return than money and can be sold at a price that is determined on the open market. and – bonds. which is a medium of exchange. . • The longer a bond’s term to maturity.Simplified asset choice • For simplicity we assume that there are just two assets: – money.

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the price of existing bonds falls and vice versa. • 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%.Bond prices and interest rates • Suppose a perpetual bond is issued at price = £100 and a coupon of £5 per annum.5% and vice versa • If the market price fell to £50 the interest rate would be 10%. • As market interest rates rise. • If the market price rose to £200 the interest rate would be 2. .

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

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

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 .

through the effect of interest rates on the exchange rate .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.

Money Demand and Supply (ii).The Effect of Changes in the Interest Rate on Investment Expenditure MD MS0 MS1 ID i0 E0 i0 A i1 E1 i1 B I 0 0 M0 M1 I0 Investment expenditure I1 Quantity of Money (i). The investment demand function .

Shift in Aggregate Expenditure E0 P0 (ii).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 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 Demand Y0 Y1 Real GDP . Shift in Aggregate Expenditure (ii).

Induced shift in aggregate supply .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].

.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. • Fiscal policy: • Same. Economy ends up back at Y* on LRAS and change in P depends on initial position. except starts with spending change via G or via C (if induced by tax change).

uk/publications/other/monetary/montrans.pdf ). 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. market rates. asset prices. • Change in interest rate affects. the GDP gap) plus import prices.co.How does monetary policy work in reality • See: “The transmission mechanism of monetary policy”.e.bankofengland.g. expectations and confidence. exchange rate. . • Interest rate affects domestic spending • Investment is affected by cost of borrowing • Consumption affected by e. mortgage rates • Net exports affected by exchange rate • Inflation affected by AD relative to AS (i.

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• The Bank of England’s 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.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.3 percentage point effect on GDP and inflation .

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but confidence and expectations matter here.Quantitative Easing • • • • • • What do you do when interest rates can go no lower? Bank of England has bought £200bn of bonds….mainly gilts. 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. What effect might this have? Raises price of bonds and lowers long-term interest rates. Could lower cost of capital for firms. Also gives banks more liquidity and meant to encourage lending. Gives cash to sellers of bonds and could encourage them to buy other assets. so probably helped stock market. • • • • • .