Modern Macroeconomics and Monetary Policy: Full Length Text - Macro Only Text

Modern Macroeconomics
and Monetary Policy

Full Length Text — Part: 3 Chapter: 14
Macro Only Text — Part: 3 Chapter: 14
To Accompany “Economics: Private and Public Choice 13th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by:
Joseph Connors, James Gwartney, & Charles Skipton
Copyright ©2010 Cengage Learning. All rights reserved.

Next page May not be scanned, copied or duplicated, or posted to a
publicly accessible web site, in whole or in part.
The Impact of Monetary
Policy on Output and Inflation

Jump to first page May not be scanned, copied or duplicated, or posted to a
Impact of Monetary Policy
• Evolution of the modern view:
• The Keynesian view dominated during the
1950s and 1960s.
• Keynesians argued that the money supply
did not matter much.
• Monetarists challenged the Keynesian view
during the1960s and 1970s.
• Monetarists argued that changes in the
money supply caused both inflation and
economic instability.
• While minor disagreements remain, the
modern view emerged from this debate.
• Modern Keynesians and monetarists agree
that monetary policy exerts an important
impact on the economy. The following
slides present this modern view.
The Demand for Money
Money
interest
rate
Money
Demand
Quantity
of money
• The quantity of money people want to hold (the demand

for money) is inversely related to the money rate of interest,
because higher interest rates make it more costly to hold
money instead of interest-earning assets like bonds.
The Supply of Money
Money
interest Money
rate Supply
Quantity
of money
• The supply of money is vertical because it is established

by the Fed and, hence, determined independently of the
interest rate.
The Demand and Supply of Money
Money
interest Money
rate Supply
Excess supply
i2 at i2
At ie, people are willing

ie to hold the money supply
set by the Fed.
i3 Excess demand
at i3
Money
Demand
Quantity
of money
• Equilibrium:
The money interest rate gravitates toward the rate where
the quantity of money people want to hold (demand) is
just equal to the stock of money the Fed has supplied.
Transmission of Monetary Policy
• When the Fed shifts to a more expansionary monetary policy,
it usually buys additional bonds, expanding the money supply.
• This increase in the money supply (shift from S1 to S2 in the
market for money) provides banks with additional reserves.
• The Fed’s bond purchases and the bank’s use of new reserves
to extend new loans increases the supply of loanable funds
andfunds
(shifting S1 to S2 in the loanable puts downward
market) …pressure on
real interest rates (a reduction to r2).
Money
interest S1 S2
Real
interest S1
rate rate S2
i1 r1
i2 r2
D1 D Qty of
Quantity loanable
Qs Qb of money Q1 Q2 funds
• As the real interest rate falls, AD increases (to AD2).
• As the monetary expansion was unanticipated, the expansion
in AD leads to a short-run increase in output (from Y1 to Y2)
and an increase in the price level (from P1 to P2) – inflation.
• The impact of a shift in monetary policy is transmitted
through interest rates, exchange rates, and asset prices.
Real
interest S1 Price
Level
rate AS1
S2
r1 P2
P1
r2 AD2
D Qty of AD1
Goods &
loanable Services
Q1 Q2 funds Y1 Y2 (real GDP)
Increases in Unanticipated Expansionary
investment & Monetary Policy
This consumption
Fed increases Real Increase in
money interest Depreciation Net exports
buys of the dollar aggregate
bonds supply rates rise demand
and bank fall
reserves Increase in Increases in
asset prices investment &
consumption
• Here, a shift to an expansionary monetary policy is shown.
• Assume the Fed expands the supply of money by buying
bonds…which will increase bank reserves …
pushing real interest rates down …which leads to increased
investment and consumption …
a depreciation of the dollar
(leading to increased net exports) and … an increase in the
general level of asset prices (and with the increased personal
wealth, increased investment and consumption).
• So, an unanticipated shift to a more expansionary monetary
policy will stimulate aggregate demand and, thereby,
increase both output and employment. Copyright ©2010 Cengage Learning. All rights reserved.
Expansionary Monetary Policy
Price
Level
LRAS
SRAS1
P2 E2
P1 e1
AD2
AD1
Goods & Services
Y 1 YF (real GDP)
• If expansionary monetary policy leads to an in increase in AD

when the economy is below capacity, the policy will help
direct the economy toward LR full-employment output (YF).
• Here, the increase in output from Y1 to YF will be long term.
AD Increase Disrupts Equilibrium
Price
Level
LRAS
SRAS1
P2 e2
P1 E1
AD2
AD1
Goods & Services
YF Y 2 (real GDP)
• Alternatively, if the demand-stimulus effects are imposed

on an economy already at full-employment YF, they will
lead to excess demand, higher product prices, and
temporarily higher output (Y2).
AD Increase: Long Run
Price
Level
LRAS SRAS2
SRAS1
P3 E3
P2 e2
P1 E1
AD2
AD1
Goods & Services
YF Y 2 (real GDP)
• In the long-run, the strong demand pushes up resource prices,

shifting short run aggregate supply (from SRAS1 to SRAS2).
• The price level rises (from P2 to P3) and output falls back to
full-employment output again (YF fromCopyright
its temp high,Y2).rights reserved.
©2010 Cengage Learning. All
A Shift to More
Restrictive Monetary Policy
• Suppose the Fed shifts to a more restrictive
monetary policy. Typically it will do so by
selling bonds which will:
• depress bond prices and
• drain reserves from the banking system,
• which places upward pressure on real interest
rates.
• As a result, an unanticipated shift to a more
restrictive monetary policy reduces aggregate
demand and thereby decreases both output
and employment.

Short-run Effects of
More Restrictive Monetary Policy
• A shift to a more restrictive monetary policy, will increase
real interest rates.
• Higher interest rates decrease aggregate demand (to AD2).
• When the reduction in AD is unanticipated, real output will
decline (to Y2) and downward pressure on prices will result.
Real
interest S2 Price
Level
rate AS1
S1
r2 P1
P2
r1 AD1
D Qty of AD
Goods
2 &
loanable Services
Q2 Q1 funds Y2 Y1 (real GDP)

Restrictive Monetary Policy
Price LRAS
Level
SRAS1
P1 e1
P2 E2
AD1
AD2
Goods & Services
YF Y 1 (real GDP)
• The stabilization effects of restrictive monetary policy depend

on the state of the economy when the policy exerts its impact.
• Restrictive monetary policy will reduce aggregate demand.
If the demand restraint occurs during a period of strong
demand and an overheated economy, then it may limit or
prevent an inflationary boom. Copyright ©2010 Cengage Learning. All rights reserved.
AD Decrease Disrupts Equilibrium
Price
Level LRAS
SRAS1
P1 E1
P2 e2
AD1
AD2
Goods & Services
Y 2 YF (real GDP)
• In contrast, if the reduction in aggregate demand takes place

when the economy is at full-employment, then it will disrupt
long-run equilibrium, and result in a recession.

Proper Timing
• If a change in monetary policy is timed
poorly, it can be a source of instability.
• It can cause either recession or inflation.
• Proper timing of monetary policy is not easy:
• While the Fed can institute policy changes
rapidly, there will be a time lag before the
change exerts much impact on output & prices.
• This time lag is estimated to be 6 to 18
months in the case of output and perhaps
as much as 36 months before there is a
significant impact on the price level.
• Given our limited ability to forecast the future,
these lengthy time lags clearly reduce the
effectiveness of discretionary monetary policy
as a stabilization tool. Copyright ©2010 Cengage Learning. All rights reserved.
Questions for Thought:
1. What are the determinants of the demand
for money? The supply of money?
2. If the Fed shifts to more restrictive monetary
policy, it typically sells bonds. How will this
action influence the following?
a. the reserves available to banks
b. real interest rates
c. household spending on consumer durables
d. the exchange rate value of the dollar
e. net exports
f. the price of stocks and real assets like
apartments or office buildings
g. real GDP
3. Timing a change in monetary policy correctly
is difficult because
a. monetary policy makers cannot act without
congressional approval.
b. it is often 6 to 18 months in the future before
the primary effects of the policy change will
be felt.
4. When the Fed shifts to a more expansionary
monetary policy, it often announces that it is
reducing its target federal funds rate. What
does the Fed generally do to reduce the
federal funds rate?

5. The demand curve for money:
a. shows the amount of money balances that
individuals and business wish to hold at
various interest rates.
b. reflects the open market operations policy
of the Federal Reserve.

Monetary Policy
in the Long Run

The Quantity Theory of Money
• The quantity theory of money:
M x V = P xY
Money Y = Income
Velocity Price
• If V and Y are constant, then an increase in
M will lead to a proportional increase in P.

Long-run Impact of Monetary Policy
-- The modern View
• Long-run implications of expansionary policy:
• When expansionary monetary policy leads to
rising prices, decision makers eventually
anticipate the higher inflation rate and build it
into their choices.
• As this happens, money interest rates, wages,
and incomes will reflect the expectation of
inflation, and so real interest rates, wages, and
real output will return to their long-run normal
levels.
• Thus, in the long run, money supply growth
will lead primarily to higher prices (inflation)
just as the quantity theory of money implies.
Long-run Effects of a Rapid
Expansion in the Money Supply
• Here we illustrate the long-term impact of an increase in the
annual growth rate of the money supply from 3 to 8 percent.
• Initially, prices are stable (P100) when the money supply is
expanding by 3% annually.
• The acceleration in the growth rate of the money supply
increases aggregate demand (shift to AD2).
Money supply Price level
growth rate (ratio scale)
LRAS
9 8% growth
SRAS1
6
3 3% growth P100 E1
AD2
Time AD1
periods Real
1 2 3 4 YF GDP
(a) Growth rate of the money supply. (b) Impact in the goods & services market.
• At first, real output may expand beyond the economy’s
potential Yhowever
F…
low unemployment and strong demand
create upward pressure on wages and other resource prices,
shifting SRAS1 to SRAS2.
• Output returns to its long-run potential YF, and the price level
increases to P105 (E2).
growth rate (ratio scale)
LRAS
SRAS2
9 8% growth
SRAS1
6 P105 E2
3 3% growth P100 E1
AD2
Time AD1
periods Real
1 2 3 4 YF Y1 GDP
• If the more rapid monetary growth continues, then AD
and SRAS will continue to shift upward, leading to still
higher prices (E3 and points beyond).
• The net result of this process is sustained inflation.

growth rate (ratio scale) SRAS3
LRAS
SRAS2
9 8% growth P110 E3
SRAS1
6 P105 E2
AD3
3 3% growth P100 E1
AD2
Time AD1
periods Real
1 2 3 4 YF GDP
Expansionary Monetary Policy
Interest
Loanable Funds
rate Market
S2 (expected rate
of inflation = 5 %)
S1 (expected rate
of inflation = 0 %)
i.09
Recall: the nominal
interest rate is the
real rate plus the
inflationary premium.
r.04
D2 (expected rate
of inflation = 5 %)
(expected rate
D1 of inflation = 0 %)
Quantity of
Q loanable funds
• With stable prices, supply and demand in the loanable funds
market are in balance at a real & nominal interest rate of 4%.
• If rapid monetary expansion leads to a long-term 5% inflation
rate, borrowers and lenders will build the higher inflation rate
into their decision making.
• As a result, the nominal interest rate i will rise to 9%.
Money and Inflation
• The impact of monetary policy differs
between the short and long-run.
• In the short-run, shifts in monetary policy will
affect real output and employment. A shift
toward monetary expansion will temporarily
increase output, while a shift toward monetary
restriction will reduce output.
• But in the long-run, monetary expansion will
only lead to inflation. The long-run impact of
monetary policy is consistent with the
quantity theory of money.
Money and Inflation
– An International Comparison 1985 - 2005
• The relationship 1000
between
the avg. annual growth
Brazil
rate of the money Nicaragua
Rate of inflation (%, log scale)

Congo, DR
supply 100
andrelationship
• The the rate of
inflation
between Sierra Leone
is shown
the two is here
clear:for the
higher Ghana Venezuela
Columbia
1985-2005 period. Paraguay
Mexico
Nigeria
Indonesia Chile
rates of money growth 10
Hungary
India
lead to higher
Note: rates of Japan
inflation.The money supply data are the
actual growth rate of the money
supply minus the growth rate of
Switzerland South Korea
Belgium
real GDP.
Central Africa Republic
United States
1
1 10 100 1,000
Rate of money supply growth (%, log scale)
Time Lags, Monetary Shifts,
and Economic Stability

Time Lags, Monetary Shifts, and
Economic Stability
• Shifts in monetary policy will influence the
general level of prices and real output only
after time lags that are long and variable.
• Given our limited forecasting ability, these
time lags will make it difficult for policy-
makers to institute changes in monetary
policy that will promote economic stability.
• Constant shifts in monetary policy are likely
to generate instability rather than stability.
• Historically, erratic monetary policy has been
a source of economic instability.
Measurement of Monetary Policy
• How can you tell whether monetary policy is
expansionary or restrictive?
• During the 1960s and 1970s the growth rate of
the money supply was a reasonably good
indicator of the direction of monetary policy.
Rapid growth of the money supply signaled
expansion, while slow growth or decline was
indicative of restriction.
• But innovations and dynamic change reduced
the reliability of the money growth data.

Measurement of Monetary Policy
• Since the mid-1980s, the Fed has used its
control over short-term interest rates more
extensively in its conduct of monetary policy.
• When the Fed shifted toward expansion, it
pushed short-term interest rates downward.
• When it shifted toward restriction, it pushed
short-term interest rates upward.
• Thus, movements of short-term interest rates
have emerged as a reliable monetary policy
indicator.

What is the Taylor Rule?
• Developed by John Taylor of Stanford, the
Taylor rule provides an estimate of the federal
funds interest rate that would be consistent
with both price stability and full employment.
• The Taylor rule equation for the target federal
funds rate is:
f = r + p + .5*(p-p*) + .5*(y-yp)
f - the target fed funds rate
r - equilibrium real interest rate (assumed to be 2.5%)
p - actual inflation rate
p* - the desired inflation rate (assumed to be 2%)
y - output
yp - potential output
• Most economists believe that price indexes
slightly overstate the rate of inflation. Thus,
the 2% desired rate of inflation might be
thought of as approximate price stability.

• The general idea of the Taylor Rule is
straightforward:
• When the rate of inflation is high and current
output is large relative to the potential, more
restrictive monetary policy and a higher target
fed funds rate would be appropriate.
• In contrast, when inflation is low and current
output well below its potential, more
expansionary monetary policy and a lower fed
funds rate would be called for.

Why is the Taylor Rule Important?
• The Taylor rule is important because it
provides both a guide for the conduct of
monetary policy and a tool for the evaluation
of how well it is being conducted.
• If the actual fed funds rate is below the target
rate implied by the Taylor rule, this indicates
monetary policy is overly expansionary.
• On the other hand, when the actual federal
funds rate is above the target rate, this signals
monetary policy is too restrictive.
• When the actual and target rates are equal, this
indicates monetary policy is on target.

The Taylor Rule and Monetary
Policy, 1960-2009
Taylor
Taylor Rule
Rule Actual
Actual Fed
Fed Funds
Funds Rate
Rate
Target
Target
• The actual fed funds rate tracked the target rate quite closely
during most of the 1960s and the 1986-1999 period,
indicating that monetary policy was appropriate for the
maintenance of full employment and low inflation.
The Taylor Rule and Monetary
Policy, 1960-2009
Taylor
Taylor Rule
Rule Actual
Actual Fed
Fed Funds
Funds Rate
Rate
Target
Target
• In contrast, the actual fed funds rate was substantially less

than the target rate in the inflationary 1970s and during 2002-
mid-year 2005.
• This indicates that monetary policy was too expansionary
during these periods. Jump to first page
May not be scanned, copied or duplicated, or posted to a
Did Monetary Policy Cause the
Crisis of 2008?
• Between January 2002 and mid-year 2006,
housing prices increased by 87%.
• This boom in housing prices was fueled by
several factors including:
• government regulations that eroded lending
standards and promoted the purchase of
housing with little or no down payment
• heavily leveraged borrowing for the financing
of mortgage-backed securities
• But, the expansionary Fed policy of 2002-
2004, followed by the shift to a more
restrictive monetary policy in 2005-2006 also
contributed to the housing boom and
subsequent bust.
Short-Term Interest Rates, 1998-
2009
Federal
Federal Funds
Funds
1-Year
1-Year T-Bill
T-Bill
• Rising short-term interest rates are indicative of monetary

restriction, while falling rates imply expansion.
• Note, how the Fed pushed short-term interest rates to historic
lows during 2002-2004, and housing prices soared.
Inflation, 1998-2009
• As inflation rose in 2005-2006, the Fed shifted toward

restriction and pushed short-term interest rates upward.
• The Fed’s low interest rate policy (2002-2004), followed by
its more restrictive policy (2005-2006), contributed to the
boom and bust in housing prices, and the Crisis of 2008.
Current Fed Policy and the Future
• As the recession worsened during the second
half of 2008, the Fed shifted toward a highly
expansionary monetary policy.
• Vast amounts of reserves were injected into
the banking system, short-term interest rates
were pushed to near zero, and the monetary
base was approximately doubled.
• Monetary policy works with a lag. It will take
some time for the expansionary monetary
policy to stimulate demand and economic
recovery.
Current Fed Policy and the Future
• The Fed now faces a dilemma: If it shifts
toward restriction too quickly, the recovery
may falter. But, if the Fed continues with the
expansionary monetary policy for too long, it
will lead to serious future inflation.
• The problem is not the Fed’s ability to control
the money supply, but its ability to time shifts
properly. Given the long and variable lags, it
is hard for monetary policy-makers to institute
stop-go policy in a stabilizing manner.
• We are in the middle of another great
monetary policy experiment. Copyright ©2010 Cengage Learning. All rights reserved.
1. When the actual interest rate is less than the rate
implied by the Taylor rule, monetary policy is
too expansionary. (True or False?)
2. Will stop-go monetary policy help stabilize
real output and employment? Why or why
not?
3. Did Fed policy contribute to the Crisis of
2008? Why or why not?
4. Did the change in Fed policy during the latter
half of 2008 help promote economic
recovery? Did this policy change lead to
long-term stability?

End
Chapter 14


Modern Macroeconomics and Monetary Policy: Full Length Text - Macro Only Text

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Modern Macroeconomics and Monetary Policy: Full Length Text - Macro Only Text

Uploaded by

Copyright:

Available Formats

Modern Macroeconomics

and Monetary Policy

To Accompany “Economics: Private and Public Choice 13th ed.”

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

• The quantity of money people want to hold (the demand

• The supply of money is vertical because it is established

At ie, people are willing

• If expansionary monetary policy leads to an in increase in AD

• Alternatively, if the demand-stimulus effects are imposed

• In the long-run, the strong demand pushes up resource prices,

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

• The stabilization effects of restrictive monetary policy depend

• In contrast, if the reduction in aggregate demand takes place

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Money supply Price level

Rate of inflation (%, log scale)

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

• In contrast, the actual fed funds rate was substantially less

• Rising short-term interest rates are indicative of monetary

• As inflation rose in 2005-2006, the Fed shifted toward

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

You might also like