Macroeconomics

Session 9

11-1
Monetary Policy

11-2
The US Economy

11-3
 Fiscal and Monetary Policy
• Fiscal policy has its initial impact in the goods market

• Monetary policy has its initial impact mainly in the assets

markets

® Because the goods and assets markets are interconnected, both

fiscal and monetary policies have effects on both the level of
output and interest rates
® Expansionary/contractionary monetary policy moves the LM
curve to the right/left
® Expansionary/contractionary fiscal policy moves the IS curve to
the right/left
11-4
Expansionary/Contractionary MP

LM1

E1

i1
Interest Rate

Y1

Income, Output

11-5
Expansionary/Contractionary FP

IS1
Interest Rate

i1

E1

Y1

Income, Output

11-6
 Monetary Policy Transmission
• Transmission of a CBs MP action to the ultimate
objective of stable inflation and growth
• Change in policy rate (repo/reverse repo)
• Change in inter-bank lending rate
• Change in deposit/lending rate
• Change in bond yields
• Change in asset prices – stock and house prices
• Ultimate impact on inflation and growth

11-7
 Channels of MP Transmission
• Primary channels:

• Interest rate channel

• Credit channel

• Exchange rate channel

• Asset price channel

11-8
 Interest Rate Channel
• Reduced policy interest rate
• Reduction in banks’ cost of funds
• Reduction in lending rates
• Increased demand for credit from households and firms
• Increased demand for goods and services
• Increased demand for factors of production
• Increase in factor incomes
• Increase in overall demand and output and income in an
economy

11-9
 Credit Channel
• Assumption – Bank’s balance sheet are strong

• Weak balance sheet hinder monetary transmission

• Ever-greening of bad loans, lending to distressed firms at

subsidized rates to avoid loan defaults

11-10
 Asset Price Channel
• Housing and stocks available at cheaper borrowing costs

• Increased household and corporate wealth

• Enhanced value of the collateral or net worth of the

borrowers

• Enhanced capacity to borrow more

• Reinforces the impulses to aggregate demand

11-11
 Exchange rate channel
• Lower domestic interest rates depreciates the domestic
currency

• Exports become competitive in the global market

• Increased exports, increased output and income

11-12
The Keynesian Transmission
Mechanism: Indirect
Keynesian Transmission Mechanisms

Because the Keynesian transmission mechanism is indirect,

both interest insensitive investment demand and the liquidity
trap may occur.
 Monetary Policy
• The Federal Reserve is
responsible for monetary
policy in the U.S. 
conducted mainly through
open market operations
• Open market operations:
buying and selling of
government bonds
 Fed buys bonds in exchange
for money  increases the
stock of money
 Fed sells bonds in exchange
for money paid by
purchasers of the bonds 
reducing the money stock
11-15
 Monetary Policy
• Consider the process of adjustment to
the monetary expansion

Interest Rate

Income, Output

11-16
 Transition Mechanism
• Two steps in the transmission mechanism (the process by which
changes in monetary policy affect AD):

1. An increase in real balances generates a portfolio

disequilibrium
• At the prevailing interest rate and level of income, people are holding more
money than they want
• Portfolio holders attempt to reduce their money holdings by buying other
assets  changes asset prices and yields
• The change in money supply changes interest rates

2. A change in interest rates affects AD

11-17
 The Liquidity Trap
• Two extreme cases arise when discussing the effects of
monetary policy on the economy  first is the liquidity
trap
• Liquidity trap = a situation in which the public is prepared, at a
given interest rate, to hold whatever amount of money is
supplied
• Implies the LM curve is horizontal  changes in the quantity of
money do not shift it
• Monetary policy has no impact on either the interest rate or the
level of income  monetary policy is powerless
• Possibility of a liquidity trap at low interest rates is a notion that
grew out of the theories of English economist John Maynard
Keynes
11-18
 What leads to Liquidity Trap
• Burst of an economic bubble
 Economic Slump
 Falling aggregate demand

 Falling Output
 Falling prices (persistent deflation)
 CB responds initially with a cut in interest rates (above zero
level) to stimulate investment, output, demand and prices
 Firms and businesses unresponsive to falling interest rates
 Interest rates reach zero level
 CB goes for quantitative easing (expansion of monetary base)

 CB also commits “close to zero” interest rates for a certain

future period
11-19
 r MS

Md (Y3)
Md (Y2)
Interest Rate

Md (Y1)
B A Interest Rate C B A
r0 r0 LM
C

Real Balances M/P Y1 Y2 Y3

Income, Output
11-20
• Second case is Banks’ reluctance to lend
• as interest rates decline, banks are reluctant to increase their
lending
• Increasing bad loans as borrowers fail to repay
• banks show little enthusiasm to lend more to new, perhaps risky,
borrowers
• they prefer to lend to the government, by buying securities such
as Treasury bills
• Fed open market purchase and an increase in aggregate demand
and output is put out of action

11-21
 The Classical Case
• Typically the money demand equation is a function of
both real income/GDP (Y) and the interest rate (i). 

• What if money demand only depends on income?

• There is no demand for money for speculation
M purpose
 kY  hi
• P
interest rate may be so high that nobody expects it to rise any
further).

• How would the LM curve look?

M  k(P Y )

11-22
The Classical case

11-23
 The Classical Case
• When the LM curve is vertical
1. A given change in the quantity of money has a maximal effect on the
level of income
2. Shifts in the IS curve do not affect the level of income

When the LM curve is vertical, monetary policy has

a maximal effect on the level of income, and fiscal
policy has no effect on income.

• Vertical LM curve implies the comparative effectiveness of

monetary policy over fiscal policy
• “Only money matters” for the determination of output

11-24
LM Curve with Different Ranges
IS6 LM

IS5

Classical Range
Interest Rate

H
IS4
IS3
IS1 IS2

Intermediate Range
K

Keynesian Range

Income, Output

11-25
 Problem 1
From the following information, calculate the equilibrium values of
investment (I), net exports (NX), and money demand (md).

expenditure sector: money sector:

S = - 200 + (1/5)YD ms = 400
TA = (1/8)Y - 40 md = (1/4)Y + 100 - 5i
TR = 60
I = 300 – 10i
G = 70
NX = 150 - (1/5)Y

11-26
 Solution
C = YD - S = YD – [-200 + (1/5)YD] = 200 + (4/5)YD
 Sp = C + I + G + NX = 200 + (4/5)[Y‑ (1/8)Y + 40 + 60] + 300 ‑ 10i + 70 + 150 -
(1/5)Y
= 720 + (4/5)(7/8)Y + (4/5)100 ‑ 10i - (1/5)Y = 800 + [(7/10) – (2/10)]Y – 10i
  = 800 + (1/2)Y ‑ 10i
 
Y = Sp ==> Y = 800 + (1/2)Y ‑ 10i ==> (1/2)Y = 800 ‑ 10i
 Y = 2(800 ‑ 10i) ==> Y = 1,600 ‑ 20i IS‑curve

ms = md ==> 400 = (1/4)Y + 100 ‑ 5i ==> (1/4)Y = 300 + 5i ==> Y = 4(300 + 5i)
  ==> Y = 1,200 + 20i LM‑curve
IS = LM ==> 1,600 ‑ 20i = 1,200 + 20i ==> 40i = 400 ==> i = 10 Y = 1,400
  ==> I = 300 - 10*10 = 200; NX = 150 - (1/5)1,400 = - 130
md = ms = 400

11-27