Modern Macroeconomics and Monetary Policy. 3. 14. 3. 14. The Impact of Monetary Policy on Output and Inflation. 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. - PowerPoint PPT Presentation
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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
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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.
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Money interestrate
• 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.
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Money interestrate
• 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.
Money Supply
The Demand and Supply of Money
Money Demand
i3
ie
i2
Excess supplyat i2
Excess demandat i3
At ie, people are willingto hold the money supply set by the Fed.
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D1
Moneyinterestrate
S1
D
S1
i1
Qs
r1
Q1
i2
Qb
r2
Q2
S2 S2
Realinterestrate
Quantityof money
Qty of loanable funds
• When the Fed shifts to a more expansionary monetary policy, it usually buys additional bonds, expanding the money supply.
Transmission of Monetary Policy
• 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 (shifting S1 to S2 in the loanable funds market) … and puts downward pressure on real interest rates (a reduction to r2).
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Unanticipated Expansionary Monetary Policy
which leads to increased investment and consumption … a depreciation of the dollar an increase in the general level of asset prices(leading to increased net exports) and …
Fedbuys
bonds
Transmission of Monetary Policy
Real interest
ratesfall
Increases in investment & consumption
Depreciation of the dollar
Increase in asset prices
Increases in investment & consumption
Net exports rise
Increase in aggregate demand
This increases money supply
and bank reserves
• 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 …
• So, an unanticipated shift to a more expansionary monetary policy will stimulate aggregate demand and, thereby, increase both output and employment.
(and with the increased personal wealth, increased investment and consumption).
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AD1
• 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).
Expansionary Monetary PolicyPriceLevel
LRAS
YFY1
AD2
Goods & Services(real GDP)
P2
SRAS1
P1
E2
e1
• Here, the increase in output from Y1 to YF will be long term.
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AD1
• 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).
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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.
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PriceLevel
Goods & Services(real GDP)
• The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its impact.
LRAS
YF
P1
P2
SRAS1
AD1
e1
Y1
Restrictive Monetary Policy
AD2
• 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.
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PriceLevel
Goods & Services(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.
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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.
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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 monetarypolicy, it typically sells bonds. How will this action influence the following? a. the reserves available to banks b. real interest ratesc. household spending on consumer durables d. the exchange rate value of the dollar e. net exportsf. the price of stocks and real assets like
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Questions for Thought: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?
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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.
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Quantity of loanable fundsQ
S1
Loanable FundsMarketInterest
rate
r.04
• 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%.
Expansionary Monetary Policy
D1
S2 (expected rate
of inflation = 5 %)
(expected rate of inflation = 0 %)
D2 (expected rate
of inflation = 5 %) (expected rate
of inflation = 0 %)
i.09 Recall: the nominal interest rate is the real rate plus the
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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.
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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.
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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.
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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 rater - equilibrium real interest rate (assumed to be 2.5%)p - actual inflation ratep* - the desired inflation rate (assumed to be 2%)y - outputyp - potential output
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What is the Taylor Rule?
• 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.
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What is the Taylor Rule?
• 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.
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The Taylor Rule and Monetary Policy, 1960-2009
• 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.
Actual Fed Funds RateActual Fed Funds RateTaylor Rule Target
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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.
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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.
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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.
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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.