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Modern Macroeconomics and Monetary Policy

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by: James Gwartney & Charles Skipton

Full Length Text —

Macro Only Text —

Part: 3

Chapter: 14

First page

The Impact of Monetary Policy: A Brief Historical Background

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Impact of Monetary Policy

A brief historical background:

The Keynesian view dominated during the 1950s and 1960s.

Keynesians argued that money supply did not matter much.

Monetarists challenged the Keynesian view during the 1960s 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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Impact of Monetary Policy

Every major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation episode has been produced by monetary expansion.

— Milton Friedman (1968)

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The Demand and Supply of Money

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The Demand for 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.

Money interest rate

Money Demand

Quantity

of money

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The Supply of Money

The supply of money is vertical because it is established by the Fed and, hence, determined independently of the interest rate.

Money interest rate

Quantity

of money

Money Supply

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The Demand and Supply 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.

Money interest rate

Quantity

of money

Money Supply

Money Demand

Excess supply at i2

Excess demand at i3

At ie, people are willing to hold the money supply set by the Fed.

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How Does Monetary Policy Affect the Economy?

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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 (shifting S1 to S2 in the loanable funds market) …

Money interest rate

Quantity of money

Real interest rate

Qty of loanable funds

and puts downward pressure on real interest rates (a reduction to r2).

Money Balances

Loanable Funds

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Transmission of Monetary Policy

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 rate

Qty of loanable funds

Loanable Funds

Price Level

Goods &

Services

(real GDP)

AS1

AD1

AD2

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(increased

net exports) and …

an increase in the general level of asset prices …

(and with the increased personal wealth) increased investment & consumption.

Here, a shift to an expansionary monetary policy is shown.

The Fed buys bonds (expanding the money supply) …

which increases bank reserves …

Transmission of Monetary Policy

pushing real interest rates down …

leading to increased investment and consumption …

a depreciation of the dollar …

So, an unanticipated shift to a more expansionary monetary policy will stimulate AD and, thereby, increase both output and employment.

Fed

buys

bonds

Real interest rates

fall

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

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Expansionary Monetary Policy

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.

AD1

Price Level

LRAS

AD2

Goods & Services (real GDP)

SRAS1

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AD Increase Disrupts Equilibrium

Alternatively, if demand-stimulus effects occur when economy is already at full-employment YF, they will lead to excess demand, higher product prices, and temporarily higher output (Y2).

Price Level

Goods & Services (real GDP)

AD1

LRAS

SRAS1

AD2

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AD Increase: Long Run

In the long-run, 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 recedes to full-employment output again (YF from its temp high,Y2).

Price Level

Goods & Services (real GDP)

AD1

LRAS

SRAS1

AD2

SRAS2

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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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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 change in AD is unanticipated, real output will decline (to Y2) and downward pressure on prices will result.

Real interest rate

Qty of loanable funds

Price Level

Goods &

Services

(real GDP)

AS1

AD1

AD2

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Restrictive Monetary Policy

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.

Price Level

Goods & Services (real GDP)

LRAS

SRAS1

AD1

AD2

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AD Decrease Disrupts Equilibrium

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.

Price Level

AD1

LRAS

AD2

SRAS1

Goods & Services (real GDP)

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Shifts in Monetary Policy and Economic Stability

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:

If expansionary effects occur during a recession and restrictive effects during an inflationary boom, the impact would be stabilizing.

However, if expansionary effects occur when an economy is already at or beyond full employment and restrictive effects occur when an economy is in a recession, the impact would be destabilizing.

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Questions for Thought:

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

(d) the exchange rate value of the dollar

(e) net exports

(f) the price of stocks & real assets (like apartments or office buildings)

(g) real GDP

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Questions for Thought:

2. What are the determinants of the demand for money? The supply of money?

3. 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.

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Monetary Policy in the Long Run

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GDP

The Quantity Theory of Money

The AD-AS model illustrates that nominal GDP is the product of the price (P) and output (Y) of each final-product good purchased during the period.

GDP can also be visualized as the money stock (M) times the number of times it is used to buy those final goods & services (V).

If V and Y are constant, then an increase in M will lead to a proportional increase in P.

Money

Velocity

Price

Y = Income

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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 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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Long-run Effects of a Rapid Expansion in 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%.

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).

Time periods

Money supply

growth rate (%)

(a)

Growth rate of the money supply.

3% growth

8% growth

Price level (ratio scale)

Real GDP

AD1

LRAS

SRAS1

(b)

Impact in the goods & services market.

AD2

P100

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At first, real output may expand beyond the economy’s potential YF …

Time periods

Money supply

growth rate (%)

(a)

Growth rate of the money supply.

3% growth

8% growth

Price level (ratio scale)

Real GDP

AD1

LRAS

SRAS1

(b)

Impact in the goods & services market.

AD2

P100

SRAS2

P105

however 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, & price level increases to P105 (E2).

Long-run Effects of a Rapid Expansion in Money Supply

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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).

Time periods

Money supply

growth rate (%)

(a)

Growth rate of the money supply.

3% growth

8% growth

Price level (ratio scale)

Real GDP

AD1

LRAS

SRAS1

(b)

Impact in the goods & services market.

AD2

P100

SRAS2

P105

The net result of this process is sustained inflation.

AD3

P110

SRAS3

Long-run Effects of a Rapid Expansion in Money Supply

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Long-Run Effects of Rapid Expansion in Money Supply on Loanable Funds Market

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%.

Quantity of loanable funds

Loanable Funds Market

Interest rate

r.04

(expected rate

of inflation = 5 %)

(expected rate

of inflation = 0 %)

(expected rate

of inflation = 5 %)

(expected rate

of inflation = 0 %)

i.09

Recall: the nominal interest rate is the real rate plus the inflationary premium.

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Money and Inflation

The impact of monetary policy differs between the short-run and the 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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Money and Inflation – An International Comparison 1990 - 2010

The relationship between the avg. annual growth rate of the money supply and the rate of inflation is shown here for the 1990-2010 period.

The relationship between the two is clear: higher rates of money growth lead to higher rates of inflation.

Note: Money supply data are the actual growth rate of the money supply minus the growth rate of real GDP.

Congo, DR

United States

Rate of money supply growth (%, log scale)

Rate of inflation (%, log scale)

100

0.1

100

1000

1,000

Brazil

Romania

Venezuela

Zambia

Turkey

Nigeria

Peru

Indonesia

Hungary

Colombia

Paraguay

India

Morocco

Japan

Central Africa Republic

South Korea

Switzerland

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Time Lags, Monetary Shifts, and Economic Stability

While the Fed can institute policy changes rapidly, there will be a time lag before the change exerts much impact on output and prices.

This time lag is estimated to be 6 to 18 months in the case of output.

In the case of the price level, the lag is estimated to be 12 to 30 months.

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The Potential & Limitations of Monetary Policy

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Two Important Points About Monetary Policy

Expansionary monetary policy cannot loosen the bonds of scarcity and therefore it cannot promote long-term economic growth. Rapid growth of the money supply will lead to inflation.

Shifts in monetary policy will influence the general level of prices and real output only after time lags that are long and variable.

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Why Proper Timing of Monetary Policy Changes is Difficult

The long and variable time lags between a monetary policy shift and their impact on the economy will make it difficult for policy-makers to institute changes in a manner that will promote economic stability.

Given our limited forecasting ability, policy errors are likely.

If monetary policy makers are constantly shifting back and forth, policy errors will occur. Thus, constant policy shifts are likely to generate instability rather than stability. Historically this has been the case.

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Key to Prosperity: Price Stability

Monetary policy that provides approximate price stability (persistently low rates of inflation) is the key to sound stabilization policy.

Modern living standards are the result of gains from trade, specialization, division of labor, and mass production processes. Price stability will facilitate the smooth operation of the pricing system and the realization of these gains.

In contrast, high and variable rates of inflation create uncertainty, distort relative prices, and reduce the efficiency of markets.

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What Causes the Ups and Downs of the Business Cycle: the Austrian View

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Austrian View of the Business Cycle

The Austrian view provides a plausible explanation of the recent boom and bust in the housing market and accompanying recession.

Austrian view of the business cycle:

Expansionary monetary policy pushes the interest rate to an artificial low.

The low interest rates will induce entrepreneurs to undertake long-term investments like houses, shopping malls, and office buildings. This will generate an economic boom.

(continued on next slide)

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Austrian View of the Business Cycle

Austrian view of the business cycle: (continued from previous page)

But, the low interest rates reflect monetary policy rather than an increase in savings.

Thus, the boom will be unsustainable because savings are too low to provide a future income that is large enough for the purchase of the newly created assets at prices that will cover their cost.

The boom turns to bust and a large share of the newly constructed assets end up unoccupied. Austrian economists refer to this as malinvestment.

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What Causes the Ups and Downs of the Business Cycle: Austrian View

In many respects, the Austrian view appears to be descriptive of the recent business cycle.

Low interest rate policies contributed to a housing boom, but future demand was inadequate to purchase the larger quantity of houses at profitable prices.

As a result, an excess supply of housing led to price declines, unsold housing inventories, empty office buildings, rising default rates, and a prolonged recession.

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Recent Monetary Policy of the United States

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Monetary policy, 1990-2011

In the 1990s: The Fed focused on price stability. Monetary policy was relatively stable and kept inflation low.

Between 2002-2004: The Fed shifted towards a more expansionary policy, M2 grew rapidly, and interest rates were pushed to historic lows.

This expansionary monetary policy contributed to the 87% increase in housing prices between 2002 and mid-2006.

Between 2005-2007: As inflation rose in 2005, the Fed shifted to a more restrictive monetary policy. M2 growth slowed and interest rates rose.

This shift contributed to the housing price bust and the recession that followed. (See graphics that follow).

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Monetary policy, 1990-2011

As interest rates rose, housing prices reversed. By 2007, housing prices were falling and mortgage default rates rising. The housing bust soon spread to the rest of the economy and resulted in the severe 2008-2009 recession.

Government regulations that eroded lending standards and promoted the purchase of housing with little or no down payment (begun in the latter half of the 1990s) were an important cause of the housing boom and bust, but monetary policy was also a contributing factor.

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The Fed Funds Rate: 1990-2013

Between 2002 and 2004 the fed pushed short-term interest rates to historic lows (< 2%).

As the inflation rate accelerated, the fed switched to a more restrictive policy in 2005-2006, pushing short-term interest rates above 5%.

As the economy slipped into a recession in 2008, the Fed again shifted to expansion, pushing interest rates to nearly 0%.

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2011

Federal Funds Interest Rate

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2012

2013

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Annual Growth Rate of M2: 1990-2013

The annual growth rate of the M2 money supply spiked above 10% in 2002-2003 and declined to less than 4% in 2005-2006.

These shifts contributed to the housing boom and bust.

In response to the recession of 2008-2009, M2 growth spiked up (again) to nearly 10%.

In 2010-2012 the M2 money supply grew rapidly.

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2011

Annual Growth Rate of M2

Average

Growth

Rate

2012

2013

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

10%

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Fed Policy During and Following the 2008 Financial Crisis

Fed response to 2008 financial crisis:

The fed responded to the recession by injecting a huge quantity of reserves into the banking system.

In the 12 months beginning in July of 2008, the fed doubled both its asset holdings and the monetary base, pushing short-term interest rates to near zero.

But, the demand for investment was weak and therefore…

expansion in credit was small, and,

banks held huge excess reserves.

While the recession ended in June 2009, growth of real GDP was slow and the unemployment rate high.

The fed responded with additional rounds of bond purchases that were referred to as quantitative easing.

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Why Wasn’t Expansionary Policy More Effective?

Nominal GDP growth indicates that Fed policy was not overly expansionary.

The impact of the expansionary monetary policy of 2008-2013 was weakened by the following factors:

Loan demand was weak, so banks simply held most of the newly created reserves.

The low interest rates resulted in a substantial reduction in the velocity of money.

The low interest rates reduced the income and wealth of people expecting to derive normal returns from their savings. This was an offset to the wealth effect of the higher stock prices.

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The Velocity of the M1 and M2 Money Supply: 1990-2013

Note how the velocity of the M1 money supply increased for more than a decade prior to 2007 but plunged in the aftermath of the 2008-2009 recession.

After fluctuating within a relatively narrow range during 1997-2007, the velocity of the M2 money supply also fell substantially in 2008-2013.

The Fed’s low interest rate policy contributed to these reductions in velocity.

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2011

The Velocity of M1 & M2

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2012

2013

10%

M1 Velocity

M2 Velocity

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Annual Growth Rate in Nominal GDP: 1990-2013

The growth rate of nominal GDP reflects the combination of changes in the money supply and its velocity.

During 1990-2007, the annual growth rate of nominal GDP averaged 5.4% and was generally in the 4% to 6% range.

After plunging in 2008-2009, nominal GDP grew about 4% annually during 2010-2012.

This modest growth rate suggests that monetary policy was not excessively expansionary in the aftermath of the 2008 recession.

- 2%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2011

Growth Rate of Nominal GDP

- 4%

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2012

2013

1990-2007 Average Growth Rate of Nominal GDP

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The Fed’s Dilemma

Fed policy during 2008-2013 injected approximately $3 trillion of additional reserves into the banking system, nearly half held as excess reserves.

As the economy recovers, the fed confronts a dilemma.

If the fed waits too long to move toward restriction, bank lending from the excess reserves will lead to rapid money growth, future inflation, & economic instability.

However, if it moves toward restriction too quickly, it will throw the economy back into recession.

The long and unpredictable time lags between a shift in Fed policy and when the shift will exert its primary impact on the economy will complicate the Fed’s task.

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Questions for Thought:

Did Fed policy contribute to the Crisis of 2008? Why / why not?

Has Fed policy since 2008 helped promote economic recovery? Has it promoted long-term stability?

3. (True / False) 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.

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Questions for Thought:

4. Why do the large excess reserves currently held by banks confront the Fed with a dilemma? How can the Fed prevent the lending from these excess reserves from providing the fuel for future inflation.

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End of

Chapter 14

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