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Monetary Policy

LO15-1 How interest rates are set in the money market.

LO15-2 How monetary policy affects macro outcomes.

LO15-3 The constraints on monetary policy impact.

LO15-4 The differences between Keynesian and monetarist monetary theories.

LEARNING OBJECTIVES

After learning about this chapter, you should know

CHAPTER

Monetary Policy

Control over the money supply is a critical policy tool for altering macroeconomic outcomes.

The quantity of money in circulation influences its value in the marketplace.

Interest rates and access to credit are basic determinants of spending behavior.

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This chapter details how and when the policy tools of the Fed are used and the various outcomes that can be expected.

Monetary Policy II

In this chapter we explore the effectiveness of monetary policy. Specifically,

What’s the relationship between money supply, interest rates, and aggregate demand?

How can the Fed use its control of the money supply or interest rates to alter macro outcomes?

How effective is monetary policy, compared to fiscal policy?

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The Money Market

Money is a commodity that is traded in a marketplace, the money market.

The money supply is controlled by the Fed and society has demand for money.

The market determines the “price” of money, the interest rate.

At high interest rates, money is expensive to acquire.

At low interest rates, money is cheap to acquire.

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Here is a good place to use the product market analogy.

Remember to make the money supply a vertical line on the market model.

While any participant in an economy can increase or decrease the quantity of money that he or she holds individually, all participants taken together cannot change the quantity of money that they hold because the quantity of money is fixed. Currency and bank account balances can move from one participant to another, but only the Fed can change the total amount of money that everyone holds in aggregate.

The Money Market II

Money supply (M1): currency held by the public, plus balances in transactions accounts.

Money supply (M2): M1 plus balances in savings accounts and money market mutual funds.

Money demand: quantities of money the public wants to hold at alternative interest rates.

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Review of definitions

The Money Market III

Money demand: If people hold cash as M1, they suffer an opportunity cost: the forgone interest they could have earned.

At low interest rates, the opportunity cost of holding money is low, so people will hold more of it, and vice versa.

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The concept of opportunity cost is a real one.

The Demand for Money

Why would people want to hold money, that is, have a demand for money?

Transactions demand: Money held for the purpose of making everyday market purchases.

Precautionary demand: Money held for unexpected market transactions or for emergencies.

Speculative demand: Money held for speculative purposes, for later financial opportunities.

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Not all people have all of these elements of money demand.

Because of that, it might be necessary to more fully explain those that the students have not encountered.

Most likely, those would be the precautionary demand (just-in-case money) and the speculative demand (I have to be ready to act when the opportunity presents itself). The transactions demand should present no problem.

Money Market Equilibrium

Money demand: the quantity of money people are willing and able to hold (demand) increases as interest rates fall, and vice versa.

Money supply: since the Fed controls the money supply, it is represented by a vertical line.

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As an exercise, you could show what happens when interest rates rise (surplus) and what happens when interest rates fall (shortage).

Also, show what happens when MS shifts left (interest rates rise) or shifts right (interest rates fall).

This sets up the next several slides.

Money Market Equilibrium II

The intersection of money demand and money supply (E1) establishes the equilibrium rate of interest.

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This slide establishes the connection between MS and interest rates.

Money Market Equilibrium III

If interest rates are higher than equilibrium, there is a money surplus.

People must hold more money as M1 than they want to.

They will move money out of M1 into M2 or other assets (such as bonds).

The interest rate will then fall to E1.

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Walk through the reactions of money holders when interest rates are above equilibrium.

Money Market Equilibrium IV

If interest rates are lower than equilibrium, there is a money shortage.

People must hold less money as M1 than they want to.

They will move money into M1 from M2 or other assets (such as bonds).

The interest rate will then rise to E1.

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Similarly for interest rates below equilibrium.

Changing Interest Rates

The Fed controls the money supply.

The Fed can use its policy tools to change the equilibrium rate of interest.

By increasing the money supply (causing a surplus), the Fed tends to lower the equilibrium rate of interest.

By decreasing the money supply (causing a shortage), the Fed tends to raise the equilibrium rate of interest.

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You might want to show this on a graph on the board.

Interest Rates and Spending

Lowering interest rates: a tactic of monetary stimulus, to increase aggregate demand (AD).

Reduce the cost of investment spending.

Reduce the cost of holding inventory.

The investment spending increase will kick off a positive multiplier effect. AD will shift right because of this.

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Here we connect lower interest rates through increased money available to increased spending and an AD shift to the right.

Interest Rates and Spending II

Raising interest rates: a tactic of monetary restraint, to decrease aggregate demand (AD).

Increase the cost of investment spending.

Increase the cost of holding inventory.

The investment spending decrease will kick off a negative multiplier effect. AD will shift left because of this.

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Here we connect higher interest rates through decreased money available to decreased investment spending and an AD shift to the left.

Summary

Goal 1: to stimulate the economy.

An increase in the money supply leads to,

Lower interest rates, which lead to,

An increase in aggregate demand.

Goal 2: to restrain the economy.

A decrease in the money supply leads to,

Higher interest rates, which lead to.

An decrease in aggregate demand.

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This summarizes the connections.

Policy Constraints: On Monetary Stimulus

Short- vs. long-term rates.

The Fed has greater influence on short-term rates (that is, the Fed funds rate) than long-term rates (mortgages and installment loans).

Monetary stimulus will be most effective if long-term interest rate changes mirror short-term rate changes.

If not, the AD increase will be less than hoped for.

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How could this happen?

Easing up in the Fed sends strong signals to the private sector, especially the investment community.

If this community concludes that, due to the Fed’s easing, future expectations are rosier, then more long-term investment will occur.

And vice versa.

Policy Constraints: On Monetary Stimulus II

Reluctant lenders.

Banks must be willing to increase lending activity.

Banks may pile up excess reserves instead of making loans (this happened 2008-2014).

They worry about their financial well-being.

They worry about not being paid back by weak borrowers.

They worry about how new bank regulations may affect profitability.

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In a previous chapter, the current atmosphere in banking was described as being reluctant to lend.

If this is the case, the Fed increasing the money supply with the intent of increasing reserves will not accomplish the added spending and the shift of AD right.

Say the Fed did this by buying bonds in the open market. Amazingly, the banks, instead of increasing loans, put their excess reserves in bonds.

Policy Constraints: On Monetary Stimulus III

Lowering interest rates too far eliminates the opportunity cost of holding M1. The public simply hold the money instead of investing.

This is the liquidity trap: The portion of the money demand curve that is horizontal; people are willing to hold unlimited amounts of money at some low interest rate.

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How low can interest rates go? Zero? Negative?

Once interest rates get down to numbers like these, the opportunity cost of holding cash is also zero.

Policy Constraints: On Monetary Stimulus IV

Low expectations:

In a recession, firms have little incentive to expand production capability (evident in 2008-2014).

There would be little expectation of future profit, or return on investment (ROI), from new investment.

Consumers may be reluctant to take on added debt when future income prospects are uncertain.

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For decades up to the onset of the Great Recession, Americans operated on credit. A major change began when the Great Recession occurred.

Instead of using stimulus funds to buy more, Americans used them to pay down existing debt, and their propensity to save increased.

This upset a lot of calculations made by policy makers, which were based on what they expected people to do, which they did not do.

Policy Constraints: On Monetary Stimulus V

Time lags:

It takes time to develop and implement new investments in response to lower interest rates.

Consumers also may take time to decide to increase their borrowing.

It may take 6 to 12 months before market behavior responds to monetary policy.

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In both the government sector and the private sector, plans must be drawn up, analyzed, approved, and then implemented.

Policy Constraints: On Monetary Restraint

High expectations:

In a growing economy consumers and businesses may believe that future income and revenue will be sufficient to cover higher interest rates.

Global Money:

Market participants can look outside of US money market for loanable funds in foreign subsidiaries, banks and bond markets.

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After a prolonged period of recession market participants may be slow to respond to “tight” money policy.

Instead of slowing down due to higher interest rates, growing expectations of future revenue and income could cause continued borrowing.

In a global economy market participants may find low interest alternatives for funding outside the US banking system.

The Monetarist Perspective

Keynesians say that changes in the money supply changes in interest rates, which shift AD.

Monetarists say that real output levels are not affected by monetary policy. Only the price level is affected by Fed policy … and then only by changes in the money supply.

So they say monetary policy is not effective for fighting recession, but is a powerful tool for managing inflation.

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Remember Keynesians are all about spending and moving AD.

Monetarists have seen over the last 50 years or so that increasing MS to improve the unemployment numbers has not been very effective, but decreasing MS to strangle inflation has been highly effective (witness the events of 1982-1984).

The Equation of Exchange

The equation of exchange is:

In this equation, total spending is price level (P) times quantity of output (Q). This spending is financed by the money supply (M) times the velocity of its circulation (V).

Velocity (V): the number of times per year, on average, that a dollar is used to purchase final goods and services.

MV = PQ

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This is not really an equation. A math purist will tell you it is an identity.

On the left is how much money is spent to buy the nominal GDP. On the right is the amount of money needed to buy the nominal GDP.

The Equation of Exchange II

PQ is the same as nominal GDP.

The quantity of money (M) in circulation and the velocity (V) with which it exchanges hands will always be equal to the value of nominal GDP.

Monetarist view: If M increases, P and/or Q must rise, or V must fall.

MV = PQ

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Velocity is an odd duck.

It might be useful to consider it as an indicator of how the public handles money. How the public handles money over a period of time can change (look at how the ubiquity of ATMs has altered the way we handle money). If we do not change the ways we handle money, then V should not vary much. When we do change the ways we handle money, then V will change. http://research.stlouisfed.org/fred2/series/M1V?cid=32242.

The Equation of Exchange III

Monetarists assume V is stable – that is, does not change.

V is a function of how people handle their money and the institutions they use to do so. Neither should change much in the short run.

Thus, total spending (PQ) must rise if money supply (M) grows and velocity (V) is stable, regardless of interest rates.

MV = PQ

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An alternative version of the formula is %change in M + %change in V = %change in P + %change in Q.

Someone in the math department will show you, via calculus, why this is so.

If V is stable, then the %change in V = 0.

So a 6% increase in M must show up as a collective 6% change in those two variables.

Possibilities: 6% increase in P and 0% change in Q; 0% change in P and a 6% increase in Q, or some combination adding up to 6.

Money Supply Focus

If spending increases when the money supply grows, then the Fed should focus on the money supply, not interest rates.

Fed policy should not be to manipulate interest rates.

Fed policy should focus on the size and growth of the money supply.

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Here is one position in the what to do with monetary policy debate.

“Natural” Unemployment

Monetarists also say that, in the short run:

Q is stable; a function of productive capacity, labor efficiency, and other “structural” forces.

This leads to a “natural” rate of unemployment that is fairly immune to short-run policy intervention.

Natural rate of unemployment: The long-term rate of unemployment determined by structural forces in labor and product markets.

MV = PQ

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In the short run, over three to six months, real GDP does not increase very much, so we could say that Q is stable.

A MS increase, however, would become effective more immediately. So an increase in M, with both V and Q constant, would cause an increase in P.

The consequence of this reasoning is that, at some level of real GDP, we reach a point where real GDP will not increase. Further injections of money will simply increase prices. The real GDP at which this happens is at the “natural” rate of unemployment, or more simply, full-employment GDP.

“Natural” Unemployment II

If both V and Q are stable, any increase in M in the long-run only increases P.

If prices rise, costs of production will rise also, so there is no profit incentive to increase Q.

Any increase in AD directly increases the price level.

MV = PQ

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Summary slide.

Monetarist Policy: Fighting Inflation

With an inflationary gap, interest rates are likely to be high. A decrease in the money supply will lower nominal interest rates, not raise them.

Nominal interest rate: the interest rate we actually see and pay.

Real interest rate: the nominal rate minus the anticipated inflation rate.

As the money supply shrinks, the price level falls and anticipated inflation decreases, so nominal interest rates fall, not rise.

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When we talked about liquidity earlier, we asked how low interest rates can go. Zero?

The interest rate people pay is the nominal rate. Lenders build the effects of inflation into that rate. Subtract the expected inflation and we get the real rate.

If the nominal rate is 1.5% and expected inflation is 3%, then the real rate is -1.5%, a negative rate.

In the example on the slide inflation is high, say 10%. Decreasing the money supply will be viewed as an inflation fighter, and expected inflation ultimately will decrease, which will lower the nominal rate.

Monetarist Policy: Fighting Inflation II

To close an inflationary GDP gap using monetary policy, reduce the money supply and shift AD left.

Monetarists advise steady and predictable changes in the money supply, to reduce uncertainty and thus stabilize both long-term interest rates and GDP growth.

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Both Keynesians and monetarists advocate a decrease in the money supply to fight inflation, but they expect it to work for different reasons.

The other big factor in the activities of the players in the economy is uncertainty. What is the Fed going to do next? What is the Congress going to do next?

In times of great uncertainty, the private sector holds off on making decisions, including investment decisions. This is why the monetarists advise a steady and predictable policy … to remove a huge element of uncertainty.

Monetarist Policy: Fighting Unemployment

The policy goal would be to increase aggregate demand.

Increased money supply leads to higher prices, immediately raising people’s inflationary expectations. Long-term interest rates might actually rise, defeating the purpose of monetary stimulus.

Monetarists conclude that expansionary monetary policy can’t lead us out of recession.

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Here are the contrasting views on how to fight high unemployment.

Monetarists believe in fixed money supply targets, or a “rule” for how much to change the money supply.

Application: The Economy Tomorrow

In the equation of exchange (MV = PQ), Keynesians’ fiscal policy relies on changes in V while monetarists assume V is stable and rely on changes in M.

The two tables following summarize their views on how fiscal and monetary policies work.

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This Economy Tomorrow segment summarizes the contrasting views of Keynesians and monetarists.

Application: The Economy Tomorrow: Fiscal Policy

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Application: The Economy Tomorrow: Monetary Policy

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Application: The Economy Tomorrow (Cont.)

Which policy lever to pull?

Monetarists favor a fixed money supply.

Keynesians reject a fixed money supply.

Keynesians advocate targeting interest rates.

Keynesians advocate liberal use of fiscal policy.

Currently the Fed favors inflation targeting.

If inflation stays below a certain level, the Fed need not adjust its policy.

Once inflation rises above that level, the Fed will go into action to fight inflation.

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Note that Keynesians do not advocate monetary policy at all except to bolster their fiscal policy moves of shifting AD.

Revisiting the Learning Objectives

LO15-1 How interest rates are set in the money market.

People have a money demand, a need to hold money as M1.

The Fed determines the money supply, the amount of money people must hold.

The intersection of money demand and money supply determines the price of money, the interest rate.

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Here we begin a review of the chapter.

Revisiting the Learning Objectives II

LO15-2 How monetary policy affects macro outcomes.

By altering the money supply, the Fed can:

Influence short-term interest rates.

Influence inflationary expectations.

Determine the amount of purchasing power available.

Shifting aggregate demand left or right.

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Revisiting the Learning Objectives III

LO15-3 The constraints on monetary policy impact.

For monetary policy to be fully effective, interest rates must respond to changes in the money supply, and spending must respond to changes in the interest rate.

In a liquidity trap, this will not happen.

Investor and buyer expectations may override interest rate considerations in buying decisions.

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Revisiting the Learning Objectives IV

LO15-4 The differences between Keynesian and monetarist monetary theories.

Monetarists emphasize long-term linkages.

Using the equation of exchange (MV = PQ), and asserting V is stable, they say changes in M must influence spending (PQ).

Structural forces make Q stable in the long run, so changes in M directly affect P.

Keynesians believe changes in the money supply affect (short-term) interest rates and thus affect spending decisions, shift aggregate demand.

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Looking Ahead: Chapter 16

Supply-Side Policy: Short-Run Options

After learning about this chapter, you should know

Why the short-run AS curve slopes upward.

How an unemployment – inflation trade-off arises.

How shifts of the aggregate supply curve affect macro outcomes.

The tools of supply-side policy.

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