differences

L*2 tu{omey and Aggregat* ffi*g"xland in the SF:*r"t Run in the short rut't,maney affe$s the ecanawy thraugh changes in the interest rale. Monetary policy influ- ences the market interest rate, which in turn affects investment, a component of aggregate demand. Let's work through the chain of causation.

$mterest ffimtes effid fis?w_.estmeffit Suppose the Fed believes that the economy is pro- ducing less than its potential and decides to stim- ulate output and employment by increasing the money supply. Recall from the previous chapter that the Fed's primary tool for increasing the money sup- ply is open-market purchases of U.S. government securities. The three panels of Exhibit 3 trace the iinks between changes in the money supply and changes in aggregate demand. We begin with equi- librium interest rate i, which is determined in panel (a) by the intersection of the money demand curve D. with the money supply curve S,n. Suppose the Fed purchases U.S. government bonds and thereby increases the money supply, as shown by a rightward shift of the money supply curve from S. to S'-. After the increase in the supply of money, people are hold- ing more money than they would prefer at interest rate i, so they try to exchange one form of wealth, money, for other f,nancial assets. Exchanging doilars for financial assets has no direct effect on aggregate demand, but it does reduce the market interest rate.

A decline in the interest rate to i', other things constant, reduces the opportunify cost of financ-

i,,:'< iiii:i'L t Effects of an lncrease in the Money Supply on lnterest Rates, lnvestment, and Aggregate Demand

(a) Supply and demand for money

ing new plants and equipment, thereby making investment more profitabie. Likewise, a lower inte rate reduces the cost of financing a new house. f deciine in the interest rate increases the amoun investment demanded. Panel (b) shows the dem for investment Dr flrst introduced several chap back.When the interest rate falis from ito i', the qr_ tiry of investment demanded increases from I to I

The spending multiplier magnifies this incre in investment, leading to a greater increase in ag1 gate demand, reflected in panel (c) by a rightw shift of the aggregate demand curve from AD to t At the given price levei P, real GDP increases fror to Y'.

The secuet.rce of evelrts can l;e sumi"ealized as foliou.'s:

:::. : :''_'::: : ',.,,.', |-,' .,.,

;r:: g::141;.itji,.ljif;.Jiil=j,y,f ., :.,,"..,.., r i 1.'*;i *,, r, ... \:: ;:::.,. :,,.,,,.,.,,,,,.,,'t,i'l'.,',,, z, ieaucino*i-b.intriie' ?iie, r

*:,,,iiri+b.-a,.9 9€sei.e!S*a1@{_f:iqAp$.,r:,, ,S,,:atagii i*iieffi;,$l€Br.deitianbgq@Sestfioni. rrs,j

The entire s€quence is also traced out in each panel of Exhibit 3 b . 'their{tbl.4n1gl-rtlfioqr, p, gqr! arlqjFqi.:ntjb; .,l r ,r;, . , ;r'' .", -. -r ,, .:, , .:-:ri :: ,-,..:.i.,i;.:l:::::in::r.: ,:.-::..:i:.;:,i'.:ui:.:::.,i i,ll::,: tj.f-:rr:,::': t.r.ttalt:ij:.)-:

Note that the graphs prbsented here ignr any feedback effects of changes in real GDP on i demand for money. Because the demand for mor depends on the levei of real GDP, an increase real GDP would shift the money demand curve the right in panel (a). If we had shifted the mor

q)

(o

o 9/ c) CI

(b) Demand for investment

(c)Aggregate demand

0 M M' Money

23O FAR'I 3 Fiscai arid lFoneiary Policy

1' lnvestment Real GDP

demand curve' the equilibrium lnterest rate would stijl have fallen, but nol by as much, so investment and aggregate demand would not have increased by as

much. Thus, Exhibit 3 is a simplified view'

but it still captures the essentials of how changes in the money supply affect the economy.

Now let's consider the effect of a Fed-

orchestrated increase in interest rates' In Exhibit 3 such a policy could be traced by

moving from point b to point a in each panel,lut we dispense with a blow-by- tlow discussion of the graphs' Suppose the Federal Reserve decides to reduce the

money supply to cool down an overheated

economy. A decrease in the money sup- p1y would increase the interest rate' At in" frigtl"t interest rate, businesses find it more iostly to finance plants and equip- ment, and households find it more costly to

frnance new homes. Hence, a higher inter-

est rate reduces the amount invested' The 0 resulting decline in investment is magni-

fied by the spending muitiplier, leading to

" gr""t"t decline in aggregate demand'

As long as the interist rate is sensitive to changes in

the money supply, and as Tong as investment is sensitiue to

changes in the interest rate, changes in the money supply

affeci investment. The extent to which a given change

in investment affects aggregate demand depends on

the size of the spending multiplier'

F :'l r' tilrl { ,j Expansionary Monetary Policy to Close a

Contractionary Gap

Potential output LRAS

o 130 o o O

E 12s

13.8 14.0 \-/J

ContractionarY gaP

price level of rz5 is below the expected price level of

r3o, und the short-run equilibrium oufPlt, of $rg'8

trition is below the economy's potential of $r+'o tril-

lion, yielding a contractionary gap of $o-z trillion'- al p"i"*, real wages are higher than had been

negod;ted and many people are looking for jobs'

fne fed can wait to see whether the economy recov-

ers on its own. Market forces could cause employers

and workers to renegotiate lower nominal wages'

This would lower pioduction costs' pushing the

short-run aggregate supply curve rightward' thus

.i"rl"g-irt" "."onitu.tionity g"p But if Fed officials

are im-patient with natural market forces' they could

try to close the gap using an expansionary monetary

fofi.y. ror "xamp1e, aulng zooT and zoo8' the Fed

'uggr"rsirr"ty cut the federal funds rate to stimuiate

;;;;;;" 6emand. if the Fed lowers that rate bv

;.iri tt" right amount, this stimulates investment' th.r, incr"Jring the aggregate demand curve enough

to achieve a new "q,'i1iUti"* at point b' where the

;";;;y produces its potential output' Given all the connections in the chain of causality between

changes in the money suppiy and changes in equi-

libriu"m output, however, it would actually be quite

remarkable for the Fed to execute monetary policy

so precisely. If the Fed overshoots the mark and stimulates aggregate demand too much' this would

;;;; ;p "n

-""*pittionary gap, thus creating infla-

tionary pressure in the economy'

*:, ;;13.

i.:

.e i:

tt

i' :::,

* ,'tt

:r: i

1

AddEmg the S$noYt-Run Aggregate SuPP$Y easrve Even after tracing the effect of a change in the money supply on aggregate demand,-we still have

only half tt "

ttoty. To determine the effects of mon-

etary policy on the equilibrium real GDP in the econ-

o*y, *u need the supply side' An-aggregate supply curve helps show how a given shift of the aggregate

demand iurve affects real GDP and the price level'

In the short run, the aggregate supply curve slopes

upward, so the quantity supplied in-c1-eas-es only if the price level increases. For a given shift of the aggre-

gate demand' curve, the steeper the short'run aggregate

iuppty curve, the smaller the increase tn real GDP and the

larger the increase in the price level' , Suppose the economy is producing at point o in

rxhibiii, where the aggregate demand cuwe AD inter- sects the short-run aggregate supply curve SRASlqo'

pelding a shcrt-ntn equiiibrium output of $r:'8 tril-

li",t *.,I a ::t:e -e';ei cf r 25. As you can see, the actual

f iiA?'I'ER :5 231

l#s Frloney and Aggregate Fernamd in the Long Rren

gate suPPlY curve is fixed at the economY's potential outPut, this greater sPending sim- ply increases the Price level. In short, more money is chasing the same output' Here are the details.

equaticn of efchange the quafititY ol moneY. i14, nrultip:ied tly its v€- tocity, V equals nominal GDE which is the Ptod- uct of the Priee le*;el. f, and real &DEY; or M x V=PxY velocity of n:oneY the average number ef times Per Year each dol' lar is used tQ Plrchase final goods and se:vices

u

l- U(, u F @v() oF U) o

232 PART 3 Fiscal and Mcneiary Policy

*"rd, "r,

increase in the money supply reduces the

market interest rate, increasing investment and

consequently increasing aggregate demand' And as

tong as the short-run aggregate,supply curve siopes

upi^rd, the short-run effect of an increase in the .riot"y suppty is an increase in both real output and

the piice ievel. gut here is one final qualification: Lowering the interest rate may not always stimu-

]ate investment. Economic prospects may become so

glum that lower interest rates may fail to achieve the

iesired increase in aggregate demand' In Japan' for

example, the central bank lowered the interest rate

nearty to zero, yet that economy remained li'feiess for years during the r99os'

\srqrs\qrrs-\-s\ss-qr:s\e\ss\q\\qrsgrr-. qrr'trre'

and the investment demand curve each slope down-

\h-qLqdreaaf, L'*aktawtqe Every transaction in the economy invoives a tt...-i--+?ri

swai: the buyer exchanges money for goods a:: the seiter exchanges goods for money' one

way c -

""pt"tti.tg this relationship among key variables in

thi econolny is the cquation of exchange'.frrst devel'

oped byclassicai economists' Although this equation

can be'arranged in different ways, depending on the

emphasis, the basic version is

MXV=PXY

where M is the quantity of money in the economy; V is

the velocity ef money, or the average number of times

per year each dollar is used to purchase final goods

andieruices; P is the average price level; and Y is real

GDP. The equation of exchange says that the quantity

of money in circulatiorl' M. muitiplied by V' the num-

ber of times that money changes hands' equals the

average price level, P, times real output, Y The price

level,-g iimes real output, ! equals the economy's nominal income and output' or nominal GDP'

By rearranging the equation of exchange' we find

that velocity equats nominal GDP divided by the

money stock, or:

When we looked at the impact of money on

the economy in the short run' we found that money influlnces aggregate demand and equi-

librium output through its effect on the interest

rate. Here we look at the long-run effects of changes

in the money supply on the economy' The long-run

view of money is more direct: if the central bank sup-

plies more money to the economy, sooner or later

peopte spend more' But because the long-run agge-

DvV \f

-

-

v- M

For example, nominal GDP in zoo8 was $r+'3 trillion'

and the money stock as measured by Mr averaged

F*$

.:tr !*' :$:.::

iitr-t:

,,.#.