hw micro and macro economy

LO 1: Howe interest rates are set in the money market

LO 2: How monetary policy affects macro outcomes

LO 3: The constraints on monetary policy impact

Lo 4: The differences between Keynesian and monetarist monetary theories

Monetary policy: the use of money and credit controls to influence macroeconomic outcomes

Interest rate: the price paid for use of money

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

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

The forgone interest if the opportunity cost (price) of money people choose to hold.

Demand fort money: the quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus

Portfolio decision: the choice of how(where) to hold idle funds

Transaction demand for money: money held for the purpose of making everyday market purchases

Precautionary demand for money: money held for unexpected market transactions or for emergencies

Speculative demand for money: money held for speculative purposes, for later financial opportunities

Equilibrium rate of interest: the interest rate at which the quantity of money demanded in a given time period equals the quantity of money supplied

THE FED CAN ALTER THE EQUILIBRIUM RATE OF INTEREST;

By increasing the money supply, the Fed tends to lower the equilibrium rate of interest

Federal funds rate: the interest rate for interbank reserve loans

The ultimate goal of monetary stimulus is to increase aggregate demand. By reducing the cost of money for banks, the Fed expects banks to reduce interest rates for consumers.

Aggregate demand: the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus

The fed’s goal of stimulating the economy is achieved in three distinct steps:

· An increase in the money supply

· A reduction in interest rates

· An increase in aggregate demand

Bernanke’s policy guide in 2009: ¼ POINT REDUCTION in long-term interest rate = $50B fiscal stimulus

Monetary restraint is achieved with:

· A decrease in money supply

· An increase in interest rates

· A decrease in aggregate demand

The success of Fed intervention depends in part on how well changes in long-term interest rates mirror changes in short-term interest rates

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; possibility that interest rates may not respond to changes in the money supply (Keynes); low expectations

Strong expectations and rising incomes may fuel continued spending even when interest rates are rising

The Monetarist perspective:

In the Keynesian model, changes in the money supply affect macro outcomes primarily through changes in interest rates; three step sequence: 1. Money supply change; 2. Interest rate movement; 3. Aggregate demand shift makes monetary policy subject to several potential uncertainties.

Monetarists asset that monetary policy isn’t an effective tool for fighting short-run business cycles, but is a powerful took for managing inflation.

Equation of exchange: money supply (M) times velocity of circulation (V) = level of aggregate spending (PxQ)

Velocity of money (V) : the # of times per year, on average, a dollar is used to purchase final goods and services; PQ/M

The quantity of money in circulations and the velocity with which it travels (changes hands) in product markets will always be equal to the value of total spending and income (nominal GDP)

Total spending must rise if the money supply (M) grows and V is stable

As monetarist see it, changes in the money supply must later total spending, regardless of how interest rates move.

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

The most extreme monetarist’s perspective concludes that changes in the money supply affect prices only

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

Real interest rate = nominal interest rate – anticipated inflation rate.

Inflation targeting: the use of an inflation ceiling (“target”) to signal the need for monetary policy adjustments

Keynesians advocate targeting interest rates, not the money supply

Monetarists favor fixed money supply targets; Keynesians reject fixed money supply targets

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