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Ch. 15: Monetary Policy Pt. II. Impact of Monetary Policy. According to monetarists, changes in the money supply affects both inflation and economic output. M oney I nterest R ate. M oney D emand. Q uantity of M oney. The Demand of Money:.
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Impact of Monetary Policy • According to monetarists, changes in the money supply affects both inflation and economic output.
Money Interest Rate MoneyDemand Quantity of Money The Demand of 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-earnings assets like bonds.
Money Interest Rate MoneySupply Determined by the Fed Quantity of Money The Supply of Money: • The supply of money is vertical because it is determined by the Fed.
i e Supply Excess at i2 i At , people are 2 willing to hold the money supply set by Fed i S Money Interest Rate e MoneySupply i 3 Q (Set by the Fed) s D Demand Excess MoneyDemand at I3 Quantity of Money The Demand and Supply of Money: Equilibrium: -- the point where the quantity of money people want to hold (the demand) is just equal to the stock of money the Fed has supplied (the supply). Quantity of money
S1 S1 S2 S2 i r 1 1 Money Interest Rate Real Interest Rate r i 2 2 D1 D Quantity of Money Quantity of Loanable Funds Qs Q1 Monetary Policy of the Fed • This increase in the money supply (shifting S1 to S2 in the market for money) will supply the banking system with additional reserves. • Expansionary monetary policy = FED buys bonds increasing the money supply. • Both the Fed’s bond purchases and the bank’s use of the additional reserves to extend new loans will increase the supply of loanable funds (shifting S1 to S2 in the loanable funds market). Qb Q2
AS1 S1 S2 P r P 2 1 2 AD2 AD1 • As the real rate of interest falls, investment increases, causing aggregate demand to increase (to AD2). Real Interest Rate Price Level D Quantity of Loanable Funds Goods & Services (Real GDP) Q2 Y1 Y2
Expansionary Monetary Policy • During expansionary monetary policy the Fed may 1. buy bonds 2. reduce the discount rate 3. reduce the reserve requirements • The Fed generally buys bonds, which: • increases bond prices • creates additional bank reserves • places downward pressure on real interest rates
Restrictive Monetary Policy • During restrictive monetary policy the Fed may 1. sell bonds 2. increase the discount rate 3. increase the reserve requirements • The Fed generally sells bonds, which: • depresses bond prices • drains bank reserves from the banking system • places upward pressure on real interest rates.
AS1 S2 S1 r 2 Real Interest Rate Price Level P r P 1 2 1 AD1 AD2 D Quantity of Loanable Funds Goods & Services (Real GDP) Q1 Y1 Short-run Effects of a Restrictive Monetary Policy • Restrictive policy = selling of bonds = reducing the reserves available to banks = decreases the supply of loanable funds = raises interest rates = lower investment = lowers AD = lowers GDP Q2 Y2
Proper Timing: • While the Fed can institute policy changes rapidly, there may be a substantial time lag before the change will exert a significant impact on AD.
= * * Money supply Y= Income Velocity Price Monetary Policy in the Long Run • The Quantity Theory of Money: Y P M V • “velocity” refers to how many times the average dollar is spent in a year • If Vand Yare constant, than an increase in M would lead to a proportional increase in P.
The Effects of Monetary Policy: • Persistent growth of the money supply at a rapid rate will cause inflation. • Interest rates can be a misleading indicator of monetary policy: • In the long run, expansionary monetary policy leads to inflation and high interest rates, rather than low interest rates. • Similarly, restrictive monetary policy, when pursued over a lengthy time period, leads to low inflation and low interest rates.
Annual % Change in Money Supply(M2) % Change in Real GDP(4-Quarter Moving Avg.) M2 Money supply Real GDP 14 14 12 12 Note that the growth 10 10 rate of the money supply 8 has been slower and 8 more stable during the 6 6 last decade. 4 4 2 2 0 0 -2 -2 -4 -4 -6 -6 1960 1965 1970 1975 1980 1985 1990 1995 1998 Source: Derived from computerized data supplied by FAME Economics. Monetary Policy and Real GDP • Sharp declines in the growth rate of the money supply have generally preceded reductions in real GDP and recessions (indicated by shading). • Conversely, periods of sharp acceleration in the growth rate of the money supply have often been followed by a rapid growth of GDP.
Annual Rate of Inflation(Percent) Annual Growth Rate of Money Supply(Percent) Money supply 12 14 10 12 8 10 6 8 4 6 2 4 0 2 - 2 0 Inflation Rate(lagged 3 years) M2 1960 1965 1970 1980 1985 1990 1995 1975 M2 1963 1968 1973 1983 1988 1993 1998 1978 P P Source: Derived from computerized data supplied by FAME Economics. Effect of Changes in Money Supply on Inflation • The relationship between the rate of growth in the money supply and the annual inflation rate3 years later.
Interest Rate(3 month Treasury bills) Percent 16 Annual Rate of Inflation 12 8 4 0 1960 1965 1970 1975 1980 1985 1990 1995 1998 Source: Derived from computerized data supplied by FAME Economics. Inflation Rate and the Money Interest Rate
