Modern Macroeconomics and Monetary Policy

1. Modern Macroeconomics and Monetary Policy Chapter 14

2. The Demand for Money Money interestrate Money Demand Quantity 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 (recall OPPORTUNITY COST) to hold money.

3. The Supply of Money Money interestrate Money Supply Quantity of money • The supply of money is vertical because it is established by the Fed. It’s EXOGENOUS in the model.

4. Three Tools of Monetary Policy • Open Market Operations • Discount rate • Reserve requirements

5. S2 S2 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. S1 Moneyinterestrate Realinterestrate S1 i1 r1 r2 i2 D1 D Qty of loanable funds Quantityof money Qs Qb Q1 Q2

6. AS1 AD2 Transmission of Monetary Policy S1 Realinterestrate PriceLevel S2 r1 P2 P1 r2 D AD1 Qty of loanable funds Goods & Services (real GDP) Y1 Y2 Q1 Q2

7. Unanticipated Expansionary Monetary Policy Fed buys bonds Increases in investment & consumption Net exports rise This increases money supply and bank reserves Real interest rates fall Increase in aggregate demand Depreciation of the dollar Increases in investment & consumption Increase in asset prices Transmission of Monetary Policy

8. Proper Timing • If a change in monetary policy is timed poorly, it can be a source of economic instability. • Proper timing of monetary policy is not easy: • While the Fed can institute policy changes rapidly, there may be a time lag before the change exerts much impact on output & prices. • This time lag may be 6 to 18 months in the case of output, and even longer, perhaps as much as 36 months, before there is a significant impact on the price level.

9. What’s a “rate cut”? • Fed's HintsOf a Rate Cut Cheer Markets • By SUDEEP REDDYNovember 29, 2007; Page A1 • The Federal Reserve, faced with mounting signs of a slowing economy, opened the door to an interest-rate cut next month, cheering the nation's stock market, which staged its biggest two-day rally in five years. • The latest signal from the central bank came in remarks by Donald Kohn, its vice chairman, which represented a Fed acknowledgment that the financial-market turmoil that started this summer remains a threat to the economy.

10. x x = Y= Income Money Velocity Price The Quantity Theory of Money • The quantity theory of money: Y P M V • If V and Y are constant, then an increase in M will lead to a proportional increase in P.

11. % change in M2 money supply a % change in real GDP b 16 14 12 10 8 6 4 2 0 -2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2003 a Annual percent change in M2 b 4-quarter percent change in real GDP Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org. • Monetary Policy and Real GDP

12. Inflation rate, % a Interest rate (3-mos. T-bill) a Inflation & the Money Interest Rate 16 12 8 4 0 2003 1960 1965 1970 1975 1980 1985 1990 1995 2000 a annual rate of inflation calculated using the CPI Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org. • The expectation of inflation . . . • reduces the supply of, and, • increases the demand for loanable funds, • Note how the short-term money rate of interest has tended to increase when the inflation rate accelerates (and decline as the inflation rate falls).

13. Brazil Argentina Turkey Ghana Canada Italy Germany Belgium Zambia Uganda Poland Israel Mexico Australia Hungary Ecuador Venezuela Portugal Chile South Africa Syria Philippines India Japan Pakistan Indonesia France Thailand U.S. Kenya Malaysia Switzerland Inflation & Money – An International Comparison 1980 - 2002 • The relationship between the avg. annual growth rate of the money supply and the rate of inflation is shown here for the 1980-2002 period. 1000 100 • The relationship between the two is clear: higher rates of money growth lead to higher rates of inflation. Rate of inflation (%, log scale) 10 Sources: World Bank, World Development Indicators, 2004. Note: The money supply data are the actual growth rate of the money supply minus the growth rate of real GDP. 1 1 10 100 1,000 Rate of money supply growth (%, log scale)