Modern Macroeconomics and Monetary Policy

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Modern Macroeconomics and Monetary Policy 314314


The Impact of Monetary Policy on Output and Inflation


Impact of Monetary PolicyEvolution of the modern view: The Keynesian view dominated during the 1950s and 1960s. Keynesians argued that the money supply did not matter much. Monetarists challenged the Keynesian view during the1960s and 1970s. Monetarists argued that changes in the money supply caused both inflation and economic instability. While minor disagreements remain, the modern view emerged from this debate. Modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy. The following slides present this modern view.


Money interest rateThe 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-earning assets like bonds.The Demand for Money Money DemandQuantity of money


Quantity of moneyMoney interest rateThe supply of money is vertical because it is established by the Fed and, hence, determined independently of the interest rate.Money SupplyThe Supply of Money


Money interest rateEquilibrium: The money interest rate gravitates toward the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the Fed has supplied. Money SupplyThe Demand and Supply of Money Money Demandi3iei2Quantity of money


D1Money interest rateS1DS1 i1Qsr1Q1i2Qbr2Q2Real interest rateQuantity of moneyQty of loanable fundsWhen the Fed shifts to a more expansionary monetary policy, it usually buys additional bonds, expanding the money supply.Transmission of Monetary PolicyThis increase in the money supply (shift from S1 to S2 in the market for money) provides banks with additional reserves.The Fed’s bond purchases and the bank’s use of new reserves to extend new loans increases the supply of loanable funds (shifting S1 to S2 in the loanable funds market) … and puts downward pressure on real interest rates (a reduction to r2).


Price LevelGoods & Services (real GDP)DS1 r1Q1r2Q2S2 Real interest rateP1Y1Y2AD1P2As the real interest rate falls, AD increases (to AD2).As the monetary expansion was unanticipated, the expansion in AD leads to a short-run increase in output (from Y1 to Y2) and an increase in the price level (from P1 to P2) – inflation.The impact of a shift in monetary policy is transmitted through interest rates, exchange rates, and asset prices.Qty of loanable fundsTransmission of Monetary Policy


which leads to increased investment and consumption … a depreciation of the dollar an increase in the general level of asset prices (leading to increased net exports) and …Transmission of Monetary PolicyHere, a shift to an expansionary monetary policy is shown. Assume the Fed expands the supply of money by buying bonds… which will increase bank reserves … pushing real interest rates down …So, an unanticipated shift to a more expansionary monetary policy will stimulate aggregate demand and, thereby, increase both output and employment. (and with the increased personal wealth, increased investment and consumption).


AD1If expansionary monetary policy leads to an in increase in AD when the economy is below capacity, the policy will help direct the economy toward LR full-employment output (YF).Expansionary Monetary PolicyPrice LevelLRASYFY1 Goods & Services (real GDP)P2SRAS1P1e1Here, the increase in output from Y1 to YF will be long term.


AD1Alternatively, if the demand-stimulus effects are imposed on an economy already at full-employment YF, they will lead to excess demand, higher product prices, and temporarily higher output (Y2).Price LevelLRASYFP2 Goods & Services (real GDP)P1SRAS1E1Y2AD Increase Disrupts Equilibrium


AD1Price LevelLRASYFP2 Goods & Services (real GDP)P1SRAS1AD2E1e2Y2In the long-run, the strong demand pushes up resource prices, shifting short run aggregate supply (from SRAS1 to SRAS2).P3AD Increase: Long RunThe price level rises (from P2 to P3) and output falls back to full-employment output again (YF from its temp high,Y2).


A Shift to More Restrictive Monetary PolicySuppose the Fed shifts to a more restrictive monetary policy. Typically it will do so by selling bonds which will: depress bond prices and drain reserves from the banking system, which places upward pressure on real interest rates. As a result, an unanticipated shift to a more restrictive monetary policy reduces aggregate demand and thereby decreases both output and employment.


Dr2Q2r1Q1S1 Real interest rateP2Y2Y1P1AD1Short-run Effects of More Restrictive Monetary PolicyA shift to a more restrictive monetary policy, will increase real interest rates.Qty of loanable fundsHigher interest rates decrease aggregate demand (to AD2).When the reduction in AD is unanticipated, real output will decline (to Y2) and downward pressure on prices will result.


The stabilization effects of restrictive monetary policy depend on the state of the economy when the policy exerts its impact.LRASYFP1P2SRAS1AD1e1Y1Restrictive Monetary PolicyRestrictive monetary policy will reduce aggregate demand. If the demand restraint occurs during a period of strong demand and an overheated economy, then it may limit or prevent an inflationary boom.


In contrast, if the reduction in aggregate demand takes place when the economy is at full-employment, then it will disrupt long-run equilibrium, and result in a recession.AD Decrease Disrupts EquilibriumAD1LRASYFY2P1SRAS1P2E1


Proper TimingIf a change in monetary policy is timed poorly, it can be a source of instability. It can cause either recession or inflation. Proper timing of monetary policy is not easy: While the Fed can institute policy changes rapidly, there will be a time lag before the change exerts much impact on output & prices. This time lag is estimated to be 6 to 18 months in the case of output and perhaps as much as 36 months before there is a significant impact on the price level. Given our limited ability to forecast the future, these lengthy time lags clearly reduce the effectiveness of discretionary monetary policy as a stabilization tool.


Questions for Thought:1. What are the determinants of the demand for money? The supply of money? 2. If the Fed shifts to more restrictive monetary policy, it typically sells bonds. How will this action influence the following? a. the reserves available to banks b. real interest rates c. household spending on consumer durables d. the exchange rate value of the dollar e. net exports f. the price of stocks and real assets like apartments or office buildings g. real GDP


Questions for Thought:3. Timing a change in monetary policy correctly is difficult because a. monetary policy makers cannot act without congressional approval. b. it is often 6 to 18 months in the future before the primary effects of the policy change will be felt.4. When the Fed shifts to a more expansionary monetary policy, it often announces that it is reducing its target federal funds rate. What does the Fed generally do to reduce the federal funds rate?


Questions for Thought:5. The demand curve for money: a. shows the amount of money balances that individuals and business wish to hold at various interest rates. b. reflects the open market operations policy of the Federal Reserve.


Monetary Policy in the Long Run


MVPYThe Quantity Theory of MoneyThe quantity theory of money:If V and Y are constant, then an increase in M will lead to a proportional increase in P.


Long-run Impact of Monetary Policy -- The modern ViewLong-run implications of expansionary policy: When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and real output will return to their long-run normal levels. Thus, in the long run, money supply growth will lead primarily to higher prices (inflation) just as the quantity theory of money implies.


Price level (ratio scale) Time periodsMoney supply growth rate3169234Real GDP3% growth8% growthLong-run Effects of a Rapid Expansion in the Money SupplyHere we illustrate the long-term impact of an increase in the annual growth rate of the money supply from 3 to 8 percent.Initially, prices are stable (P100) when the money supply is expanding by 3% annually.The acceleration in the growth rate of the money supply increases aggregate demand (shift to AD2).P100


At first, real output may expand beyond the economy’s potential YF …Time periods3169234Real GDPAD1LRASYFSRAS1 E1P1003% growthAD28% growth however low unemployment and strong demand create upward pressure on wages and other resource prices, shifting SRAS1 to SRAS2.Output returns to its long-run potential YF, and the price level increases to P105 (E2).P105Y1Price level (ratio scale) Money supply growth rateLong-run Effects of a Rapid Expansion in the Money Supply


Time periods3169234Real GDPAD1LRASYFSRAS1 E1P1003% growthAD2SRAS28% growthIf the more rapid monetary growth continues, then AD and SRAS will continue to shift upward, leading to still higher prices (E3 and points beyond).The net result of this process is sustained inflation. E2P105P110Price level (ratio scale) Money supply growth rateLong-run Effects of a Rapid Expansion in the Money Supply

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Last Updated: 8th March 2018

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