CHAPTER 15 – MONETARY POLICY

I. Introduction
A. This chapter examines the following questions:

1. What is the relationship between the money supply and aggregate demand?

2. How can the Fed use its control of the money supply to alter macro outcomes?

3. How effective is monetary policy, compared to fiscal policy?

II. The Money Market
A. Money is traded like other commodities.
B. Monetary policy – The use of money and credit controls to influence macroeconomic activity.
C. Interest Rate – The price paid for the use of money.
D. Money Balances

1. Most of the money is our common measures of money supply (M1 and M2) is in the form of bank balances

2. Money Supply (M1) – Currency held by the public, plus balances in transactions accounts.

3. M2 Money Supply - M1 plus balances in most savings accounts and money market mutual funds.

4. The Price of Money – The cost of holding money is its opportunity cost or the difference between the prevailing rate of interest and the rate paid on deposit balances.

E. The Demand for Money (Figure 15.1, Page 300)

1. Demand for Money – The quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus.

2. Portfolio Decision – The choice of how (where) to hold idle funds.

3. Although holding money provides little or no interest, there are reasons for doing so.

4. Transactions Demand

• People hold money so they can buy goods and services.

• Transactions Demand for Money – Money held for the purpose of making everyday market purchases.

5. Precautionary Demand

• Another reason people hold money is for sudden emergency purchases.

• Precautionary Demand for Money – Money held for unexpected market transactions or for emergencies.

6. Speculative Demand

• People also hold money for speculative purposes, so they can respond to financially attractive opportunities.

• Speculative Demand for Money – Money held for speculative purposes, for later financial opportunities.

7. The Market-Demand Curve - The quantity of money that people are willing and able to hold (demand) increases as interest rates fall (ceteris paribus).

F. Equilibrium (Figure 15.1, Page 300)

1. The intersection of the money-demand and money-supply curves establishes an equilibrium rate of interest.

2. 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.

G. Changing Interest Rates (Figure 15.2, Page 301)

1. The Federal Reserve is able to alter the money supply; therefore, it can affect the equilibrium rate of interest.

2. By increasing the money supply, the Fed tends to lower the equilibrium rate of interest. People are willing to hold larger money balances only at lower interest rates.

3. Federal Funds Rate (Table 15.1, Page 302)

• Federal Funds Rate – The interest rate for inter-bank reserve loans.

• When the Fed injects or withdraws reserves from the banking system, via open-market operations, the interest rat on inter-bank loans is most directly affected.

III. Interest Rates and Spending
A. Monetary Stimulus (Figure 15.3, Page 303)

1. The goal of monetary stimulus is to increase aggregate demand. The mechanism for doing so is lower interest rates.

2. Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

3. Investment - Lowering the interest rates encourages investment due to the lower cost of borrowing.

4. Aggregate Demand

• The increased investment brought about represents an injection of new spending into the circular flow. That jump will kick off multiplier effects and result in an even larger increase in aggregate demand.

• The Fed’s objective 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

5. Quantitative Impact

• Fed Chairman Alan Greenspan claims that the impact of a 1/10-point reduction in the long-term interest rate has the same stimulus effect of $10 billion of new government spending.

• World View: “Interest Rates Cut in Europe 11 Euro Nations Try to Stimulate Growth”
  The central banks of the 11 European countries that will merge their currencies into one in less than a month unexpectedly cut interest rates today in a coordinated response to sagging economic growth. Central banks (like the Fed) use interest rate reductions to stimulate more spending. If successful, monetary stimulus will accelerate short-run economic growth.

B. Monetary Restraint (Figure 15.3, Page 303)

1. To lessen inflationary pressures, the Fed will apply a policy of monetary restraint.

2. Higher Interest Rates – Higher interest rates, caused by Fed policy, are an attempt to discourage spending. Interest rates may be increased by:

• Selling bonds

• Increasing the discount rate

• Increasing the reserve requirement

3. Reduced Aggregate Demand – The ultimate objective of a restrictive monetary policy is to reduce aggregate demand. Monetary restraint is achieved with:

• A decrease in the money supply.

• An increase in interest rates.

• A decrease in aggregate demand.

4. In the News: “Why Mortgage Rates Aren’t Falling”
   Despite interest rate reductions by the US Federal Reserve, mortgage rates stayed high in 2001. The article points out that the Fed controls short-term, not long-term rates.

IV. Policy Constraints
A. Constraints on Monetary Stimulus (Figure 15.4, Page 306)

1. Reluctant Lenders - The Fed does not have direct control of the money supply. The banks themselves must expand the money supply by making new loans.

2. Liquidity Trap

• 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.

• When interest rates are low, people may decide to hold all the money they can get -- waiting for opportunities to improve.

3. Low Expectations – With little expectation of future profit, investors are likely to be unimpressed by low interest rates and may decline to use the lending capacity that banks make available.

4. In The News: “Uneasy Banks May Tighten Loans, Stunt Recovery”
   Increasing numbers of bad loans may cause banks to reduce lending despite lower interest rates.

B. Limits on Monetary Restraint

1. Expectations - Consumers’ optimistic expectations may cause them to believe that future income will be sufficient to cover larger debts and higher interest charges.

2. Global Money - Market participants might also tap global sources of money or local non-bank lenders not regulated by the Fed. This makes it harder for the Fed to restrain aggregate demand.

3. How Effective? – Some economists consider monetary policies undependable. Keynes believed that it would not be effective at ending a deep recession. However, the limitations on monetary restraint are not considered as serious. The Fed has the power to reduce the money supply. If the money supply shrinks far enough, the rate of spending will have to slow.

4. World View: “Why Japan is Stuck”
   Even though Japan had cut its discount rate to 0.5 percent in 1999, the economy still wasn’t growing. Some economists believe that Japan was in a liquidity trap.

5. In the News: “Vicious Cycle: Despite Rate Cuts, Mood in Boardroom is Darkening Further”
   In 2001, despite lower interest rates, the nation’s businesses are cutting spending, closing facilities and laying off workers.

V. The Monetarist Perspective
A. In the Keynesian model, changes in the money supply affect macro outcomes primarily through changes in interest rates.
B. The Equation of Exchange

1. Equation of Exchange – Money supply (M) time velocity of circulation (V) equals level of aggregate spending (P X Q)

2. Formula:
    

3. Income Velocity of Money (V): - The number of times per year, on average, a dollar is used to purchase final goods and services; PQM.

4. The equation implies that if M (the money in circulation) increases, then prices (P) or output (Q) must rise or V must fall.

5. The goal of monetary policy is to change the macro outcomes on the right side of the equation. It is possible, however, that a change in M might not bring about a change in the desired target variable. (Another might change instead.)

6. If M increases, prices (P) or output (Q) must rise, or V must fall.

C. Stable Velocity.

1. Monetarists add some important assumptions to transform the equation of exchange into a behavioral model of macro performance.

2. One of these assumptions is that the velocity of money (V) is stable.

3. Accordingly, total spending must rise if the money supply (M) grows and V is stable.

D. Money-Supply Focus.

1. As Monetarists see it, changes in the money supply must alter total spending, regardless of how interest rates move.

2. Therefore, monetarists believe that the Fed should not try to manipulate interest rates, but should focus on the money supply itself.

3. In The News: “Monetarists Reject Focus on Lowering Rates”
   Monetarists argue that lower interest rates will not necessarily stimulate aggregate demand. To them, what matters is the level of the money supply, not the interest rate.

E. “Natural” Unemployment.

1. Some monetarists claim that Q, as well as V, is stable. They claim that the quantity of goods produced is primarily dependent on structural forces (production capacity, labor-market efficiency, etc.). These structural forces establish a “natural” rate of unemployment that is immune to short-run policy intervention.

2. Natural Rate of Unemployment – Long-term rate of unemployment determined by structural forces in labor and product markets.

3. The most extreme monetarist perspective concludes that changes in the money supply affect prices only.

4. In The News: “ ‘Not Worth a Continental’: The U.S. Experience With Hyperinflation”
   The government of the U.S. had no means to pay for the Revolutionary War. So, they printed their own money. However, rapid expansion of the money supply will push up prices.

F. Monetarist Policies

1. Fighting Inflation

• The policy objective is to reduce aggregate demand to fight inflation.

• From a Keynesian perspective, the recommendation is to shrink the money supply and drive up interest rates.

• Monetarists argue that rates are already likely to be high and an effective anti-inflation policy will cause rates to go down, not up.

2. Real vs. Nominal Interest

• Real Interest Rate – The nominal rate of interest minus anticipated inflation rate.

• Formula:

• If the real interest rate is stable, changes in the nominal interest rates reflect changes in anticipated inflation.

• Monetarists advocate steady and predictable changes in the money supply.

• In The News: “Money Is Free!”
  When inflation is high and interest rates low, the real interest rate may even be negative. Monetarists would argue that nominal changes in the interest rate have little effect on investment. Real interest rates are the determinant of investment behavior.

3. Fighting Unemployment

• The Keynesian cure for unemployment is to expand M and lower interest rates.

• Monetarists fear that an increase in M will lead, via the equation of exchange, to higher P (prices).

• From a monetarists perspective, expansionary monetary policies are not likely to lead us out of a recession, rather such policies might double our burden by heaping inflation on top of our unemployment woes.

VI. The Concern for Content
A. Monetary policy, like fiscal policy, can affect the content of GDP as well as its level.
B. The Mix of Output

1. Some industries, like the residential housing market, are more susceptible to monetary policy than others.

2. Monetary policy can affect the competitive structure of the market. Large, powerful corporations are more likely to obtain “tight” money than smaller ones.

C. Income Redistribution - Monetary policy redistributes money between lenders and borrowers.

VII. The Economy Tomorrow: Which Lever to Pull?
A. The Policy Levers

1. What Keynesians and Monetarists argue about is which of the policy levers – M or V – is likely to be effective in altering aggregate spending.

2. Monetarists point to the money supply (M) as the principal lever.

3. Keynesians must rely on changes in V because tax and expenditure policies have no direct impact on the money supply.

B. Crowding Out

1. If V is constant, changes in total spending can come about only through changes in the money supply.

2. If the government raises taxes or borrows more money, it effectively crowds out consumers and investors who would otherwise be spending or borrowing.

3. Crowding Out – A reduction in private-sector borrowing (and Spending) caused by increased government borrowing.

C. How Well Fiscal Policy Works: Two Views (Table 15.2, Page 317)

1. The central issue is whether and how a change in G or T will alter macroeconomic outcomes.

2. Keynesians assert that aggregate spending will be affected as the velocity of money (V) changes.

3. Monetarists say no, because they anticipate an unchanged V.

4. How well fiscal policy works depends on how much the velocity of money can be changed by government tax and spending decisions.

D. How Monetary Policy Works: Two Views (Table 15.3, Page 317)

1. Monetarists say a change in M must alter total spending because V is stable.

2. Keynesians assert that V may vary, so they aren’t convinced that monetary policy will always work.

3. How well monetary policy works depends on how stable or predictable V is.

E. Is Velocity Stable? (Figure 15.6, Page 319)

1. Long-Run Stability. The velocity of money (V) turns out to be quite stable over long periods of time.

2. Short-Run Instability. While stable in the long run, V has many short-run variations -- tending to decline during recessions.

F. Money-Supply Targets

1. The differing views of Keynesians and monetarists clearly lead to different conclusions about which policy lever to pull.

2. Monetarist Advice - Monetarists favor fixed money-supply targets. They believe that V is stable in the long run and unstable in the short-run, therefore, the safest course is to focus on M.

3. Keynesian Advice – Keynesians reject fixed money-supply targets. Rather, they advocate targeting interest rates, not the money supply.

4. The Fed’s Eclecticism - The Fed has adopted an eclectic mixture of monetarist and Keynesian policies.

5. In 2000, the US Federal Reserve attempted to engineer a ‘soft landing’ for the economy, then abruptly changed course and lowered interest rates from May 2000 until the end of 2001.

G. World View: “Deflation Still Haunts the Bank of Japan”
In 2001, Japan faced deflation with prices falling for ten consecutive months. There was pressure on the Bank of Japan to further increase the money supply.

COMMON STUDENT ERRORS

Students often believe the following statements are true. The correct answer is explained after the incorrect statement is presented.

1. When the interest rate goes down, the demand for money increases. Don’t fail to distinguish between a change in demand and a change in quantity demanded. Remember that each demand schedule (speculative, transactions, precautionary) is drawn on the assumption of ceteris paribus. Unless there is a change in one of the things held constant (e.g., expectations), there will be no change in demand when the interest rate falls, only a change in quantity demanded.
    

2. High nominal rates of interest mean high real rates of interest. High nominal interest rates and high real interest rates will coincide only if the average level of prices is not changing rapidly enough to offset the differential. For example, if the nominal rate is 10 percent and prices are rising at 10 percent, the real rate of interest is zero.
    

3. Monetary policy is easy to determine and to administer. One could easily get the idea that monetary policy is easy to administer and that the Fed always knows the rate at which the money supply should grow. This is not so. Many variables intervene to make monetary policy difficult to prescribe and implement. Such variables include timing and the duration of a given policy, unanticipated events on the fiscal side, and problems abroad. The Fed’s policymakers analyze the data available and do the best they can to achieve a given objective, which often involves compromises. The process is much more difficult than turning a printing press on and off.