Modern Macroeconomics and

Monetary PolicyChapter 14

Discuss Milton Friedman’s contribution to modern economic thought.

Evaluate appropriately timed monetary policy and its impacts on interest rates and aggregate demand.

Distinguish appropriately timed from ill timed policy and list its consequences.

Chapter 14 Objectives

1950s and 1960s: economists thought monetary policy◦ Could control inflation◦ Could not stimulate AD

Today: Most economists believe that monetary policy impacts◦ Output in the short run, but not the long run◦ Prices in the short run and the long run◦ Can be a source of economic instability

History of Monetary Policy Beliefs

Every major contraction in this country has been either produced by

monetary disorder or greatly exacerbated by monetary disorder.

Every major inflation episode has been produced by monetary

expansion.

Demand for money balances is not the same as the demand for wealth

Reasons to hold money◦ Buy stuff now◦ In case of emergency◦ Buy stuff later

Supply and Demand of Money

Demand for money – Illustrates the relationship between the interest rate and quantity of money people want to hold

Downward sloping: the opportunity cost of holding money is the nominal interest rate

Shifts right: when nominal GDP rises Shifts left

◦ When nominal GDP falls◦ As people use more electronic transactions

Demand for Money

The Fed controls the supply of money through◦ Reserve requirement◦ Open market operations (federal funds rate)◦ Discount-rate◦ Interest paid on excess reserves

Vertical: changes in the interest rate do not impact the Fed’s ability to control the money supply

Supply of Money

Supply and Demand of Money

Money Supply

Quantity of Money

Qs

Equilibrium – the quantity of money demanded equals the quantity supplied

i1

Money Demand

Nom

inal Inte

rest

Rate

When the Fed buys bonds◦ Supply of money increases◦ Supply of loanable funds increases◦ AD shifts right

Expansionary Monetary Policy

Aggregate demand will increase because◦ A lower interest rate makes current investment

and consumption cheaper◦ A lower interest rate causes financial assets to

move abroad, the dollar will depreciate, and net exports will increase

◦ A lower interest rate increases asset prices (stocks, houses) which also increases investment and consumption (aggregate demand)

Expansionary Monetary Policy

Expansionary Monetary Policy: Money Balances

S1

Q1

The fed buys bonds to increase the money supply and the interest rate will fall

i1

Money Demand

Nom

inal Inte

rest

Rate

S2

Q2

i2

Quantity of Money

Expansionary Monetary Policy: Loanable Funds

Real In

tere

st R

ate

D

r1

Q1

S1

Loanable Funds

Increases supply of loanable funds as banks make more loans, real interest rate falls

r2

Q2

S2

Expansionary Monetary Policy: Goods and Services (real GDP)

Expansionary Monetary policy shifts AD right as spending by consumers and businesses increases.

Price Level

Goods and Services (real GDP)

AD2

Y2

P2

P1

SRAS1

AD1

Y1

In the short run output increases

Expansionary monetary policyWhat happens in the long run?

Price Level

Goods and Services (real GDP)

AD2

YF

P2

P1

SRAS1

AD1

Y1

If the economy was initially at less than full employment, no further adjustments take place

LRAS1

E2

e1

Expansionary monetary policyWhat happens in the long run?

Price Level

Goods and Services (real GDP)

AD1

YF

P1

P2

SRAS1

AD2

Y2

If the economy was initially at (or greater than) full employment, SRAS shifts left and inflation occurs

LRAS1

E2e2

E1

P3

SRAS2

When the Fed sells bonds◦ Supply of money decreases◦ Supply of loanable funds decreases◦ AD shifts left

Restrictive Monetary Policy

Aggregate demand will decrease because◦ A higher interest rate makes current investment

and consumption more expensive◦ A higher interest rate causes financial assets to

flow the U.S., the dollar will appreciate, and net exports will fall

◦ A higher interest rate decreases asset prices (stocks, houses) which also decreases investment and consumption (aggregate demand)

Restrictive Monetary Policy

Restrictive Monetary Policy: Money Balances

S1

Quantity of Money

Q1

i1

Money Demand

Nom

inal Inte

rest

Rate

S2

Q2

i2

The fed sells bonds to decrease the money supply and the interest rate will rise

Restrictive Monetary Policy: Loanable Funds

Real In

tere

st R

ate

D

r2

Q2

S2

Loanable Funds

Decreases supply of loanable funds as banks make fewer loans, real interest rate rises

r1

Q1

S1

Restrictive Monetary Policy:Goods and Services (real GDP)

Restrictive Monetary policy shifts AD left as spending by consumers and businesses decreases.

Price Level

Goods and Services (real GDP)

AD1

Y1

P1

P2

SRAS1

AD2

Y2

In the short run output decreases

Restrictive monetary policyWhat happens in the long run?

Price Level

Goods and Services (real GDP)

AD2

YF

P2

P1

SRAS1

AD1

Y1

If the economy was initially at greater than full employment, no further adjustments take place

LRAS1

E2

e1

Restrictive monetary policyWhat happens in the long run?

Price Level

Goods and Services (real GDP)

AD1

YF

P1

SRAS1

AD2

Y2

If the economy was initially at full employment, the policy will cause a recession

LRAS1

e2

E1P2

Eventually, self-correction will occur as resource prices adjust downward (this is not pictured)

Timed correctly ◦ Will help mitigate a recession◦ Will help control / prevent inflation ◦ Will lead to economic stability

Timed incorrectly ◦ Will make a recession even worse◦ Will lead to massive inflation ◦ Will lead to economic instability

Summary Monetary Policy

Quantity theory of money – a theory that says a change in the money supply will cause a proportional change in the price level

Velocity of money – average number of times a dollar is use to purchase final goods and services during a year

Monetary Policy in the Long Run

P ~ price level Y ~ real GDP M ~ money supply V ~ velocity of money PY ~ nominal GDP

Quantity Theory of Money

MVPY Equation of Exchange

Can be written in terms of growth rates

Equation of Exchange

Rate of inflation + Growth rate of real output

=Growth rate of money supply + Growth rate of velocity

In the short-run, monetary policy will impact real output and employment◦ Expansionary will increase output◦ Restriction will reduce output

In the long-run, expansionary monetary policy will only lead to inflation

Money and Inflation

Fed can easily change policy, but After policy change

◦ 6 – 15 months to impact real output◦ 12 – 30 months to impact price level and inflation

Implementing monetary policy in a stabilizing way is difficult

Monetary policy time lags

Expansionary monetary policy cannot promote long term economic growth

Economists have limited forecasting abilities Price stability is a key to economic

prosperity

Limitations of Monetary Policy

Austrian View of the Business Cycle

Explains the housing boom (2002-2006), bust (2008) and subsequent slow recovery:

Austrians believe: ◦Expansionary monetary policy pushes the interest

rate to an artificial low.◦The low interest rates will induce entrepreneurs to

undertake long-term investments. This will generate an economic boom.

Austrian View of the Business Cycle

Austrians believe:◦But, the boom will be unsustainable because

savings are too low to purchase these new assets. ◦The boom turns to bust and a large share of the

newly constructed assets end up unoccupied. Austrian economists refer to this as malinvestment.

Impact of Stop-Go Monetary Policy

Monetary policy variable over the past decade Likely to increase economic instability Hard for monetary policy-makers to institute stop-

go policy in a stabilizing manner

Discuss Milton Friedman’s contribution to modern economic thought.

Evaluate appropriately timed monetary policy and its impacts on interest rates and aggregate demand.

Distinguish appropriately timed from ill timed policy and list its consequences.

Chapter 14 Objectives