Interest Rates and Monetary Interest Rates and Monetary Policy in the Short Run and the Policy in the Short Run and the

Long RunLong Run

Unit 4 Lesson 6Unit 4 Lesson 6Activity 41 & 42Activity 41 & 42

Goodman, Rae Jean B.. U.S. Naval AcademyGoodman, Rae Jean B.. U.S. Naval AcademyAdvanced Placement Economics Teacher Resource ManualAdvanced Placement Economics Teacher Resource Manual. .

National Council on Economic Education, New York, N.YNational Council on Economic Education, New York, N.Y

ObjectivesObjectives

Define the real interest rate and the nominal Define the real interest rate and the nominal interest rateinterest rateExplain the relationship among the real interest Explain the relationship among the real interest rate, the nominal interest rate and the inflation rate, the nominal interest rate and the inflation rate. This is also known as the rate. This is also known as the Fisher EquationFisher Equation..Explain the Explain the Fisher EffectFisher Effect, or how changes in the , or how changes in the money supply are transmitted to the nominal money supply are transmitted to the nominal interest rate in the long run.interest rate in the long run.Explain the effects of monetary policy to the Explain the effects of monetary policy to the short run and the subsequent changes in the short run and the subsequent changes in the model as the economy moves to the long run. model as the economy moves to the long run. Define Define neutrality of money.neutrality of money.

Introduction and DescriptionIntroduction and Description

This lesson explores the relationship between This lesson explores the relationship between the nominal interest rate and the real interest the nominal interest rate and the real interest rate, the implications for monetary policy, and rate, the implications for monetary policy, and the short-run and long-run effects of monetary the short-run and long-run effects of monetary policy on real output and the price level. policy on real output and the price level.

You need to understand the relationship You need to understand the relationship between real and nominal interest rates because between real and nominal interest rates because the real interest rate determines the level of the real interest rate determines the level of investment, whereas the nominal interest rate investment, whereas the nominal interest rate determines the demand for money.determines the demand for money.

The Fisher Effect demonstrates how The Fisher Effect demonstrates how changes in the money supply affect the changes in the money supply affect the nominal interest rate in the long run. The nominal interest rate in the long run. The discussion of the short-run and long-run discussion of the short-run and long-run effects on interest rates leads to the effects on interest rates leads to the discussion of the effects of monetary discussion of the effects of monetary policy in the short-run and long-run.policy in the short-run and long-run.

Understanding of the dynamics of the Understanding of the dynamics of the macroeconomic model over time is macroeconomic model over time is essential to explaining the effects of essential to explaining the effects of monetary policy on the economy.monetary policy on the economy.

Activity 41 will help you gain an understanding of Activity 41 will help you gain an understanding of the difference between nominal interest rates the difference between nominal interest rates and real interest rates, and the effect of and real interest rates, and the effect of monetary policy on both in the short and long monetary policy on both in the short and long run.run.

Activity 42 is designed to bring the dynamic Activity 42 is designed to bring the dynamic macroeconomic model together with monetary macroeconomic model together with monetary policy actions and to help you integrate the policy actions and to help you integrate the effects of monetary policy in the short and long effects of monetary policy in the short and long run with your understanding of how the economy run with your understanding of how the economy works.works.

This will help you analyze current monetary This will help you analyze current monetary policy and understand monetary policy policy and understand monetary policy discussions.discussions.

Nominal and Real Interest RatesNominal and Real Interest Rates

The nominal interest rate is the rate that The nominal interest rate is the rate that appears on the financial pages of appears on the financial pages of newspapers and on the signs and ads of newspapers and on the signs and ads of financial institutions.financial institutions.

The real interest rate is the increase in The real interest rate is the increase in purchasing power the lender wants to purchasing power the lender wants to receive to forego consumption now for receive to forego consumption now for consumption in the future.consumption in the future.

Nominal vs. Real Interest RatesNominal vs. Real Interest Rates

There are two relationships between the There are two relationships between the real and nominal interest rates.real and nominal interest rates. The The ex anteex ante real interest rate, which is the real interest rate, which is the

expected interest rate and equals the nominal expected interest rate and equals the nominal interest rate minus the expected inflation rate.interest rate minus the expected inflation rate.

The The ex posteex poste real interest rate, which is the real interest rate, which is the real interest rate actually received and equals real interest rate actually received and equals the nominal interest rate minus the actual rate the nominal interest rate minus the actual rate of inflation. of inflation.

Nominal vs. Real Interest RatesNominal vs. Real Interest Rates

The The ex posteex poste real interest rate will equal the real interest rate will equal the ex ex anteante interest rate, if people accurately anticipate interest rate, if people accurately anticipate the inflation rate.the inflation rate.

The relationship between the real and nominal The relationship between the real and nominal interest rate is called the interest rate is called the Fisher Equation. Fisher Equation.

Fisher Effect: Fisher Effect: The direct relationship between The direct relationship between inflation and interest rates. Increasing inflation and interest rates. Increasing inflationary expectations result in increasing inflationary expectations result in increasing interest rates interest rates

Looking at the equation of exchange – the Looking at the equation of exchange – the changes in the money supply – holding changes in the money supply – holding velocity and real output constant – led to velocity and real output constant – led to changes in the price level. These changes changes in the price level. These changes in the price level change the nominal in the price level change the nominal interest rate once they are anticipated.interest rate once they are anticipated.

Complete Activity 41. Complete Activity 41.

Real Interest Rates and Nominal Real Interest Rates and Nominal Interest RatesInterest Rates

If you bought a one-year bond for $1,000 If you bought a one-year bond for $1,000 and the bond paid an interest rate of 10% and the bond paid an interest rate of 10% at the end of the year, would you be 10% at the end of the year, would you be 10% wealthier?wealthier?You will certainly have 10% more money You will certainly have 10% more money than you did a year earlier, but can you than you did a year earlier, but can you buy 10% more?buy 10% more? If the price level has risen, the answer is that If the price level has risen, the answer is that

you cannot buy 10% more. you cannot buy 10% more.

If the inflation rate were 8%, then you could buy If the inflation rate were 8%, then you could buy only 2% more, if the inflation rate were 12%, you only 2% more, if the inflation rate were 12%, you would be able to buy 2% less!would be able to buy 2% less!

The The nominal interest ratenominal interest rate is the rate the bank is the rate the bank pays you on your savings or the rate that pays you on your savings or the rate that appears on your bond or car loan.appears on your bond or car loan.

The The actual real interest rateactual real interest rate represents the represents the change in your purchasing power. change in your purchasing power.

The The expected real interest rate expected real interest rate represents the represents the amount you need to receive in real terms to amount you need to receive in real terms to forgo consumption now for consumption in the forgo consumption now for consumption in the future.future.

The relationship between the nominal interest The relationship between the nominal interest rate, the real interest rate and the inflation rate rate, the real interest rate and the inflation rate can be written as:can be written as:

r = I - r = I - ππ rr = real interest rate, = real interest rate, II = nominal interest rate = nominal interest rate ππ = inflation rate = inflation rate (Yes, it is the ‘pi” sign, but it is only a symbol!)(Yes, it is the ‘pi” sign, but it is only a symbol!)

This relationship is called the This relationship is called the Fisher EquationFisher Equation In the example on the previous slide with the In the example on the previous slide with the

10% bond, if the inflation rate were 6%, then 10% bond, if the inflation rate were 6%, then you real interest rate (the increase in your you real interest rate (the increase in your purchasing power) would be 4%.purchasing power) would be 4%.

Obviously banks and customers do not know Obviously banks and customers do not know what inflation is going to be, so the interest what inflation is going to be, so the interest rates on loans, bonds, etc. are set based on rates on loans, bonds, etc. are set based on expected inflation. The expected real interest expected inflation. The expected real interest rate israte is

r = i – r = i – ππ

ππ = = expected inflation rate the quotation expected inflation rate the quotation can be written as:can be written as:

i = r i = r + + ππ

e e

e

e e

A bank sets nominal interest rate equal to A bank sets nominal interest rate equal to its expected real interest rate plus the its expected real interest rate plus the expected inflation rate. However, the real expected inflation rate. However, the real interest rate it actually receives may be interest rate it actually receives may be different if inflation is not equal to the different if inflation is not equal to the bank’s expected inflation rate.bank’s expected inflation rate.

The equation of exchange is MV = PQ. The equation of exchange is MV = PQ.

If we assume that velocity (V) is constant, If we assume that velocity (V) is constant, then changes in money supply (M) result then changes in money supply (M) result in changes in the nominal output (PQ).in changes in the nominal output (PQ).

The equation of exchange can be rewritten The equation of exchange can be rewritten in terms of percentage change to bein terms of percentage change to be

percentage change in money supply + percentage percentage change in money supply + percentage change in velocity = change in velocity = percentage change in price level + percentage percentage change in price level + percentage change in real outputchange in real output

The first term, The first term, percentage change in the percentage change in the money supply, money supply, is controlled by the is controlled by the monetary authority (Federal Reserve).monetary authority (Federal Reserve).Assuming that velocity is constant, the Assuming that velocity is constant, the second term is zero.second term is zero.

The third term is the inflation rate and the The third term is the inflation rate and the fourth term is the growth in real output.fourth term is the growth in real output.

Output (Q) is determined by the factors of Output (Q) is determined by the factors of production, technology and the production production, technology and the production function. function.

Output can be taken as given. Therefore, Output can be taken as given. Therefore, the percentage change in the money the percentage change in the money supply results in an equal percentage supply results in an equal percentage change in the price level.change in the price level.

Increases in the money supply by the Increases in the money supply by the Federal Reserve will result in increase in Federal Reserve will result in increase in the price level, or inflation. the price level, or inflation.

Using the Fisher Equation, the increase in Using the Fisher Equation, the increase in inflation would result in an increase in the inflation would result in an increase in the nominal interest rate or a decrease in the nominal interest rate or a decrease in the real interest rate or in some combination.real interest rate or in some combination.

This is known as the This is known as the Fisher Effect, or Fisher Effect, or Fisher HypothesisFisher Hypothesis..

Evidence indicates that increases in the Evidence indicates that increases in the inflation rate result in increases in the inflation rate result in increases in the nominal interest rate in the long run.nominal interest rate in the long run.

Increases in the money supply are Increases in the money supply are translated into increases in the price level translated into increases in the price level and increase in the nominal interest rate and increase in the nominal interest rate in in the long run.the long run.

We know that:We know that: In the short run, increase in the money In the short run, increase in the money

supply decrease the nominal interest supply decrease the nominal interest rate and real interest raterate and real interest rate

In the long run, increases in the money In the long run, increases in the money supply will result in an increase in the supply will result in an increase in the price level and the nominal interest rate.price level and the nominal interest rate.

Activity 41Activity 41

1.1. Fig. 41.1 provides the nominal interest Fig. 41.1 provides the nominal interest rates and inflation rates for the years rates and inflation rates for the years 1991 through 2001.1991 through 2001.

A.A. Compute the actual real interest rates Compute the actual real interest rates for 1991 through 2001.for 1991 through 2001.

B.B. Graph the nominal interest rates and Graph the nominal interest rates and the actual real interest rates on Fig. the actual real interest rates on Fig. 41.241.2

1991 5.41% 3.12%  

1992 3.46 2.30  

1993 3.02 2.42  

1994 4.27 2.05  

1995 5.51 2.12  

1996 5.02 1.87  

1997 5.07 1.85  

1998 4.78 1.14  

1999 4.64 1.56  

2000 5.82 2.29  

2001 3.39 1.96  

Year Nominal Interest Rate

Inflation RateReal Interest Rate

2.29%

1.16

0.60

2.22

3.39

3.15

3.22

3.64

3.08

3.53

1.43

Fig. 41.2 Real Nominal Interest RatesFig. 41.2 Real Nominal Interest Rates

7%

6

5

4

3

2

1

0

Inte

rest

rat

es

Year

199

1

199

2

199

3

199

4

199

5

199

6

199

7

199

8

199

9

200

0

                     

                     

                     

                     

                     

                     

                     

200

1

C.C. Has the actual real interest rate stayed Has the actual real interest rate stayed constant? ____constant? ____

D.D. If it has not, explain why you think the real rate If it has not, explain why you think the real rate has not been constant.has not been constant.

E.E. For what years has the actual real interest rate For what years has the actual real interest rate remained nearly constant?remained nearly constant?

No

The actual real interest rate has not been constant because the inflation rate has changed often. The money supply growth rate has also changed during the period shown in the graph

During the 1995 to 2000 period, the actual real interest rate fluctuated within a small range. The result is probably because of the reasonably steady inflation rate and the announced desire by the Fed to control inflation.

2. Frequently, economists argue that the 2. Frequently, economists argue that the monetary authorities should try to maintain monetary authorities should try to maintain a steady real interest rate. Explain why a steady real interest rate. Explain why you think a steady real rate of interest is you think a steady real rate of interest is important to the economy.important to the economy.

My interest rate is important to induce firms to invest and expand the capital stock.

Fig. 41.3 Expansionary Monetary PolicyFig. 41.3 Expansionary Monetary Policy

LRASSRAS

AD

Real GDP

Pric

e Le

vel

3. Suppose that initially the economy is at the intersection of AD and SRAS as shown. Now the Fed decides to implement expansionary monetary policy to increase the level of employment.

A.A. In the short run, what happens to real In the short run, what happens to real output? Explain why.output? Explain why.

B.B. In the short run, what happen to the price In the short run, what happen to the price level? Explain why. level? Explain why.

Real output should increase. With the decrease in interest rates because of the expansionary monetary policy, the interest rates sensitive components of AD (Consumption and investment) will increase, thereby increasing output.

The price level increases because the increase in demand can only be met if firms have the incentive to produce more. An increasing price level provides this incentive.

C.C. In the short run, what happens to In the short run, what happens to employment and nominal wages? Explain employment and nominal wages? Explain why.why.

D.D. In the short run, what happens to nominal In the short run, what happens to nominal interest rates and real interest rates?interest rates and real interest rates?

Employment increases and nominal wages remain the same. Employment increases because firms now have to produce more goods and services and they need people to this. Nominal wages stay the same because people do not realize that the average price level has increased.

In the short run, the nominal and real interest rates decrease.

E.E. In the long-run, what happens to real In the long-run, what happens to real output? Explain why.output? Explain why.In the long-run, the real output will be at the full employment level. So real output will fall relative in to the level of output in the short-run. An employment increases, nominal wages increase, which raises the costs of production and the SRAS curve shifts to the left. The price level increases, and real output will fall back toward the original level.

F.F. In the long-run, what happens to the In the long-run, what happens to the price level? Explain why.price level? Explain why.

G.G. In the long-run, what happens to In the long-run, what happens to employment and nominal wages? employment and nominal wages? Explain why.Explain why.

The price level rises in the long-run because the SRAS curve shifted to the left in response to an increase in nominal wages.

Employment is at full employment and nominal wages have risen so that the real income of people has remained the same. To induce labor to work at the new higher level firms must increase the nominal wage.

H.H. In the long-run, what happens to the In the long-run, what happens to the nominal interest rate and the real interest nominal interest rate and the real interest rate? rate?

In the long run, the real interest rate goes to the long-run level and the nominal interest rate is the real interest rate plus the inflation rate. In the United States, the long-run real interest rate is about 2% to 3%.

Monetary PolicyMonetary PolicyActivity 42Activity 42

You should be able to explain why the You should be able to explain why the curves shift by now.curves shift by now.

Changes in the money supply over time Changes in the money supply over time result in changes in the price level and no result in changes in the price level and no change in the output level.change in the output level.

Monetary policy is Monetary policy is neutralneutral..

Factors that shift the AD curve:Factors that shift the AD curve: Changes in autonomous consumptionChanges in autonomous consumption Changes in autonomous investmentChanges in autonomous investment Changes in government spendingChanges in government spending Changes in taxes Changes in taxes Changes in the money supplyChanges in the money supply

Factors that shift the SRAS:Factors that shift the SRAS: Changes in resource pricesChanges in resource prices Changes in technologyChanges in technology Changes in capital stockChanges in capital stock Changes in expectationsChanges in expectations

REVIEW!

Do you remember what happens after the Do you remember what happens after the initial effects in the AD and AS model?initial effects in the AD and AS model?

From the Short run to the Long RunFrom the Short run to the Long Run

Pric

e Le

vel

Real GDPY* Y*1

p

p₁

p₂

AD

SRAS₁

AD₁

SRAS

LRASInitially the economy is at Y*, potential GDP and P.

Aggregate demand increases from AD to AD1 and the economy to Y1 and p1

The final equilibrium is Y* and p2

The economy is initially at full The economy is initially at full employment output: Y*employment output: Y*

There is an increase in There is an increase in aggregate demand: aggregate demand:

ADAD ADAD11

Output increases to YOutput increases to Y11, and , and the price level increases to Pthe price level increases to P11

Pric

e Le

vel

Real GDPY* Y*1

p

p1

p2

AD

SRAS1

AD1

SRAS

LRAS

The increase in the price level means that real wages have fallen. Labor will push for higher nominal wages to compensate for the higher price level. The increase in nominal wages will shift the aggregate supply curve to the left. Eventually, the economy will return to the potential output level, Y*, but at a higher price level p. This is the process of adjustment over the long run.

Long Run Adjustment

Monetary PolicyMonetary Policy

Re-read and STUDY the Appendix to Re-read and STUDY the Appendix to Lesson 4 from Unit 4 with Activity 24!Lesson 4 from Unit 4 with Activity 24!

We our now going to bring together all of We our now going to bring together all of the pieces of the process by which the pieces of the process by which monetary policy is transmitted in the monetary policy is transmitted in the economy, and we examine both the short-economy, and we examine both the short-run and the long-run effects of monetary run and the long-run effects of monetary policy.policy.

Effects of Monetary PolicyEffects of Monetary Policy

1.1. Suppose the initially the economy is at the intersection of AD and Suppose the initially the economy is at the intersection of AD and SRAS in Fig. 42.1SRAS in Fig. 42.1

A.A. What monetary policy should the fed implement to move the What monetary policy should the fed implement to move the economy to full-employment output? economy to full-employment output? ________________________________________________

B.B. If the Fed is going to use open market operations, it should If the Fed is going to use open market operations, it should ((buy / sellbuy / sell) Treasury securities.) Treasury securities.

Real GDP

SRAS

AD

LRAS

Pric

e Le

vel

Fig. 42.1

Expansion Monetary Policy

C.C. What is the effect on Treasury security What is the effect on Treasury security (bond) prices?(bond) prices?

D.D. In the short-run, what is the effect on In the short-run, what is the effect on nominal interest rates? Explain.nominal interest rates? Explain.

Bond prices should rise.

Nominal interest rates should fall because financial institutions have more funds to lend out because people have sold their Treasury to the Fed.

E.E. In the short-run, what happens to real In the short-run, what happens to real output? Explain how the Fed’s action output? Explain how the Fed’s action results in a change in real output.results in a change in real output.

F.F. In the short-run, what happens to the In the short-run, what happens to the price level? Explain how the Fed’s action price level? Explain how the Fed’s action results in a change to the price level. results in a change to the price level.

Real output should increase. With the decrease in interest rates, the increase interest-rate sensitive components of AD (C & I) will increase, thereby increasing output.

The average price level increase because the increase in demand can be met only if firms have the incentive to produce more. An increasing price level provides this incentive.

Moving to Full Employment Fig. 42.2Moving to Full Employment Fig. 42.2

2.2. Suppose that initially the economy is at the intersection of Suppose that initially the economy is at the intersection of AD and SRAS.AD and SRAS.

A.A. What monetary policy should the fed implement to move What monetary policy should the fed implement to move the economy to full-employment output? the economy to full-employment output? _______________________________ _______________________________

B.B. If the Fed is going to use open market operations, it If the Fed is going to use open market operations, it should (should (buy / sellbuy / sell) Treasury securities. ) Treasury securities.

Real GDP

SRAS

AD

LRAS

Pric

e Le

vel

Contractionary Monetary Policy

C.C. What is the effect on Treasury security What is the effect on Treasury security (bond) prices?(bond) prices?

D.D. In the short-run, what is the effect on In the short-run, what is the effect on nominal interest rates? Explain.nominal interest rates? Explain.

Bond prices will decline.

In the short-run, nominal interest rates will increase. When the public buys bonds, they pay for them by reducing their demand deposits, decreasing the supply of money, which means the interest rate will increase.

E.E. In the short-run, what happens to real In the short-run, what happens to real output? Explain how the Fed’s action output? Explain how the Fed’s action results in a change in real output.results in a change in real output.

F.F. In the short-run, what happens to the In the short-run, what happens to the price level? Explain how the Fed’s action price level? Explain how the Fed’s action results in a change to the price level. results in a change to the price level.

As a result of the Fed’s actions interest rates have increased; therefore, the interest sensitive components of AD (C & I) will decrease and thus, decrease AD. With a reduced AD, firms will experience an increase in inventories, which in turn leads to a decrease in production. Output ↓

The price level will fall as firms attempt to clear out inventory by reducing prices, having a sale.

Fig.42.3 Expansionary Monetary PolicyFig.42.3 Expansionary Monetary Policy

3.3. Suppose that in the situation shown in the above fig., Suppose that in the situation shown in the above fig., the AS and demand curves are represented by LRAS, the AS and demand curves are represented by LRAS, SRAS and AD. The monetary authorities decide to SRAS and AD. The monetary authorities decide to maintain the level of employment represented by the maintain the level of employment represented by the output level Youtput level Y11 by using expansionary monetary policy. by using expansionary monetary policy.

Real GDP

SRAS

AD

LRASPL

p

Y*

A.A. Explain the effect of the expansionary Explain the effect of the expansionary monetary policy on the price level and monetary policy on the price level and output in the short-run.output in the short-run.

Real GDP

SRAS

AD

LRASPL

p

Y*

AD1

p1

Y1

In the short-run, the monetary authorities (the Fed) will expand the money supply, which in turn increases the AD curve to AD1. The price level and output increase.

B.B. Explain the effect on the price level and output Explain the effect on the price level and output in the long-run.in the long-run.

Real GDP

SRAS

AD

LRASPL

p

Y*

AD1

p1

Y1

The SRAS will shift leftward, leading to a decrease in output and an increase in price level. Given the Fed’s desire to remain at Y1, the Fed will continue to expand the money supply, shifting AD to AD2. With the decrease in SRAS, the economy might be at a point like the intersection of AD2 and SRAS1. Thus, the price level will continue to rise and the economy will experience inflation.

AD2

SRAS1

p2

C.C. Explain what you think will happen to the Explain what you think will happen to the nominal rate of interest and the real rate nominal rate of interest and the real rate of interest in the short run as the Fed of interest in the short run as the Fed continues to increase the money supply. continues to increase the money supply. Explain why. Explain why.

In the short run, both the nominal interest rate and the real interest rate will decline. Consumers and financial intermediaries will not have correctly anticipated the inflation, and both interest rates will decline. As consumers and producers recognize that the price level is increasing, they will take steps to maintain their real income. Nominal wages will rise, and the nominal and real interest rates will start to rise.

D.D. Explain what you think will happen to the Explain what you think will happen to the nominal rate of interest and the real rate nominal rate of interest and the real rate of interest in the long run. Explain why.of interest in the long run. Explain why.

In the long-run, the real interest rate will return to its long-run equilibrium, and the nominal interest rate will be the real interest plus inflation. Since inflation is increasing, the nominal interest rate will increase as well. Producers and consumers will adjust expectations to match reality.

4.4. Many economists think that moving from Many economists think that moving from short-run equilibrium to long-run short-run equilibrium to long-run equilibrium may take several years. List equilibrium may take several years. List three reasons why the economy might three reasons why the economy might not immediately move to long-run not immediately move to long-run equilibrium.equilibrium.

Wages will adjust slowly to changes in prices (inflation) because of wage contracts.

Prices adjust slowly because business is slow to change prices to maintain customer loyalty.

Both labor and firms have inaccurate expectations about inflation

5.5. In a short paragraph, summarize the In a short paragraph, summarize the long-run impact of an expansionary long-run impact of an expansionary monetary policy on the economy.monetary policy on the economy.In the long-run, increases in the money supply translates into increases in the PL and no long-term increase in output. This is known as the neutrality of money.

In the short-run, nominal and real interest rates decline. In the long-run, nominal interest rates follow the Fisher Equation and equal the real rate plus the inflation rate. Real interest rates return to their long-run level; the rate people require to forgo consumption now for consumption in the future.