Understanding Monetary Policy Dynamics: Key Factors and Impacts

1. Chapter 16 Domestic and International Dimensions of Monetary Policy

2. Introduction Today the total reserves that depository institutions hold with the Fed exceed $1 trillion, as compared to less than $45 billion in 2008. What determines the quantity of reserves that depository institutions choose to hold with the Fed? Why are they opting to hold so many more reserves now than a few years ago? This chapter will help you understand the answers to these questions.

3. Learning Objectives Identify the key factors that influence the quantity of money that people desire to hold Describe how Federal Reserve monetary policy actions influence market interest rates Evaluate how expansionary and contractionary monetary policy actions affect equilibrium real GDP and the price level in the short run Understand the equation of exchange and its importance in the quantity theory of money and prices

4. Learning Objectives (cont'd) Discuss the interest-rate-based transmission mechanism of monetary policy Explain why the Federal Reserve cannot stabilize both the money supply and interest rates simultaneously Describe how the Federal Reserve achieves a target value of the federal funds rate Explain key issues the Federal Reserve confronts in selecting its target for the federal funds rate

5. Chapter Outline The Demand for Money How the Fed Influences Interest Rates Effects of an Increase in the Money Supply Open Economy Transmission of Monetary Policy Monetary Policy and Inflation Monetary Policy in Action: The Transmission Mechanism

6. Chapter Outline (cont'd) The Way Fed Policy is Currently Implemented Selecting the Federal Funds Rate Target

7. Did You Know That … In late 2000s, Zimbabwe’s daily inflation rate some times exceeded 100 percent, meaning that the nation’s price level more than doubled within 24-hour periods? Meanwhile, daily rates of money supply growth in Zimbabwe also exceeded 100 percent. Why are higher rates of inflation associated with higher rates of money growth? One objective of this chapter is to answer this question.

8. The Demand for Money • To see how Fed monetary policy actions have an impact on the economy by influencing market interest rates, we must understand how much money people desire to hold—the demand for money. • All flows of nonbarter transactions involve a stock of money. • To use money, one must hold money.

9. People have certain motivation that causes them to want to hold money balances: Transactions demand Precautionary demand Asset demand The Demand For Money

10. The Demand for Money (cont'd) • Money Balances • Synonymous with money, money stock, and money holdings

11. The Demand for Money (cont'd) • Transactions Demand • Holding money as a medium of exchange to make payments • The level varies directly with nominal GDP

12. The Demand for Money (cont'd) • Precautionary Demand • Holding money to meet unplanned expenditures and emergencies

13. The Demand for Money (cont'd) • Asset Demand • Holding money as a store of value instead of other assets such as certificates of deposit, corporate bonds, and stocks

14. The Demand for Money (cont'd) • The demand for money curve • Assume the amount of money demanded for transactions purposes is proportionate to income • Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate)

15. Figure 16-1 The Demand for Money Curve

16. How the Fed Influences Interest Rates The Fed seeks to alter consumption, investment, and total aggregate expenditures by altering the rate of growth of the money supply

17. How the Fed Influences Interest Rates (cont'd) • The Fed has four tools at its disposal as monetary policy actions: • Open market operations • Changes in the reserve ratio • Changes in the interest rate paid on reserves • Discount rate changes

18. How the Fed Influences Interest Rates (cont'd) • Open market operations • Fed purchases and sells government bonds issued by the U.S. Treasury • An open market operation causes a change in the price of bonds

19. Figure 16-2 Determining the Price of Bonds, Panel (a) Contractionary Policy • Fed sells bonds • Supply of bonds increases • The price of bond falls

20. Figure 16-2 Determining the Price of Bonds, Panel (b) Expansionary Policy • Fed buys bonds • Supply of bonds falls • The price of bond rises

21. How the Fed Influences Interest Rates (cont'd) • Example • You pay $1,000 for a bond that pays $50 per year in interest Bond Yield = $50 = 5% $1,000

22. How the Fed Influences Interest Rates (cont'd) • Example • Now suppose you pay $500 for the same bond (with $50 in interest) Bond Yield = $50 = 10% $500

23. How the Fed Influences Interest Rates (cont'd) • The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy • Implications: • A Fed open market sale that reduces the equilibrium price of bonds brings about an increase in the interest rate • A Fed open market purchase that boosts the equilibrium price of bonds generates a decrease in the interest rate

24. Effects of an Increase in The Money Supply What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter? People pick up the money and put it in their pockets, but how do they dispose of the new money?

25. Effects of an Increase in The Money Supply (cont'd) Direct effect Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services

26. Effects of an Increase in The Money Supply (cont'd) Indirect effect Not everybody will necessarily spend the newfound money on goods and services Some of the money gets deposited, so banks have higher reserves (and they lend the excess out)

27. Effects of an Increase in The Money Supply (cont'd) Indirect effect Banks lower rates to induce borrowing Businesses engage in investment Individuals consume durable goods (like housing and autos) Increased loans generate an increase in aggregate demand More people are involved in more spending (even those who didn’t get money from the helicopter!)

28. Effects of an Increase in The Money Supply (cont'd) Assume the economy is operating at less than full employment Expansionary monetary policy can close the recessionary gap Direct and indirect effects cause the aggregate demand curve to shift outward

29. Figure 16-3 Expansionary Monetary Policy with Underutilized Resources • The recessionary gap isdue to insufficient AD • To increase AD,use expansionary monetary policy • AD increases and real GDP increases to full employment

30. Effects of an Increase in The Money Supply (cont'd) Assume there is an inflationary gap Contractionary monetary policy can eliminate this inflationary gap Direct and indirect effects cause the aggregate demand curve to shift inward

31. Figure 16-4 Contractionary Monetary Policy with Overutilized Resources • The inflationary gap is shown • To decrease AD, use contractionary monetary policy • AD decreases and real GDP decreases

32. Open Economy Transmission of Monetary Policy So far we have discussed monetary policy in a closed economy When we move to an open economy, monetary policy becomes more complex

33. Open Economy Transmission of Monetary Policy (cont'd) The net export effect of contractionary monetary policy Boosts the market interest rate Higher rates attract foreign investment International price of dollar rises Appreciation of dollar reduces net exports Negative net export effect

34. Open Economy Transmission of Monetary Policy (cont'd) Contractionary monetary policy causes interest rates to rise Such a rise will induce international inflows of funds, thereby raising the international value of the dollar and making U.S. goods less attractive abroad The net export effect of contractionary monetary policy will be in the same direction as the monetary policy effect, thereby amplifying the effect of such policy

35. Open Economy Transmission of Monetary Policy (cont'd) The net export effect of expansionary monetary policy Lower interest rates Financial capital flows out of the United States Demand for dollars will decrease International price of dollar goes down Foreign goods look more expensive in United States Net exports increase (imports fall)

36. Open Economy Transmission of Monetary Policy (cont'd) Globalization of international money markets The Fed’s ability to control the rate of growth of the money supply may be hampered as U.S. money markets become less isolated If the Fed reduces the growth of the money supply, individuals and firms in the United States can obtain dollars from other sources and more regularly conduct transactions using other nations’ currencies.

37. Monetary Policy and Inflation Most media discussions of inflation focus on the short run when the price index can fluctuate due to such events as Oil price shocks, labor union strikes In the long run, empirical studies show that excessive growth in the money supply results in inflation

38. Monetary Policy and Inflation (cont'd) Simple supply and demand analysis can be used to explain why the price level rises when the money supply increases If the supply of money expands relative to the demand for money: People have more money balances than they desire, so their spending on goods and services increases (i.e., the price level has risen)

39. Monetary Policy and Inflation (cont'd) The Equation of Exchange The formula indicating that the number of monetary units (Ms) times the number of times each unit is spent on final goods and services (V) is identical to the price level (P) times real GDP (Y) It shows the relationship between changes in the quantity of money in circulation and the price level

40. Monetary Policy and Inflation (cont'd) MS= money balances held by nonbanking public V = income velocity of money P = price level or price index Y = real GDP per year MsV  PY

41. Monetary Policy and Inflation (cont'd) Income Velocity of Money The number of times per year the dollar is spent on final goods and services Equal to the nominal GDP divided by the money supply

42. Monetary Policy and Inflation (cont'd) The equation of exchange as an identity () Total funds spent on final output MsV equals total funds received PY The value of goods purchased is equal to the value of goods sold MsV  PY nominal GDP

43. Monetary Policy and Inflation (cont'd) Quantity Theory of Money and Prices The hypothesis that changes in the money supply lead to equiproportional changes in the price level If we assume that V and Y are constant, than an increase in the money supply by, say 20%, can lead only to a 20% increase in the price level

44. Figure 16-5 The Relationship Between Money Supply Growth Rates and Rates of Inflation

45. International Policy Example: North Korea Divides Its Money by 100 Inflation has been so rampant in North Korea that even the poorest individuals commonly have held thousands of won, the nation’s currency, and banks have routinely transferred single payments denominated in trillions of won. To simplify matters, the North Korean government recently stripped two zeros from the currency.

46. Figure 16-6 The Interest-Rate-Based Money Transmission Mechanism

47. Figure 16-7 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model At lower rates, a larger quantity of money will be demanded The decrease in the interest rate stimulates investment

48. The Fed’s target choice: The interest rate or the money supply? The Fed has sought to achieve an interest rate target There is a fundamental tension between targeting the interest rate and controlling the money supply The Fed can attempt to stabilize the interest rate or the money supply, but not both Monetary Policy in Action: The Transmission Mechanism

49. Figure 16-8 Choosing a Monetary Policy Target If the Fed selects re, it must accept Ms If the Fed selects M’s, it must allow the interest rate to fall

50. Monetary Policy in Action: The Transmission Mechanism (cont’d) Choosing a policy target Money supply When variations in private spending occur Interest rates When the demand for (or supply of) money is unstable Interest rate targets are preferred