4 Macroeconomics LESSON 6

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1 4 Macroeconomics LESSON 6 Interest Rates and Monetary Policy in the Short Run and the Long Run Introduction and Description This lesson explores the relationship between the nominal interest rate and the real interest rate, the implications for monetary policy, and the shortrun and long-run effects of monetary policy on real output and the price level. The students need to understand the relationship between real and nominal interest rates because the real interest rate determines the level of investment, whereas the nominal interest rate determines the demand for money. Further, the Fisher Effect demonstrates how changes in the money supply affect the nominal interest rate in the long run. The discussion of the short-run and long-run effects on interest rates leads to the discussion of the effects of monetary policy in the short run and long run. Student understanding of the dynamics of the macroeconomic model over time is essential to explaining the effects of monetary policy on the economy. Activity 41 helps the students gain an understanding of the difference between nominal interest rates and real interest rates, and the effect of monetary policy on both in the short and long run. Activity 42 is designed to bring the dynamic macroeconomic model together with monetary policy actions and to help the students integrate the effects of monetary policy in the short and long run with their understanding of how the economy works. This will help them to analyze current monetary policy and understand monetary policy discussions. Objectives 1. Define the real interest rate and the nominal interest rate. 2. Explain the relationship among the real interest rate, the nominal interest rate and the inflation rate. This is also known as the Fisher Equation. 3. Explain the Fisher Effect, or how changes in the money supply are transmitted to the nominal interest rate in the long run. 4. Explain the effects of monetary policy in the short run and the subsequent changes in the model as the economy moves to the long run. Define neutrality of money. Time Required Three class periods or 135 minutes Materials 1. Activities 41 and Visual 3.13 Procedure 1. Define the nominal interest rate and the real interest rate. The nominal interest rate is the rate that appears on the financial pages of newspapers and on the signs and ads of financial institutions. Emphasize that the real interest rate is the increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future. 2. Stress that there are two relationships between the real and nominal interest rates. There is the ex ante real interest rate, which is the expected interest rate and equals the nominal interest rate minus the expected inflation rate. There is the ex poste real interest rate, which is the real interest rate actually received and equals the nominal interest rate minus the actual rate of inflation. The ex poste real interest rate will equal the ex ante interest rate if people accurately anticipate the inflation rate. The relationship between the real and nominal interest rate is called the Fisher Equation. 3. Explain the Fisher Effect. Looking at the equation of exchange, we see that changes in the money supply holding velocity and real out- 566 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

2 4 Macroeconomics LESSON 6 put constant lead to changes in the price level. These changes in the price level change the nominal interest rate once they are anticipated. 4. Have the students complete Activity 41, and review the answers with the students. Emphasize the need to be able to work through and explain exactly the transmission mechanism of money supply changes to changes in the economy. This is an area where students frequently miss points in answering questions on the Advanced Placement Examination. 5. Review the effects of increases and decreases in the money supply in the short-run aggregate supply and aggregate demand model. 6. Project Visual Have the students work through and explain money supply changes in the aggregate demand and aggregate supply model over the long run. The students should be able to do more than simply shift the curves; they should be able to explain why the curves shift. Emphasize that changes in the money supply over time result in changes in the price level and no change in the output level. Monetary policy is neutral. The Appendix to Lesson 4 in Unit 3 graphically presents the shifts in SRAS and the movement from the short run to the long run. 7. Have the students complete Activity 42. Review the answers to Activity 42 with the students. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 567

3 4 Macroeconomics LESSON 6 ACTIVITY 41 Answer Real Interest Rates and Nominal Interest Rates Figure 41.1 Real and Nominal Interest Rates Year Nominal Interest Rate Inflation Rate Real Interest Rate % 3.12% 2.29% Figure 41.1 provides the nominal interest rates and inflation rates for the years 1991 through (A) Compute the actual real interest rates for 1991 through (B) Graph the nominal interest rates and the actual real interest rates on Figure Figure 41.2 Real and Nominal Interest Rates 7% 6 INTEREST RATES Nominal Interest Rates YEAR Real Interest Rates 568 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

4 4 Macroeconomics LESSON 6 ACTIVITY 41 Answer (C) Has the actual real interest rate stayed constant? (D) If it has not, explain why you think the real rate has not been constant. 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. No (E) For what years has the actual real interest rate remained nearly constant? 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 monetary authorities should try to maintain a steady real interest rate. Explain why you think a steady real rate of interest is important to the economy. A steady interest rate is important to induce firms to invest and expand the capital stock. Figure 41.3 Expansionary Monetary Policy PRICE LEVEL LRAS SRAS AD REAL GDP 3. Suppose that initially the economy is at the intersection of AD and SRAS as shown in Figure Now, the Fed decides to implement expansionary monetary policy to increase the level of employment. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 569

5 4 Macroeconomics LESSON 6 ACTIVITY 41 Answer (A) In the short run, what happens to real output? Explain why. Real output should increase. With the decrease in interest rates because of the expansionary monetary policy, the interest rate sensitive components of aggregate demand (consumption and investment) will increase, thereby increasing output. (B) In the short run, what happens to the price level? Explain why. 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) In the short run, what happens to employment and nominal wages? Explain why. 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 do this. Nominal wages stay the same because people do not realize that the average price level has increased. (D) In the short run, what happens to nominal interest rates and real interest rates? In the short run, the nominal and real interest rates decrease. (E) In the long run, what happens to real output? Explain why. In the long run, the real output will be at the full-employment level. So real output will fall relative to the level of output in the short run. As 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 its original level. (F) In the long run, what happens to the price level? 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. (G) In the long run, what happens to employment and nominal wages? Explain why. 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) In the long run, what happens to the nominal interest rate and the real interest 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 percent to 3 percent. 570 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

6 4 Macroeconomics LESSON 6 ACTIVITY 42 Answer Monetary Policy We now bring together all of the pieces of the process by which monetary policy is transmitted to the economy, and we examine both the short-run effects and the long-run effects of monetary policy. Figure 42.1 Effects of Monetary Policy PRICE LEVEL LRAS SRAS AD REAL GDP 1. Suppose that initially the economy is at the intersection of AD and SRAS in Figure (A) What monetary policy should the Fed implement to move the economy to full-employment output? Expansionary monetary policy (B) If the Fed is going to use open market operations, it should (buy / sell) Treasury securities. (C) What is the effect on Treasury security (bond) prices? Bond prices should rise. (D) In the short run, what is the effect on nominal interest rates? Explain. Nominal interest rates should fall because financial institutions have more funds to lend out because people have sold their Treasury securities to the Fed. (E) In the short run, what happens to real output? Explain how the Fed s action results in a change in real output. Real output should increase. With the decrease in interest rates, the interest-rate sensitive components of aggregate demand (consumption and investment) will increase, thereby increasing output. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 571

7 4 Macroeconomics LESSON 6 ACTIVITY 42 Answer (F) In the short run, what happens to the price level? Explain how the Fed s action results in a change to the price level. The average price level increases because the increase in demand can be met only if firms have the incentive to produce more. An increasing price level provides this incentive. Figure 42.2 Moving to Full Employment PRICE LEVEL LRAS SRAS AD REAL GDP 2. Suppose that initially the economy is at the intersection of AD and SRAS in Figure (A) What monetary policy should the Fed implement to move the economy to full-employment output? Contractionary monetary policy (B) If the Fed is going to use open market operations, it should (buy / sell) Treasury securities. (C) What is the effect on Treasury security (bond) prices? Bond prices will decline. (D) In the short run, what is the effect on nominal interest rates? Explain. 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) In the short run, what happens to real output? Explain how the Fed s action results in a change in real output. In the short run, real output will decline. As a result of the Fed s actions, interest rates have increased; therefore the interest-sensitive components of aggregate demand (consumption and investment) will decrease and thus, decrease aggregate demand. With a reduced aggregate demand, firms will experience an increase in inventories, which in turn leads to a decrease in production. Output decreases. 572 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

8 4 Macroeconomics LESSON 6 ACTIVITY 42 Answer (F) In the short run, what happens to the price level? Explain how the Fed s action results in a change to the price level. The price level will fall as firms attempt to clear out inventory by reducing prices, having a sale. Figure 42.3 Expansionary Monetary Policy PRICE LEVEL LRAS SRAS 1 SRAS AD 1 AD 2 AD Y* REAL GDP Y 1 3. Suppose that in the situation shown in Figure 42.3, the aggregate supply and demand curves are represented by LRAS, SRAS and AD. The monetary authorities decide to maintain the level of employment represented by the output level Y 1 by using expansionary monetary policy. (A) Explain the effect of the expansionary monetary policy on the price level and output in the short run. In the short run, the monetary authorities (the Fed) will expand the money supply, which in turn increases the aggregate demand curve to AD 1. The price level and output increase. (B) Explain the effect on the price level and output in the long run. 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 Y 1, the Fed will continue to expand the money supply, shifting AD to AD 2. With the decrease in SRAS, the economy might be at a point like the intersection of AD 2 and SRAS 1. Thus, the price level will continue to rise and the economy will experience inflation. Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 573

9 4 Macroeconomics LESSON 6 ACTIVITY 42 Answer (C) Explain what you think will happen to the nominal rate of interest and the real rate of interest in the short run as the Fed continues to increase the money supply. 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) Explain what you think will happen to the nominal rate of interest and the real rate 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 rate plus inflation. Since inflation is increasing, the nominal interest rate will increase as well. Producers and consumers will adjust expectations to match reality. 4. Many economists think that moving from short-run equilibrium to long-run equilibrium may take several years. List three reasons why the economy might not immediately move to long-run 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. In a short paragraph, summarize the long-run impact of an expansionary monetary policy on the economy. In the long run, increases in the money supply translate into increases in the price level 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. 574 Advanced Placement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

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