Introduction. Learning Objectives. Chapter 17 Domestic and International Dimensions of Monetary Policy

Transcription

1 Copyright 2011 by Pearson Education, Inc. Chapter 17 Domestic and International Dimensions of Monetary Policy All rights reserved. Introduction From the early 1970s through the late 1990s, the number of times that a dollar was used to purchase goods and services called the income velocity of money increased as innovations like ATMs simplified the movement of funds But then, between 2000 and 2009, the income velocity of money declined considerably In this chapter, you will learn more about the income velocity of money and its role in an important relationship called the equation of exchange 17-2 Learning Objectives 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 Discuss the interest-rate-based transmission mechanism of monetary policy 17-3

2 Learning Objectives (cont'd) 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 17-4 Chapter Outline 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 17-5 Chapter Outline (cont'd) The Way Fed Policy is Currently Implemented Selecting the Federal Funds Rate Target 17-6

3 Did You Know That During the mid-2000s, the Bank of Japan, sought to keep the interest rate on overnight call-money loans to 0 percent? By the end of 2008, the Federal Reserve was mimicking this policy stance by setting a target range of 0 percent to 0.25 percent for the federal funds rate 17-7 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? 17-8 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 17-9

4 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) 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!) Effects of an Increase in The Money Supply (cont'd) Graphing the Effects of an Expansionary Monetary Policy 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 17-12

5 Figure 17-1 Expansionary Monetary Policy with Underutilized Resources The recessionary gap is due to insufficient AD To increase AD, use expansionary monetary policy AD increases and real GDP increases to full employment Effects of an Increase in The Money Supply (cont'd) Graphing the Effects of Contractionary Monetary Policy 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 Figure 17-2 Contractionary Monetary Policy with Overutilized Resources The inflationary gap is shown To decrease AD, use contractionary monetary policy AD decreases and real GDP decreases 17-15

6 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 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 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) 17-18

7 Open Economy Transmission of Monetary Policy (cont'd) Globalization of international money markets How will global money markets impact the Fed's ability to control the rate of growth in the money supply? Monetary Policy and Inflation Most theories of inflation relate to the short run and the price index in the short run can fluctuate due to Oil price shocks, labor union strikes In the long run, there is a more stable relationship between growth in the money supply and inflation 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 is increased If the supply of money expands relative to the demand for money It takes more units of money to purchase given quantities of goods and services (i.e., the price level has risen) 17-21

8 Monetary Policy and Inflation (cont'd) The Equation of Exchange The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP M s V = PY Monetary Policy and Inflation (cont'd) The equation of exchange and the quantity theory: M S V = PY M S = actual money balances held by nonbanking public V = income velocity of money; the number of times, on average per year, each monetary unit is spent on final goods and services 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 17-24

9 Monetary Policy and Inflation (cont'd) The equation of exchange and the quantity theory: M S V = PY P = price level or price index Y = real GDP per year 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 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 17-27

10 Monetary Policy and Inflation (cont'd) The quantity theory of money and prices Assume: V is constant Y is stable M s V = PY Monetary Policy and Inflation (cont'd) The quantity theory of money and prices Increases in M s must be matched by equal increases in the price level M s V = PY Figure 17-3 The Relationship Between Money Supply Growth Rates and Rates of Inflation 17-30

11 International Policy Example: Zimbabwe Discovers What Happens When It Adds Zeros to Its Currency Notes In 2004, Zimbabwe s inflation rate reached 600% per year In 2006, its annual inflation rate rose above 1,000% as its central bank decided to pay off debts to the IMF by printing more currency In 2007, its inflation rate exceeded 100,000% per year as the central continued printing money In 2008, instead of printing as many currency notes, the central bank began adding zeroes to the denominations A consequence of adding all these zeroes was an even higher inflation of over 200 million percent Monetary Policy in Action: The Transmission Mechanism Recall we talked about the direct and indirect effects of monetary policy Direct effect: implies increase in money supply causes people to have excess money balances Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up Figure 17-4 The Interest-Rate-Based Money Transmission Mechanism 17-33

12 Figure 17-5 Adding Monetary Policy to the Aggregate Demand Aggregate Supply Model, Panels (a) and (b) At lower rates, a larger quantity of money will be demanded The decrease in the interest rate stimulates investment Figure 17-5 Adding Monetary Policy to the Aggregate Demand Aggregate Supply Model, Panel (c) The increase in investment shifts the AD curve to the right Monetary Policy in Action: The Transmission Mechanism (cont d) The Fed s Target Choice: Interest Rates or Money Supply? It is not possible to stabilize the money supply and interest rates simultaneously The Fed has often sought to achieve an interest rate target There is a fundamental tension between targeting interest rates and controlling the money supply 17-36

13 Figure 17-6 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 Monetary Policy in Action: The Transmission Mechanism (cont d) The Fed, in the short run, can select an interest rate or a money supply target but not both 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 17-39

14 The Way Fed Policy is Currently Implemented At present the Fed announces an interest rate target The rate referred to is the federal funds rate of interest Or, the rate at which banks can borrow excess reserves from each other The Way Fed Policy is Currently Implemented (cont'd) If the Fed wants to raise the interest rate, it engages in contractionary open market operations Fed sells more Treasury securities than it buys, thereby reducing the money supply This tends to boost the rate of interest The Way Fed Policy is Currently Implemented (cont'd) Conversely, if the Fed wants to decrease the rate of interest, it engages in expansionary open market operations Fed buys more Treasury securities, increasing the money supply This tends to lower the rate of interest 17-42

15 Figure 17-7 The Market for Bank Reserves and the Federal Funds Rate, Panel (a) Figure 17-7 The Market for Bank Reserves and the Federal Funds Rate, Panel (b) The Way Fed Policy is Currently Implemented (cont'd) FOMC Directive A document that summarizes the Federal Open Market Committee s general policy strategy Establishes near-term objectives for the federal funds rate and specifies target ranges for money supply growth 17-45

16 The Way Fed Policy is Currently Implemented (cont'd) Trading Desk An office at the Federal Reserve Bank of New York charged with implementing monetary policy strategies developed by the FOMC Policy Example: The Wide Variation in Forecasts of Fed Policy in the Late 2000s For much of 2009, the FOMC aimed for a federal funds rate target near 0 percent in an effort to bring about an end to the Great Recession When signs of a possible upswing in economic activity emerged in the summer of 2009, economic forecasters reached differing conclusions about when and by how much the Fed might raise its target for the federal funds rate A survey of professional forecasters revealed a 4- percentage-point range across the forecasts of Fed interest-rate policymaking through the next year Selecting the Federal Funds Rate Target The Neutral Federal Funds Rate A value of the interest rate on interbank loans at which the growth rate of real GDP tends neither to rise nor to fall relative to the rate of growth of potential, long-run, real GDP, given the expected rate of inflation 17-48

17 Selecting the Federal Funds Rate Target (cont d) The value of neutral federal funds rate varies over time. The potential rate of growth of real GDP is not constant When the rate of growth rises or falls, so does the value of the neutral federal funds rate The FOMC must respond by changing the target for the federal funds rate that it includes in the FOMC Directive transmitted to the Trading Desk Selecting the Federal Funds Rate Target (cont d) Taylor Rule A suggested guideline for monetary policy An equation determining the Fed s interest rate target based on Estimated long-run real interest rate Deviation of the actual inflation rate from the Fed s objective Gap between actual real GDP and a measure of potential GDP Figure 17-8 Actual Federal Funds Rates and Values Predicted by a Taylor Rule 17-51

18 Policy Example: Supplementing the Taylor Rule with the Taylor Principle John Taylor, the Taylor rule s designer, also suggested that The Fed should adjust its federal funds rate target more than one-for-one with movements in inflation If the actual inflation rate rises by, say, 0.25 percentage point and if the Fed fails to push the federal funds rate up by at least 0.25 percentage point, then the real federal funds rate the difference between the nominal federal funds rate that the Fed targets and the expected inflation rate will actually decline Issues and Applications: The Rise and Fall of the Income Velocity of Money Figure 17-9 shows considerable variation in the value of the income velocity of money, which increased by about 25 percent between the mid- 1980s and late 1990s Since then, the income velocity has dropped, recovered somewhat, and then declined once again Figure 17-9 The Income Velocity of Money in the United States 17-54

19 Issues and Applications: The Rise and Fall of the Income Velocity of Money (cont d) Between 1970 and the mid-1990s, the rising income velocity was a reflection of improved payments technology, and so more efficient use of each unit of money Between 1998 and 2003, the sudden decreases in velocity appears to be a result of a change in people s desired holdings of money relative to their purchases of goods and services Since 2006, the decline in velocity may be the outcome of a significant housing-price downturn and the subsequent financial crisis, which caused many households to increase their desired holdings of money Summary Discussion of Learning Objectives How expansionary and contractionary monetary policy affect equilibrium real GDP and the price level in the short run Expansionary monetary policy Pushing up money supply, inducing a fall in interest rates Total planned expenditures rise, AD shifts rightward Contractionary monetary policy Reduces the money supply increasing interest rates Total planned expenditures fall, AD shifts leftward Summary Discussion of Learning Objectives (cont'd) The equation of exchange and the quantity theory of money and prices Equation of exchange MV = PY Quantity theory of money and prices V is constant and Y is stable Increases in M lead to equiproportional increases in P 17-57

20 Summary Discussion of Learning Objectives (cont'd) The interest-rate-based transmission mechanism of monetary policy Operates through effects of monetary policy actions on market interest rates Bring about changes in desired investment and thereby affect equilibrium GDP via the multiplier effect Summary Discussion of Learning Objectives (cont'd) Why the Federal Reserve cannot stabilize the money supply and the interest rate simultaneously To target the money supply the Fed must permit the interest rate to vary when the demand for money changes To target a market interest rate the Fed must adjust the money supply as necessary when the demand for money changes Summary Discussion of Learning Objectives (cont'd) How the Federal Reserve Achieves a Target Value of the Federal Funds Rate The interest rate at which banks can borrow excess reserves from other banks is at an equilibrium level when the quantity of reserves demanded by banks equals the quantity of reserves supplied by the Fed The Trading Desk conducts open market sales or purchases to alter the supply of reserves as necessary to keep the federal funds rate at the FOMC s target 17-60

21 Summary Discussion of Learning Objectives (cont'd) Issues the Federal Reserve Confronts in Selecting its Target for the Federal Funds Rate The FOMC target is the neutral federal funds rate The Taylor Rule specifies an equation for the federal funds rate target based on an estimated long-run real interest rate the current deviation from the Fed s inflation goal the gap between actual real GDP and a measure of potential real GDP Figure D-1 An Increase in the Money Supply 17-62