Modern Macroeconomics and Monetary Policy

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To Accompany “Economics: Private and Public Choice 13th ed.”


James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by:


Joseph Connors, James Gwartney, & Charles Skipton

Full Length

Text




Macro Only

Text



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Modern Macroeconomics
and Monetary Policy

3

14

3

14

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The Impact of Monetary
Policy on Output and Inflation

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Impact of Monetary Policy


Evolution of the modern view:


The Keynesian view dominated during the
1950s and 1960s.


Keynesians argued that the money supply
did not matter much.


Monetarists challenged the Keynesian view
during the1960s and 1970s.


Monetarists argued that changes in the
money supply caused both inflation and
economic instability.


While minor disagreements remain, the
modern view

emerged from this debate.


Modern Keynesians and monetarists agree
that monetary policy exerts an important
impact on the economy. The following
slides present this modern view.

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Money

interest

rate


The quantity of money people want to hold (the
demand

for money
) is inversely related to the money rate of interest,
because higher interest rates make it more costly to hold
money instead of interest
-
earning assets like bonds.

The Demand for Money


Money
Demand

Quantity

of money

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Quantity

of money

Money

interest

rate


The
supply of money

is vertical because it is established

by the Fed and, hence, determined independently of the
interest rate.

Money
Supply

The Supply of Money

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Money

interest

rate


Equilibrium
:

The money interest rate gravitates toward the rate where

the quantity of money people want to hold (
demand
) is

just equal to the stock of money the Fed has
supplied
.

Money
Supply

The Demand and Supply of Money


Money
Demand

i
3

i
e

i
2

Excess
supply

at
i
2

Excess
demand

at
i
3

At
i
e
, people are willing

to hold the money supply
set by the Fed.

Quantity

of money

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D
1

Money

interest

rate

S
1

D

S
1


i
1

Q
s

r
1

Q
1

i
2

Q
b

r
2

Q
2

S
2

S
2


Real

interest

rate

Quantity

of money

Qty of
loanable
funds


When the Fed shifts to a more expansionary monetary policy,

it usually buys additional bonds, expanding the money supply.

Transmission of Monetary Policy


This increase in the money supply (shift from
S
1

to
S
2

in the
market for money) provides banks with additional reserves.


The Fed’s bond purchases and the bank’s use of new reserves
to extend new loans increases the supply of loanable funds
(shifting
S
1

to
S
2

in the loanable funds market) …









and puts
downward pressure on real interest rates (a reduction to
r
2
).

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Price

Level

Goods &

Services

(real GDP)

D

S
1


r
1

Q
1

r
2

Q
2

S
2


Real

interest

rate

P
1

Y
1

Y
2

AS
1


AD
1

P
2

AD
2


As the real interest rate falls,
AD

increases (to
AD
2
).


As the monetary expansion was unanticipated, the expansion
in
AD

leads to a short
-
run increase in output (from
Y
1

to
Y
2
)
and an increase in the price level (from
P
1

to
P
2
)


inflation
.


The impact of a shift in monetary policy is transmitted
through interest rates, exchange rates, and asset prices.

Qty of
loanable
funds

Transmission of Monetary Policy

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Unanticipated Expansionary

Monetary Policy




which leads to increased
investment and consumption …







a depreciation of the dollar



an increase in the
general level of asset prices


(leading to increased net exports) and …

Fed

buys

bonds

Transmission of Monetary Policy

Real
interest
rates

fall

Increases in
investment &
consumption

Depreciation
of the dollar

Increase in
asset prices

Increases in
investment &
consumption

Net exports

rise

Increase

in
aggregate
demand

This

increases

money

supply

and bank

reserves


Here, a shift to an
expansionary monetary policy

is shown.


Assume the Fed expands the supply of money by buying
bonds…




which will increase bank reserves …


pushing real interest rates down …


So, an
unanticipated
shift to a more expansionary monetary
policy will stimulate
aggregate demand

and, thereby,
increase both output and employment.



(and with the increased personal
wealth, increased investment and consumption).

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AD
1


If expansionary monetary policy leads to an in increase in
AD

when the economy is below capacity, the policy will help
direct the economy toward LR full
-
employment output (
Y
F
).

Expansionary Monetary Policy

Price

Level

LRAS

Y
F

Y
1

AD
2


Goods & Services

(real GDP)

P
2

SRAS
1

P
1

E
2

e
1


Here, the increase in output from
Y
1

to
Y
F

will be long term.

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AD
1


Alternatively, if the demand
-
stimulus effects are imposed
on an economy already at full
-
employment
Y
F
, they will
lead to excess demand, higher product prices, and
temporarily higher output (
Y
2
)
.

Price

Level

LRAS

Y
F

P
2


Goods & Services

(real GDP)

P
1

SRAS
1

E
1

Y
2

AD Increase Disrupts Equilibrium

AD
2

e
2

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AD
1

Price

Level

LRAS

Y
F

P
2


Goods & Services

(real GDP)

P
1

SRAS
1

AD
2

E
1

e
2

Y
2


In the long
-
run, the strong demand pushes up resource prices,
shifting
short run aggregate supply

(from
SRAS
1

to
SRAS
2
).

P
3

AD Increase: Long Run

SRAS
2


The price level rises (from
P
2

to
P
3
) and output falls back to

full
-
employment output again (
Y
F

from its temp high,
Y
2
).

E
3

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A Shift to More

Restrictive Monetary Policy


Suppose the Fed shifts to a more restrictive
monetary policy. Typically it will do so by
selling bonds which will:


depress bond prices and


drain reserves from the banking system,


which places upward pressure on real interest
rates.


As a result, an unanticipated shift to a more
restrictive monetary policy reduces
aggregate
demand

and thereby decreases both output
and employment.

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Price

Level

Goods &

Services

(real GDP)

D

r
2

Q
2

r
1

Q
1

S
1


S
2


Real

interest

rate

P
2

Y
2

Y
1

AS
1


P
1

AD
1

AD
2

Short
-
run Effects of

More Restrictive Monetary Policy


A shift to a
more restrictive monetary policy
, will increase
real interest rates.

Qty of
loanable
funds


Higher interest rates decrease aggregate demand (to
AD
2
).


When the reduction in
AD

is unanticipated, real output will
decline (to
Y
2
) and downward pressure on prices will result.

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Price

Level


Goods & Services

(real GDP)


The stabilization effects of restrictive monetary policy depend
on the state of the economy when the policy exerts its impact.

LRAS

Y
F

P
1

P
2

SRAS
1

AD
1

e
1

Y
1

Restrictive Monetary Policy

AD
2


Restrictive monetary policy will reduce
aggregate demand
.

If the demand restraint occurs during a period of strong
demand and an overheated economy, then it may limit or
prevent an inflationary boom.

E
2

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Price

Level


Goods & Services

(real GDP)


In contrast, if the reduction in
aggregate demand

takes place
when the economy is at full
-
employment, then it will disrupt
long
-
run equilibrium, and result in a
recession
.

AD Decrease Disrupts Equilibrium

AD
1

LRAS

Y
F

Y
2

AD
2

P
1

SRAS
1

P
2

E
1

e
2

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Proper Timing


If a change in monetary policy is timed poorly,
it can be a source of instability.


It can cause either recession or inflation.


Proper timing of monetary policy is not easy:


While the Fed can institute policy changes
rapidly, there will be a time lag before the
change exerts much impact on output & prices.


This time lag is estimated to be 6 to 18
months in the case of output and perhaps

as much as 36 months before there is a
significant impact on
the price level
.


Given our limited ability to forecast the future,
these lengthy time lags clearly reduce the
effectiveness of discretionary monetary policy
as a stabilization tool.

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Monetary Policy

in the Long Run

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=

x

x

M

V

P

Y

M
oney

V
elocity

P
rice

Y

=
Income

The Quantity Theory of Money


The
quantity theory of money
:


If
V

and
Y

are constant, then an increase in
M

will lead to a proportional increase in
P
.



M1 = $1.5T; GDP = $15T; V = 10

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Example of Quantity Theory


%MS + %V = %P + %Y


If V is constant and %V = 0, then


%MS = %P + %Y and


%P = %MS
-

%Y




-
3% = 0%
-

3%


0% = 3%
-

3%


7% = 10%
-

3%


100% = 103%
-

3%

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Long
-
run Impact of Monetary Policy

--

The modern View


Long
-
run implications of expansionary policy:


When expansionary monetary policy leads to
rising prices, decision makers eventually
anticipate the higher inflation rate and build it
into their choices.


As this happens, money interest rates, wages,
and incomes will reflect the expectation of
inflation, and so real interest rates, wages, and
real output will return to their long
-
run normal
levels.


Thus, in the long run, money supply growth
will lead primarily to higher prices (inflation)
just as the quantity theory of money implies.

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Price level

(ratio scale)


Time

periods

Money supply

growth rate

3

1

6

9

2

3

4

Real

GDP

AD
1

LRAS

Y
F

SRAS
1

(a)


Growth rate of the money supply.


(b)


Impact in the goods & services market
.


3% growth

AD
2

8% growth

Long
-
run Effects of a Rapid

Expansion in the Money Supply


Here we illustrate the long
-
term impact of an increase in the
annual growth rate of the money supply from 3 to 8 percent.


Initially, prices are stable (
P
100
) when the money supply is
expanding by 3% annually.


The acceleration in the growth rate of the money supply
increases
aggregate demand

(shift to
AD
2
).

P
100


E
1

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At first, real output may expand beyond the economy’s
potential
Y
F


Time

periods

3

1

6

9

2

3

4

Real

GDP

AD
1

LRAS

Y
F

SRAS
1


E
1

P
100

(a)


Growth rate of the money supply.


(b)


Impact in the goods & services market
.


3% growth

AD
2

SRAS
2

8% growth





however low unemployment and strong
demand create upward pressure on wages and other resource
prices, shifting
SRAS
1

to
SRAS
2
.


Output returns to its long
-
run potential
Y
F
, and the price level
increases to
P
105

(
E
2
).


E
2

P
105

Y
1

Price level

(ratio scale)


Money supply

growth rate

Long
-
run Effects of a Rapid

Expansion in the Money Supply

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Time

periods

3

1

6

9

2

3

4

Real

GDP

AD
1

LRAS

Y
F

SRAS
1


E
1

P
100

(a)


Growth rate of the money supply.


(b)


Impact in the goods & services market
.


3% growth

AD
2

SRAS
2

8% growth


If the more rapid monetary growth continues, then
AD


and
SRAS

will continue to shift upward, leading to still
higher prices (
E
3

and points beyond).


The net result of this process is sustained
inflation
.


E
2

P
105

AD
3

P
110

SRAS
3

Price level

(ratio scale)


Money supply

growth rate


E
3

Long
-
run Effects of a Rapid

Expansion in the Money Supply

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Quantity of
loanable funds

Q

S
1

Loanable Funds

Market

Interest

rate

r
.04



With stable prices, supply and demand in the loanable funds
market are in balance at a real & nominal interest rate of 4%.


If rapid monetary expansion leads to a long
-
term 5% inflation
rate, borrowers and lenders will build the higher inflation rate
into their decision making.


As a result, the nominal interest rate
i

will rise to 9%.

Expansionary Monetary Policy


D
1

S
2


(expected rate

of inflation = 5 %)


(expected rate

of inflation = 0 %)


D
2


(expected rate

of inflation = 5 %)


(expected rate

of inflation = 0 %)

i
.09


Recall:

the nominal

interest rate is the

real rate plus the

inflationary premium.

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Money and Inflation


The impact of monetary policy differs
between the short and long
-
run.


In the short
-
run, shifts in monetary policy will
affect real output and employment. A shift
toward monetary expansion will temporarily
increase output, while a shift toward monetary
restriction will reduce output.


But in the long
-
run, monetary expansion will
only lead to inflation. The long
-
run impact of
monetary policy is consistent with the
quantity theory of money.

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The relationship between


the two is clear:
higher


rates of money growth


lead to higher rates of


inflation
.

Note:

The money supply data are the
actual growth rate of the money
supply minus the growth rate of
real GDP.



The relationship between


the avg. annual growth


rate of the money supply


and the rate of inflation


is shown here for the


1985
-
2005 period.

Rate of money supply growth
(%, log scale)

Money and Inflation



An International Comparison 1985
-

2005

Rate of inflation
(%, log scale)

100

1,000

1

10

1

10

100

1000


Brazil


Nicaragua


Congo, DR

Ghana


Sierra Leone

Venezuela

Mexico

Nigeria

Chile

Indonesia


Hungary

Columbia

Paraguay

India

Switzerland

Japan

Central Africa Republic

South Korea

Belgium

United States

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Time Lags, Monetary Shifts,
and Economic Stability

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Time Lags, Monetary Shifts, and
Economic Stability


Shifts in monetary policy will influence the
general level of prices and real output only
after time lags that are long and variable.


Given our limited forecasting ability, these
time lags will make it difficult for policy
-
makers to institute changes in monetary policy
that will promote economic stability.


Constant shifts in monetary policy are likely
to generate instability rather than stability.


Historically, erratic monetary policy has been
a source of economic instability.

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Measurement of Monetary Policy


How can you tell whether monetary policy is
expansionary or restrictive?


During the 1960s and 1970s the growth rate of
the money supply was a reasonably good
indicator of the direction of monetary policy.
Rapid growth of the money supply signaled
expansion, while slow growth or decline was
indicative of restriction.


But innovations and dynamic change reduced
the reliability of the money growth data.

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Measurement of Monetary Policy


Since the mid
-
1980s, the Fed has used its
control over short
-
term interest rates more
extensively in its conduct of monetary policy.


When the Fed shifted toward expansion, it
pushed short
-
term interest rates downward.


When it shifted toward restriction, it pushed
short
-
term interest rates upward.


Thus, movements of short
-
term interest rates
have emerged as a reliable monetary policy
indicator.

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What is the Taylor Rule?


Developed by John Taylor of Stanford, the
Taylor rule provides an estimate of the federal
funds interest rate that would be consistent
with both price stability and full employment.


The Taylor rule equation for the target federal
funds rate is:

f

=

r

+

p

+

.5

*

(
p
-
p
*
)

+

.5

*

(
y
-
y
p
)

f

-

the target fed funds rate

r

-

equilibrium real interest rate (assumed to be 2.5%)

p

-

actual inflation rate

p*

-

the desired inflation rate (assumed to be 2%)

y

-

output

y
p

-

potential output

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What is the Taylor Rule?


Most economists believe that price indexes
slightly overstate the rate of inflation. Thus,
the 2% desired rate of inflation might be
thought of as approximate price stability.

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Did Monetary Policy Cause the
Crisis of 2008?


Between January 2002 and mid
-
year 2006,
housing prices increased by 87%.


This boom in housing prices was fueled by
several factors including:


government regulations that eroded lending
standards and promoted the purchase of
housing with little or no down payment


heavily leveraged borrowing for the financing
of mortgage
-
backed securities


But, the expansionary Fed policy of 2002
-
2004, followed by the shift to a more
restrictive monetary policy in 2005
-
2006 also
contributed to the housing boom and
subsequent bust.

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Short
-
Term Interest Rates, 1998
-
2009


Rising short
-
term interest rates are indicative of monetary
restriction, while falling rates imply expansion.


Note, how the Fed pushed short
-
term interest rates to historic
lows during 2002
-
2004, and housing prices soared.

Federal Funds

1
-
Year T
-
Bill

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Inflation, 1998
-
2009


As inflation rose in 2005
-
2006, the Fed shifted toward
restriction and pushed short
-
term interest rates upward.


The Fed’s low interest rate policy (2002
-
2004), followed by
its more restrictive policy (2005
-
2006), contributed to the
boom and bust in housing prices, and the Crisis of 2008.

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Current Fed Policy and the Future


As the recession worsened during the second
half of 2008, the Fed shifted toward a highly
expansionary monetary policy.


Vast amounts of reserves were injected into
the banking system, short
-
term interest rates
were pushed to near zero, and the monetary
base was approximately doubled.


Monetary policy works with a lag. It will take
some time for the expansionary monetary
policy to stimulate demand and economic
recovery.

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Current Fed Policy and the Future


The Fed now faces a dilemma: If it shifts
toward restriction too quickly, the recovery
may falter. But, if the Fed continues with the
expansionary monetary policy for too long, it
will lead to serious future inflation.


The problem is not the Fed’s ability to control
the money supply, but its ability to time shifts
properly. Given the long and variable lags, it
is hard for monetary policy
-
makers to institute
stop
-
go policy in a stabilizing manner.


We are in the middle of another great
monetary policy experiment.

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End

Chapter 14