Macroeconomics

Unit 15 Monetary Policy and Theory The Top Five Concepts

Introduction
This unit discusses another economic policy tool called monetary theory. Similar to fiscal policy or Keynesian theory it focuses on demand. However, its main emphasis is controlling the demand for money by consumers and businesses.

In the United States, monetary policy and the tools used to control the supply of money are controlled and implemented by the Federal Reserve.

Concept 1: The Money Market

Money is confronted with its own demand and supply curve. The demand and supply of money is controlled through the interest rate. The interest rate in this case is the price paid for the use of money. The amount of money demanded is based upon the interest rate. Think of the interest rate as the cost of money. When interest rates are low, borrowing money to buy a home or car is less expensive. When interest rates are higher, your cost (and monthly payment) increases. There are three types of demand for money: transactions, precautionary, and speculative.

Concept 1: Money Demand

Transactions demand This is money that is being held for the purpose of making everyday market purchases.

Examples of routine market purchases include paying for gas, buying lunch, shopping for clothes, buying a home.
Payments are made using cash, check, debit card, credit card, and loans. Think about the money that you have in your wallet or purse, and in your checking account. Chances are this money is for your routine transactions that occur every day.

Concept 1: Money Demand

Precautionary demand This is money held in reserve for unexpected needs or purchases, and emergencies.

Examples include money held in certificates of deposit, extra cash kept in a checking account, and extra cash kept in a money market account or a savings account.
Uses of money for precautionary demand included unexpected illnesses, a great deal on some new electronic equipment, or the unexpected loss of a car or home not adequately covered by insurance. Most people think of this money as their emergency money although it can also be used to take advantage of a great bargain.

Concept 1: Money Demand

Speculative demand This is the money you keep in reserve for later financial opportunities or speculation. For example, extra cash in the bank reserved for when stocks fall to a certain price. Its also the extra cash being held to buy some property when the price falls enough. Or, it could be the extra cash you use to invest in a friends business.

Concept 1: Money Demand

The three different types of demand affect the market demand for money.

The market demand curve for money indicates that as the price of money falls (the cost in terms of the interest rate), the demand for money will increase.
The supply of money is fixed by current monetary policy initiated and controlled by the Federal Reserve. So in regards to the money supply, the supply curve is vertical, while the demand for money is a downward sloping curve.

The Demand For Money

Interest Rate (percent per year)

Money supply The amount of money demanded (held) depends on interest rates Equilibrium Money demand

0
Quantity Of Money (billions of dollars)

Concept 2: Money Equilibrium

At the equilibrium point the demand and supply of money intersect indicating that people are willing to hold as much money as is available. If interest rates increase, then money will be transferred to other markets, like the bond market. The demand for money falls. The equilibrium point represents the equilibrium rate of interest indicating the interest rate at which the demand and supply of money are equal.

Concept 2: Changes to Equilibrium

Federal Reserve policy can have an impact on the equilibrium rate of interest.

The Federal Reserve can increase the supply of money by:

lowering the reserve requirement lowering the discount rate buying bonds in the open market The increase in the supply of money causes the equilibrium rate of interest to fall.

Changing Interest Rates

When rates drop from 7% to 6%, there is movement along the demand curve to the right. The demand for money increases. Interest Rate(percent per year)

7 6

E1

E2

Demand for money

0
Quantity Of Money (billions of dollars)

Economic Effects
Federal Reserve policy changes have an effect on aggregate demand. Monetary stimulus is achieved by the Federal Reserve through: Increasing the supply of money. Reducing interest rates. Buying bonds in the market. As a rule, a 1/10 point reduction in long-term interest rates can produce $10 billion dollars in fiscal stimulus according to Alan Greenspan, former chair of the Federal Reserve.

Economic Effects
Federal Reserve policy can also be used to restrain the economy.

To reduce aggregate demand, the Federal Reserve can:

Decrease the money supply. Increase interest rates. Sell more bonds at attractive prices. All three policy changes will cause a leftward shift in aggregate demand.

Concept 3: Policy Constraints

Changes in short-term interest rates (federal funds rates, 6 month Treasury bonds) need to produce changes in long-term interest rates. Long-term interest rates are the rates on home mortgages, installment loans, 10 year Treasury bonds, etc. Most Federal Reserve Open Market operations focus on shortterm rates. In order to have a lasting effect on the economy, long-term rates need to change as well as short-term rates. The success of Federal Reserve policy changes is often measured by changes in long-term interest rates.

Concept 3: Policy Constraints

Long-term rates may not change as fast or as much due to the following:

Reluctant Lenders Private banks may not be willing to increase their lending activity. They may be concerned about consumer or business credit quality and/or general economic conditions.
Liquidity Trap If interest rates are already low, people may continue to hold money waiting for better investment options, and not seek loans or conduct additional spending. At this point the demand curve is horizontal and increases in the supply of money do not push rates lower.

Concept 3: Policy Constraints

Long-term rates also may not change due to low expectations. If businesses do not believe that the demand for goods and services will increase, they may curtail investment spending until economic conditions improve. Any further interest rate reductions may not produce an increase in demand at this point demand is inelastic until expectations change. The U.S. economy during 2002 2003 had some of the lowest interest rates in the last 40 years. Expectations of future growth remained pessimistic until consumer and business spending increased significantly during the third and fourth quarters of 2003.

Concept 4: Monetarists
Keynes believed changes in the money supply can affect aggregate demand. Changes in the supply of money occur when interest rates change. Monetarists believe that changes in short-term interest rates (like the discount rate and federal funds rate) do not have a significant effect on the supply of money. They believe the changes in these rates affect the price of money. Monetarists believe that monetary policy is not effective for recessionary problems, but is effective against inflation.

Concept 4: Monetarists
Monetary policy can be viewed as a relationship between four variables according to Monetarists. The relationship is expressed by the equation of exchange. The equation of exchange shows the relationship between four variables that affect monetary policy.

MV = PQ is the equation of exchange.

M = quantity of money in circulation V = the velocity of money in circulation P = average price of goods Q = quantity of goods purchased

Concept 4: Equation of Exchange

V indicates the number of times per year, on average, a dollar is used to purchase final goods and services. Monetarists believe that V is stable and does not change over the long run. MXV=PXQ Any change that occurs in M indicates a change will also occur in P and/or Q. The equation must remain in balance.

Monetarists believe that any change in the supply of money (M) will alter total spending (PQ), even if interest rates change.

Concept 5: Monetary Theory

Monetarists believe that Federal Reserve policy should be directed at increasing/decreasing the supply of money, not at changing interest rates. Expanding upon the basic theories of monetarists, some believe that Q is stable too. Under this theory, a natural rate of unemployment exists within the economy that is not affected by short term monetary policy changes. If this is true, then some monetarists believe that changes in M will lead to changes only in P.

Concept 5: Monetary Theory

In regards to interest rates, the real rate of interest is important to Monetarists. The real interest rate is the nominal interest rate minus anticipated inflation. For example, if the nominal or current rate of interest is 4% and the anticipated inflation rate is 2%, the real rate of interest = 4% - 2% = 2%. The real rate of interest tells you if, after a year, you actually gained or lost money. For example, if a bank wishes to receive a 5% return (profit) on a loan when the inflation rate is 3%, then the bank should charge an interest rate of 8%. This nominal rate of 8% has a real rate of interest of 5% after inflation.

Concept 5: Monetary Theory

Monetarists believe that the real rate of interest is stable and that changes in nominal interest rates are caused by changes in the anticipated rate of inflation. If inflation exists, monetarists believe that a reduction in the supply of money will lessen inflation. As the supply of money is gradually reduced by the Federal Reserve through open market operations and/or changes in the reserve ratio, nominal interest rates will fall. Keynesians believe that increasing interest rates (discount and federal funds rate) is an effective method to lessen inflation.

Concept 5: Monetary Policy

For recessionary problems, monetarists believe that increasing the supply of money or reducing interest rates is not an effective way to end recessions. Keynesians believe that lowering rates and increasing the supply of money (M) can help eliminate a recession, along with fiscal policy changes. Monetarists believe that increasing the supply of money (M) could cause an increase in prices (P). Rising prices and interest rates would stall any economic recovery.

Monetarists Keynesians Comparison

Monetarists Changes in interest rates do not affect the supply of money. To change the money supply, you need to change bond prices through the buying and selling of bonds by the Federal Reserve, or change the bank reserve requirements (reserve ratio). Keynesians Changes in interest rates do affect the supply and demand for money. They prefer interest rate changes but will also support selling/buying of bonds to change the supply of money. Interest rate changes are used to supplement fiscal policy tools (government spending, taxes, transfer payments).

Further Analysis
When interest rates fall, borrowers are very happy. Interest rates on mortgages and car loans fall which increases lending activity and new purchases. Banks and other lenders receive lower income from lending activity as interest rates fall. However it is important to examine the real rate of interest again. During a period of higher rates, a bank may have been loaning money for mortgages at 9% when inflation was at 6%; the real rate of interest is 3%. If both nominal interest rates and the inflation rate falls, the bank may be loaning money for mortgages at 5%, but if the rate of inflation is only 2%, then the real rate of interest remains at 3%.

Further Analysis
So is anyone not happy about lower interest rates? Well the banks and other lenders may not be if the real interest rate has fallen. Their profits are likely to be lower. Individuals who have investments in savings account, CDs, money market accounts, and Treasury bills will receive lower rates of interest on their savings and investments. Their incomes will be lower as a result.

Summary Demand for money (3). Equilibrium rate of interest. Monetary stimulus and constraints. Real interest rate. Equation of Exchange. Keynesian view of monetary policy. Monetarist view of monetary policy.