MONETARY POLICYGT01003

Macroeconomics

Learning Objectives

1. Analyze how changes in real interest rates affect planned aggregate expenditures (PAE) and short-run equilibrium output

2. Show how the demand for money and the supply of money determine equilibrium nominal interest rate

3. Discuss how central bank uses control of the money supply to influence nominal and real interest rates

Introduction: Monetary Policy• Monetary policy is a major stabilization tool• Quickly decided and implemented• More flexible and responsive

Introduction: Central Banks• Responsibilities of Central Banks are

• Conduct monetary policy• Oversight and regulation of financial markets

• Central to solving financial crises

Introduction: Central Bank and the Economy

Eliminate output gaps by changing the money supply

Changes in money supply cause changes in nominal interest rate

Interest rates affect planned aggregate expenditures, PAE

HOW DOES INTEREST RATE AFFECT PAE & SHORT-RUN EQUILIBRIUM OUTPUT??

PAE and Real Interest Rate• Planned Aggregate Expenditures have components that

are affected by r• Savings decisions of households

• More saving at higher real interest rates• Higher saving means less consumption

• Investment by firms• Higher interest rates mean less investment

• Investments are made if the cost of borrowing is less than the return on the investment

• Both consumption and planned investment decrease when the interest rate increases

Interest in the Keynesian Model – An Example

• Components of aggregate spending areC = 640 + 0.8 (Y – T) – 400rIP = 250 – 600 r

G = 300

NX = 20

T = 250

• If r increases from 0.04 to 0.05 (that is, from 4% to 5%)• Consumption decreases by 400 (0.01) = 4• Planned investment decreases by 600 (0.01) = 6

• A one percentage point increase in r reduces planned spending by 10 – before the multiplier is considered

Planned Aggregate Expenditures

PAE = C + IP + G + NX

PAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r + 300 + 20

PAE = 1,010 – 1,000 r + 0.8 Y

• In this example, planned aggregate expenditure depends on both the real interest rate and the level of output• Equilibrium output can only be found once we know the value of r

Planned Aggregate Expenditures

PAE = 1,010 – 1,000 r + 0.8 Y• Suppose the real interest rate is 5%, or 0.05• Planned aggregate expenditures becomes

PAE = 1,010 – 1,000 (0.05) + 0.8 Y

PAE = 960 + 0.8 Y• Short-run equilibrium output is PAE = Y

Y = 960 + 0.8 Y

0.2 Y = 960

Y = $4,800• The graphical solution is the same as before

Can Central Bank Control the Real Interest Rates?• Central Bank controls the money supply to control

nominal interest rates, i• Investment and saving decisions are based on the real

interest rate, r• Central bank has some control over the real interest rate

r = i - where is the rate of inflation

• Central Bank has good control over i• Inflation changes relatively slowly

• Changes in nominal rates become changes in real rates

Monetary Policy and Economic Fluctuations

r C, IP PAE Y via the multiplier

r C, IP PAE Y via the multiplier

Recessionary Gap

Expansionary Gap

Central Bank Fights a Recession

Output (Y)

Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

Y = PAE

E

Expenditure line (r = 5%)

4,800

A reduction in r shifts the expenditure line upward and closes the recessionary gap

5,000Y*

Expenditure line (r = 1%)

F

Central Bank Fights Inflation• Expansionary gap can lead to inflation

• Planned spending is greater than normal output levels at the established prices

• Short-run unplanned decreases in inventories• If gap persists, prices will increase

• Central bank attempts to close expansionary gaps• Raise interest rates• Decrease consumption and planned investment• Decrease planned aggregate expenditures• Decrease equilibrium output

Monetary Policy for an Expansionary Gap

PAE = 1,010 – 1,000 r + 0.8 Y• The real interest rate, r, is 5%

• Short-run equilibrium output is $4,800

• Potential output is $4,600• Expansionary gap is $200

• Monetary policy can be used to decrease PAE• The Central Bank should decrease the real interest rate to

9%

Central Bank Fights Inflation

Output (Y)

Pla

nn

ed a

gg

rega

te e

xpe

ndi

ture

(P

AE

)

Y = PAE

E

Expenditure line (r = 5%)

4,800

An increase in r shifts the expenditure line down and closes the expansionary gap

4,600Y*

Expenditure line (r = 9%)

G

Central Bank Fights Inflation

r

Planned C and I

PAE

Y

r

Planned C and I

PAE

Y

Expansionary Gap Recessionary Gap

HOW DO CENTRAL BANKS CONTROL INTEREST RATES?

Central Bank and Interest Rates• Controlling the money supply is the primary task of a

central bank:• Money supply and demand determine the interest rate• Central bank manipulates supply to achieve its desired interest rate

• To better understand how the central bank determines interest rates, we will look first at the market for money – the demand for money and the supply of money.

Demand for Money• Demand for money is sometimes called

an individual's liquidity preference• The Cost – Benefit Principle indicates people

will balance the marginal cost of holding money versus the marginal benefit• Money's benefit is the ability to make

transactions

• Quantity of money demanded increases with income

• Technologies such as online banking and ATMs have reduced the demand for money• M1 has decreased from 28% of GDP in 1960 to

12% in 2004

Demand for Money• Demand for money depends on

• Nominal interest rate (i)• The higher the interest rate, the lower the quantity of money demanded

• Real income or output (Y)• The higher the level of income, the greater the quantity of money

demanded

• The price level (P)• The higher the price level, the greater the quantity of money demanded

Demand for Money• The marginal cost of holding money is the interest

foregone• Most forms of money pay little or no interest

• Assume the nominal interest rate on money is 0• Alternative assets such as stocks or bonds have a positive nominal

interest rate

• The higher the nominal interest rate, the smaller the quantity of money demanded

• Business demand for money is similar to individuals'• Businesses hold more than half of the money stock

The Money Demand Curve• Interaction of the aggregate demand for money and the

supply of money determines the nominal interest rate• The money demand curve shows the relationship

between the aggregate quantity of money demanded, M, and the nominal interest rate• An increase in the

nominal interest rate increases the opportunity cost of holding money• Negative slope

Money (M)

Nom

inal

inte

rest

rat

e (i)

MD

The Money Demand Curve• Changes in factors other than the nominal interest rate

cause a shift in the money demand curve• An increase in demand for money can result from

• An increase in output• Higher price levels• Technological advances• Financial advances• Foreign demand for

dollars

Money (M)Nom

inal

inte

rest

rat

e (i)

MDMD'

Supply of Money• Central bank primarily controls the supply of money with

open-market operations• An open-market purchase of bonds by central bank increases the

money supply (expansionary monetary policy)• An open-market sale of

bonds by central bank decreases the money supply (contractionary monetary policy)

• Supply of money is vertical• Equilibrium is at E

Money (M)

MD

E

MS

M

i

No

min

al in

tere

st r

ate

(i

)

Central Bank Controls the Nominal Interest Rate

• Initial equilibrium at E• Central Bank increases the money

supply to MS'• New equilibrium at F• Interest rated decrease to i'

to convince the marketto hold the new, largeramount of money

Money (M)

MD

MS

M

Ei

Nom

inal

inte

rest

rat

e (i)

Fi'

M'

MS'

Central Bank (CB) Controls the Nominal Interest Rate

CB sells bonds to the public

Supply of bonds increases

Price of bonds decrease

Interest rate increases

To Decrease the Money Supply

CB buys bonds from the public

Demand for bonds increases

Price of bonds increase

Interest rate decreases

To Increase the Money Supply

The US Federal Funds Rate, 1970-2008

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ay-0

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0.5

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1.5

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3.5

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Malaysian Overnight Policy Rates

Overnight Policy Rates

Additional Controls over the Money Supply

• Open market operations are the main tool of money supply

• Central bank offers lending facility to banks• If a bank needs reserves, it can borrow from the

Central Bank at the discount rate

• The discount rate is the rate the Central Bank charges banks to borrow reserves

• Lending increases reserves and ultimately increases the money supply

• Changes in the discount rate signal tightening or loosening of the money supply

Additional Controls over the Money Supply

• Central Bank can also change the reserve requirement for banks• The reserve requirement is the minimum percentage of bank

deposits that must be held in reserves• The reserve requirement is rarely changed

• The Central Bank could increase the money supply by decreasing the reserve requirement• Banks would have excess reserves to loan

• The Central Bank could decrease the money supply by increasing the reserve requirement

Conclusion

Keynesian Model

Open Market Operations

Discount Rate

Reserve Requirement

Money Market

Monetary Policy

Demand for Money

Supply of Money

Central Bank

Stabilization Policy

Interest Rates