Next: Monetary theory and

policy
Every major contraction in this

country has been either

produced by monetary disorder
or greatly exacerbated by
monetary disorder. Every
major inflation has been
produced by monetary
expansion.
--the late Milton Friedman (1967)

So monetary policy has great

capacity to do harm. Why?
And can it do good, as well?
1

The Federal Reserves Goals

What the Fed wants monetary policy to do:

1. Price stability
2. High employment
3. Stability of financial markets and institutions
4.Economic growth

And after the inflationary 70s (we were all

Keynesians), it seemed pretty successful
we called this the Great Moderation til
the Great Recession of 2007-09 hit
What went wrong (or right)?
2

Nominal GDP growth rates

since 1960

The Monetary Transmission

Mechanism
As we said (in Ch. 14), the Fed can control

money growth via (1) Open Mkt Ops, (2)

Discount Rate, (3) Reqd Reserve Ratio
Now we need to take a closer look at how
these tools actually work, i.e.:

How money demand and money supply interact in

the money market;
How this affects interest rates;
How interest rates affect AD & AS, and therefore
prices, output, and employment
4

Figure 15.2

The Demand for Money

The money demand curve slopes downward because lower interest rates cause households
and firms to switch from financial assets, such as U.S. Treasury bills, to money.
All other things being equal, a fall in the interest rate from 4 percent to 3 percent will increase
the quantity of money demanded from $900 billion to $950 billion.
An increase in the interest rate will decrease the quantity of money demanded.

The interest rate is the opportunity cost, or what you forgo, to hold money.

Figure 15.3

Shifts in the Money Demand Curve

Changes in real GDP or the price level cause the money demand curve to shift.
1.An increase in real GDP or an increase in the price level will cause the money demand
curve to shift from MD1 to MD2.
2.A decrease in real GDP or a decrease in the price level will cause the money demand
curve to shift from MD1 to MD3.

Figure 15.4

The Effect on the Interest Rate

When the Fed Increases the
Money Supply
When the Fed increases the
money supply, households and
firms will initially hold more
money than they want, relative
to other financial assets.
Households and firms use the
money they dont want to hold
to buy Treasury bills and make
deposits in interest-paying
bank accounts.
This increase in demand allows
banks and sellers of Treasury
bills and similar securities to
offer lower interest rates.
Eventually, interest rates will fall enough that households and firms will be willing to hold the
additional money the Fed has created.
In the figure, an increase in the money supply from $900 billion to $950 billion causes the
money supply curve to shift to the right, from MS1 to MS2,
and causes the equilibrium interest rate to fall from 4 percent to 3 percent.

Figure 15.5

The Effect on Interest Rates When

the Fed Decreases Money Supply
When the Fed decreases the
money supply, households and
firms will initially hold less
money than they want, relative
to other financial assets.
Households and firms will sell
Treasury bills and other
financial assets and withdraw
money from interest-paying
bank accounts.
These actions will increase
interest rates.
Eventually, interest rates will
rise to the point at which
households and firms will be
willing to hold the smaller
amount of money that results
from the Feds actions.
In the figure, a reduction in the money supply from $900 billion to $850 billion causes the
money supply curve to shift to the left, from MS1 to MS2,
and causes the equilibrium interest rate to rise from 4 percent to 5 percent.

A tale of two interest rates (i

In the loanable
funds market, lenders and borrowers are concerned
and
r)
with the long-term real rate of interest (call it r)as the relevant price

of the good (credit) they are exchanging while in the

(aforementioned) money market transactors are concerned with the
short-term nominal rate of interest (call it i)
But theres often a close connection between their movements (see
following graphics).

The long-term real rate of interest r is the interest rate that is most
relevant when:
Savers consider purchasing a long-term financial investment
Firms borrow to finance long-term investment projects
Households take out mortgage loans
When conducting monetary policy, however, the short-term nominal
interest rate i is most relevant because it is the interest rate most
affected by increases and decreases in the money supply.

Tracing effects of M (first, expansion)

Suppose the Fed buys bonds in open mkt, so M. In the money

mkt, this shifts S1 to S2 , i , and banks reserves .

In the loanable funds mkt, banks use their new reserves to offer new
loans to households and businesses, so the supply of loanable funds
(shifting S1 to S2), and r .
Money
interest
rate

Real
interest
rate

S1 S2

i1

r1

i2

r2

S1
S2

D1
Qs

Qb

Quantity
of money

D
Q1

Q2

Qty of
loanable
funds

Monetary expansion (cont.)

As i and r , AD (to AD2). And since the M expansion was

unanticipated, the AD leads to a short-run in output (from Y1 to Y2)
and in the price level inflation.

So: monetary policy is transmitted mostly through interest rates

(but also through exchange rates and asset prices).
Real
interest
rate

Price
Level

S1

AS1

S2

r1

P2
P1

r2

D
Q1

Q2

AD2
Qty of
loanable
funds

AD1
Y1 Y2

Goods &
Services
(real GDP)

But notice

In the previous AD-AS picture, we didnt draw

the LRAS curve
Didnt say whether we were starting at full
employment, below it, or above it i.e., didnt
say whether Y1 or Y2 = Yf
Thats a key question: If we start stimulating
AD when theres slack, were doing good; if we
start when theres none, were destabilizing
the economy and inflating*
*Why on earth would we ever do that?
12

Monetar
y
expansi
on
with
slack

Price
Level

LRAS
SRAS1

P2
P1

E2
e1

AD1
Y 1 YF

AD2
Goods & Services
(real GDP)

If the increase in AD accompanying expansionary monetary policy is

felt when the economy is operating below capacity, the policy may
help direct the economy toward long-run full-employment equilibrium
YF if the timings right (i.e., before SRAS shifts ).
13

Monetar
y
expansio
n
at Yf

Price
Level

LRAS
SRAS1

P2
P1

e2
E1

AD1
YF Y2

AD2

Goods & Services

(real GDP)

But if the demand-stimulus effects are imposed on an

economy already at full-employment YF, they will lead to
excess demand, higher product prices, and temporarily higher
output Y2.
14

And in
the
Long
Run

Price
Level

LRAS

SRAS2
SRAS1

P3

E3

P2
P1

e2
E1

AD1
YF Y2

AD2

Goods & Services

(real GDP)

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

SRAS1 to SRAS2.

P rises to P3 and output falls back to full-employment output again (YF

from its temporary high,Y2).
15

Timing is everything

Proper diagnosis and timing of monetary

policy aint easy.
While the Fed can change monetary policy
rapidly, there may be a non-trivial time lag
before the change will impact AD.
So, even if the Fed is starting with slack in
the economy, if SRAS has begun to shift
before AD, then trouble happens.

For you to do: work through effects of contractionary monetary policy

in money, loanable funds, and final goods markets.

Figure 15.8

The Effect of a Poorly Timed Monetary Policy on the Economy

The upward-sloping straight line represents the long-run growth trend in real GDP.
The curved red line represents the path real GDP takes because of the business cycle.
If the Fed is too late in implementing a change in monetary policy,
real GDP will follow the curved blue line.
The Feds expansionary monetary policy results in too great an increase in aggregate
demand during the next expansion, which causes an increase in the inflation rate.

Making
the

Connection

Trying to Hit a Moving Target: Making Policy with RealTime Data

In addition to the other problems the Federal Reserve encounters in successfully conducting
monetary policy, it must make decisions using data that may be subject to substantial
revisions.
MyEconLab Your Turn:

Test your understanding by doing related problems 3.13 and 3.14 at the end of this chapter.

Notice also: our two

interest rates
and
not
in
(i
When
ther)
fedmay
increases
M, move
that puts SR
downward pressure on nominal interest rate i
lockstep

But remember:
i = r + expected inflation
Over time, increases in M (or M growth)
inflation that is built into expectations
So: M i in SR, but P and eventual i
Fed has to be careful not to over-expand M

Money growth, i, and r in SR

and LR

20

Summary: Interest rates and monetary policy

While the Fed can affect real interest rate r in the short
term, its impact on long-term rates is limited to nominal
rate i and not necessarily in a good way!
I.e., its naive to advocate, e.g., that the Fed should cut
interest rates so I can afford a house in a few years!
In the long run, expansionary monetary policy leads
to inflation and high nominal interest rates, rather than
low interest rates.
Similarly, restrictive monetary policy, when pursued
over a lengthy time period, leads to low inflation and
low nominal interest rates.
I.e., monetary policy tends to be neutral in the long
run with respect to real variables (like r)

A Summary of How Monetary Policy Works (at least in the SR)

Table 15.1

Expansionary and Contractionary Monetary Policies

The arrows point to the steps involved in the policy that occur relative to what
would have happened without the policy.

Why Doesnt the Fed Target Both the Money Supply and the Interest
Rate?
Figure 15.11

The Fed Cant Target Both

the Money Supply and
the Interest Rate
The Fed is forced to
choose between using
either an interest rate or
the money supply as its
monetary policy target.
In this figure, the Fed can
set a target of $900 billion
for the money supply
or a target of 5 percent
for the interest rate,
but the Fed cant hit both
targets because it can
achieve only combinations
of the interest rate and the money supply that represent equilibrium in the money market.

A case study: The Great

Depression and
the
Quantity
Theory
of Money
Popular
wisdom
on the Depression:

The Roaring 20s bubble burst;

Social inequality economic instability
Autonomous decline in C, I
Maintenance of gold standard crisis in foreign
exchange markets

Visuals: Commanding Heights, Chs. 4 & 5

24

Monetary Origins of the

Depression

Quantity Equation (% change form):

M/M + V/V = P/P + Y/Y
1923-28 values:
+4.4% + 0.1% = +0.3% + 4.2%
But Fed saw excessive speculation as a
problem it decided to solve with a contraction
of M starting in April, 1928

25

The Great Contraction

Money growth rates:

4/28 4/29: -1.0%
4/29 4/30: -0.9%
4/30 4/31: -4.3%
4/31 4/32: -19.0%!!!
4/32 4/33: -15.9%

26

How does monetary contraction

turn to Depression?

Effects on bank lending

SR effects on nominal/real interest rates
Effects on AD, real GDP, corporate profits,
and stock prices
Effects on confidence and reliance on the
banking system (The Great Panic?) and
Feds failure to act as lender of last resort

27

The Great Depression

Quantity Equation (% change form):

M/M + V/V = P/P + Y/Y
1928-33 values:
-8.2% - 2.9% = -5.1% - 6.0%

28

Total employed, U.S., 192040

29

Compounding factors

SmootHawley Tariff Act (1930)

And retaliation from abroad

1932 federal tax increase (reflecting preKeynesian fixation on balanced budgets)

Reductions in state and local govt spending
(balanced budget reqs.)

30

1933-37 Recovery

Real output grew 9%/year

over 33-37, and
unemployment rate fell to
14%
Did the New Deal help or
hurt? Yes to both.
1937: another Fed blunder
doubling of required
reserve ratio to reclassify
excess reserves

31

Correcting some myths

of the Great Depression

Onset can be laid at feet of

monetary policy-makersnot at
contradictions of capitalism,
etc.
Severity traced to Feds
continued failures and to
additional policy errors by
legislative and executive
branches
New Deal had ambiguous
effects, but hardly hastened
recovery
Recovery started well before WWII

32

Another Case Study: Who Caused the

Crisis of 2008?

This time around, relatively few blame rising

inequality and the contradictions of capitalism
(though there are a few Marxist profs who will
talk about this!)
Rather, most blame:

Unregulated, evil bankers who forced unsuspecting

homeowners to borrow (unwisely) to speculate in real
estate markets
This inflated a housing bubble, which inevitably
popped and destroyed a lot of equity, which in turn
reduced AD and started us on our downward slide

But the reality is a little more complicated

Home prices, 1900-today. See

anything odd?

34

Maex: Who spiked the

punch?
What function does Wall Street serve?

What
good are financial instruments like stocks?
What good are more sophisticated
instruments like options or mortgage-backed
securities?
What institutional changes did we make that
created problems in the markets for these
instruments?

35

The Changing Mortgage Market

90s: Congress believed that home ownership could be increased by creating a
secondary market in mortgages, where banks and savings and loans could resell
mortgages so individual investors could provide funds for them to grant more
mortgages.
One barrier to creating this secondary market was that most investors were
unwilling to buy mortgages because they were afraid of losing money if the
borrower stopped making payments, or defaulted, on the loan.
To reassure investors, Congress used two government-sponsored enterprises
(GSEs):
The Federal National Mortgage Association (Fannie Mae)
The Federal Home Loan Mortgage Corporation (Freddie Mac)
By the 1990s, a large secondary market existed in mortgages, with funds
flowing from investors through Fannie Mae and Freddie Mac to banks and,
ultimately, to individuals and families borrowing money to buy houses.

And 2 key problems soon

arise

Moral hazard

Mortgage lenders can pass their risks along to

Fannie and Freddie (and others via mortgagebacked securities or MBSs), so they now have an
incentive to make riskier loans, since Fannie and
Freddie are now on the hook for losses

Adverse selection

Lenders also had an incentive to package the

worst of these loans to the GSEs and suckers
who were buying the MBSs

And Fed adds fuel: i, 19982009

Federal Funds
1-Year T-Bill

Rising short-term interest rates are indicative of monetary restriction,

while falling rates imply expansion; note how the Fed pushed shortterm interest rates to historic lows during 2002-2004, as housing prices
soared.

Inflation, 1998-2009

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

Making We eagerly enter The Wonderful World of Leverage

the

Connection

During the housing boom, many people

purchased houses with down payments equal to 5 percent
or less of the price, as opposed to the 20 percent
traditionally expected.
In this sense, borrowers were highly leveraged, which
means that their investment in their house was made
mostly with borrowed money.
An investment financed at least partly by borrowing is
called a leveraged investment.

Making a very small down payment on a

home mortgage leaves a buyer
vulnerable to falling house prices.

Return on your Investment from . . .

Down Payment
100%

A 10 Percent Increase in the

Price of Your House

A 10 Percent Decrease in the

Price of Your House

10%

10%

20

50

50

10

100

100

200

200

The equity in your house is the difference between the market price of the house and the
amount you owe on a loan; if the latter is greater than the former, you have negative equity,
and are said to be upside down on your mortgage.
MyEconLab Your Turn:

Test your understanding by doing related problem 6.8 at the end of this chapter.

Bad times. But why is

recovery so slow?

AN

INSIDE
LOOK
AT
POLICY

Fed Tries (hard!) to Stimulate Housing Market . . . Again

The average annual rates for federal funds, 30-year mortgages, and 10- and 30-year
Treasury securities from 2001 through September 2011.

But maybe money growth

isnt as rapid as we think?

Low fed funds rate easy money

But look at banks balance sheets: theyre not
actually making a lot of loans to public,
instead using reserves to buy govt bonds
(hey, theyre safe and source of profit)
In addition, post-Recession regulations may
have inhibited lending (credit crunch)
So look at alternative Divisia measures of M

Divisia moneys not so

easy