Chapter 10
Monetary Policy
and Aggregate
Demand
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Preview
• To understand the positive relationship
between real interest rates and inflation,
which is called the monetary policy (MP)
curve
• To develop the aggregate demand curve
using the monetary policy curve and the
IS curve
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-2
The Federal Reserve and
Monetary Policy
• The Fed of the United States conducts
monetary policy by setting the federal funds
rate—the interest rate at which banks lend to
each other
e
r

i


• Because the real interest rate is
(Chapter 2), and if prices are sticky, changes
in monetary policy does not immediately
affect inflation and expected inflation
• When the Federal Reserve lowers the federal
funds rate, real interest rates fall; and when
the Federal Reserve raises the federal funds
rate, real interest rates rise.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-3
The Monetary Policy Curve
• The monetary policy (MP) curve shows
how monetary policy, measured by the real
interest rate, reacts to the inflation rate,  :
r  r  
where
r  autonomous component of r
  responsiveness of r to inflation
• The MP curve is upward sloping: real interest
rates rise when the inflation rate rises
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-4
FIGURE 10.1 The Monetary Policy
Curve
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-5
The Taylor Principle: Why the Monetary
Policy Curve Has an Upward Slope
• The key reason for an upward sloping MP
curve is that central banks seek to keep
inflation stable
• Taylor principle: To stabilize inflation,
central banks must raise nominal interest
rates by more than any rise in expected
inflation, so that r rises when  rises
• Schematically, if a central bank allows r to
fall when  rises, then (Y ad =AD) :
  r  Y
ad
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
   r  Y
ad
 
10-6
Shifts in the MP Curve
• Two types of monetary policy actions that
affect interest rates:
1. Automatic (Taylor principle) changes as
reflected by movements along the MP curve
2. Autonomous changes that shift the MP curve
–
–
Autonomous tightening of monetary policy that
shifts the MP curve upward (in order to reduce
inflation)
Autonomous easing of monetary policy that
shifts the MP curve downward (in order to stimulate
the economy)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-7
FIGURE 10.2 Shifts in the Monetary
Policy Curve
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-8
Policy and Practice: Autonomous Monetary
Easing at the Onset of the 2007-2009
Financial Crisis
• When the financial crisis started in August 2007,
inflation was rising and economic growth was
quite strong
• The MP curve would have suggested that the
Fed would continue to keep raising the federal
funds rate
• Instead the Fed lowered the federal funds rate
• This reflects that the Fed pursued autonomous
monetary policy easing, thus shifting the MP
curve down, because the Fed perceived the
economy to weaken in the near future due to
the financial crisis
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-9
FIGURE 10.3 The Inflation Rate and
the Federal Funds Rate, 2007-2010
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-10
The Aggregate Demand Curve
• The aggregate demand curve represents the
relationship between the inflation rate and
aggregate demand when the goods market
is in equilibrium
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-11
Deriving the Aggregate Demand
Curve Graphically
• The AD curve is derived from:
– The MP curve
– The IS curve
• The AD curve has a downward slope: As
inflation rises, the real interest rate rises, so
that spending and equilibrium aggregate
output fall
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-12
FIGURE 10.4 Deriving the AD Curve
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-13
Box: Deriving the Aggregate Demand
Curve Algebraically
• The numerical version of the AD curve can be derived from (1)
the numerical IS curve from Chapter 9 (Y  12  r ) , and (2)
then substituting in for r from the numerical MP curve
(r  1.0  0.5) :
Y  12  (1.0  0.5)  (12  1)  0.5  11  0.5
• Similarly, the general version of the AD curve can be derived by
substituting in for r from the MP curve
using
the
(r  r  
)
algebraic version of the IS curve in Chapter 9:
Y  [C  I  G  NX  mpc  T ] 
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
1
cdx

 (r  )
1  mpc 1  mpc
10-14
Factors that Shift the Aggregate
Demand Curve
• Shifts in the IS curve
1.
2.
3.
4.
5.
Autonomous consumption expenditure
Autonomous investment spending
Government purchases
Taxes
Autonomous net exports
• Any factor that shifts the IS curve shifts the
aggregate demand curve in the same
direction
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-15
FIGURE 10.5 Shift in the AD Curve
From Shifts in the IS Curve
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-16
Factors that Shift the Aggregate
Demand Curve (cont’d)
• Shifts in the MP curve
– An autonomous tightening of monetary policy,
that is a rise in real interest rate at any given
inflation rate, shifts the aggregate demand
curve to the left
– Similarly, an autonomous easing of monetary
policy shifts the aggregate demand curve to the
right
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-17
FIGURE 10.6 Shift in the AD Curve From
Autonomous Monetary Policy Tightening
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-18
The Money Market and Interest
Rates
• The liquidity preference framework
determines the equilibrium nominal
interest rate by equating the supply of and
demand for money
• John Maynard Keynes developed a theory
of money demand that he described as
liquidity preference theory
• Real money balances—the quantity of
money in real terms—reflect how much
money people want to hold (demand)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-19
Liquidity Preference and the Demand
for Money
• According to Keynes, the demand for
money can be expressed in the form of the
liquidity preference function:
M d / P  L(i , Y )

where
i = nominal interest rate
Y = nominal income
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-20
Liquidity Preference and the Demand
for Money (cont’d)
• Why are real money balances negatively
related to i?
– i represents the opportunity cost of holding
money
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-21
Liquidity Preference and the Demand
for Money (cont’d)
• Why are real money balances positively
related to Y?
– As income rises, households and firms conduct
more transactions and so keep more money on
hand to make purchases
– Higher incomes make households and firms
wealthier, and the wealthy tend to hold larger
quantities of all financial assets, including money
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-22
Demand Curve for Money
• In short-run analysis, prices are assumed to
be sticky so the price level is fixed at P
• All else being equal, lower real interest rates
mean the opportunity cost of holding money
falls, so that firms and households desire to
higher quantities of real money balances
• As a result, the demand curve for money
slopes downward
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-23
Supply Curve for Money
• The Fed fixes the money supply by open
market operations
• When the Fed buys (sells) government
securities in open market operations, it
increases (decreases) deposits at banks, so
that bank reserves and liquidity in the
banking system increase (decrease)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-24
Supply Curve for Money
• An open market purchase leads to an
increase in liquidity and the money supply
• An open market sale of government
securities leads to a decrease in liquidity
and a decrease in the money supply
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-25
Supply Curve for Money (cont’d)
• The supply curve for money (MS) shows the
quantity of real money balances supplied at
each price level
• The line MS is a vertical line because:
– The money supply is fixed by the Fed at M
– The price level in the short run is fixed at P
– Thus, the quantity of real money balances
supplied is M s / P  M / P
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-26
FIGURE 10.7 Equilibrium in the
Money Market
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-27
Equilibrium in the Money Market
• Equilibrium in the money market occurs
when the quantity of real money balances
demanded equals the quantity of real money
balances supplied:
Md Ms

P
P
• Graphically, equilibrium occurs where MD
and MS curves intersect at i*
• An excess supply (demand) of money results
in a decrease (an increase) in i
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-28
Changes in the Equilibrium Interest
Rate
• A shift in the MD (or MS) curve occurs when
the quantity demanded (or supplied)
changes at each given interest rate in
response to a change in some other factor
besides the interest rate
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-29
Changes in the Equilibrium Interest
Rate (cont’d)
• Examples of factors that shifts the MD or
MS:
– When income rises, MD shifts to the right and
so interest rates will rise
– When the money supply increases, MS shifts to
the right and so interest rates will decline
– When the price level rises, MS shifts to the
right and so interest rates will rise
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-30
FIGURE 10.8 Response to Shift in the
Demand Curve from a Rise in Income
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-31
FIGURE 10.9 Response to Shifts in
the Supply Curve (a)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-32
FIGURE 10.9 Response to Shifts in
the Supply Curve (b)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-33
Chapter 10
Appendix
The Demand
for Money
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Keynesian Theories of Money
Demand
• Three motives behind the demand for money
in Keynes’ liquidity preference theory:
1. Transactions motive
•
•
People hold money to carry out everyday transactions
Affected by payment technology (e.g., credit cards)
2. Precautionary motive
•
Money holding as a cushion against unexpected needs
•
Proportional to income, Y
3. Speculative motive
•
•
Money as a store of wealth
As the interest rate i rises, the opportunity cost of
money rises (it is more costly to hold money relative
to bonds) and the quantity of money demanded falls
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-35
Putting the Three Motives Together
• Keynes’ liquidity preference function that
combines the 3 motives together:
Md
 L(i, Y )
P

• An important implication is that velocity, V, is
not a constant buy will fluctuate with changes
in interest rates. This is because P / M d  1/ L(i, Y ),
so that (assuming Md=M):
V
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
PY
Y

M
L(i, Y )
10-36
Portfolio Theories of Money
Demand
• In Keynes’ portfolio theories of money
demand, the main determinants of the demand
for an asset:
1. Wealth—total resources owned by individuals,
including all assets
2. Expected return—the return expected on the
asset relative to other assets
3. Risk—the degree of uncertainty associated with
the return on the asset relative to other assets.
Most people do not like risk (risk averse)
4. Liquidity—the ease and speed with which an
asset can be turned into cash relative to other
assets
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-37
Portfolio Theory and Keynesian
Liquidity Preference
• Portfolio theory justifies Keynesian liquidity
preference theory as the demand for real
money balances in both theories is:
– positively related to income
– negatively related to the nominal interest rate
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-38
Other Factors That Affect the
Demand for Money
• Wealth
– Portfolio theory posits that as wealth increases,
investors have more resources to purchase
assets, increasing the demand for money (such
as M1, known as dominated assets because
they are perceived as safe)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-39
Other Factors That Affect the
Demand for Money (cont’d)
• Risk
– When the stock market becomes more volatile,
the demand for money, which is perceived as
less risky, increases
– An increase in the variability of the real return
on money reduces its money as people shift
into alternative assets as inflation hedges
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-40
Other Factors That Affect the
Demand for Money (cont’d)
• Liquidity of other assets
– The development of new liquidity assets, e.g.,
money market mutual funds, reduces the
relative liquidity of money, so that the demand
for money falls
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-41
TABLE 10A1.1 Factors That
Determine the Demand for Money
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-42
Empirical Evidence on the
Demand for Money
• Is the demand for money sensitive to
changes in interest rates?
– The liquidity trap is an extreme case of
ultrasensitivity in the demand for money to
interest rates, implying that a change in the
money supply has no effect on interest rates
– There is little evidence of a liquidity trap, except
in recent years when interest rates fell to near
zero
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-43
Empirical Evidence on the
Demand for Money (cont’d)
• Is the demand for money function stable?
– By the early 1970s, evidence strongly
supported the stability of the money demand
function.
– After 1973, there is evidence substantial
instability in estimated money demand
functions because of the rapid pace of financial
innovation, which changed which items could be
used for money.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
10-44