Chapter 17
Domestic and
International
Dimensions of
Monetary Policy
Introduction
It is up to the Federal Reserve Board
of Governors to determine whether
the pace of money supply growth will
be aimed at maintaining a steady rate
of inflation. If so, then the interest
rate will fluctuate. Why are these two
variables related?
Slide 17-2
Learning Objectives
 Identify the key factors that influence the
quantity of money that people desire to hold
 Describe how the Federal Reserve’s tools of
monetary policy affect the level of real GDP
and the price level
 Evaluate how expansionary and
contractionary monetary policy actions affect
equilibrium real GDP and the price level in
the short run
Slide 17-3
Learning Objectives
 Understand the equation of exchange and
its importance in the crude quantity theory of
money and prices
 Distinguish between the Keynesian and
monetarist views on the transmission
mechanism of monetary policy
 Explain why the Federal Reserve cannot
stabilize both the money supply and the
interest rate simultaneously
Slide 17-4
Chapter Outline
 What’s So Special About Money?
 The Tools of Monetary Policy
 Effects of an Increase in the Money
Supply
 Open Economy Transmission of
Monetary Policy
Slide 17-5
Chapter Outline
 Monetary Policy and Inflation
 Monetary Policy in Action: The Transmission
Mechanism
 Fed Target Choice: Interest Rates or Money
Supply?
 The Way Fed Policy is Currently Announced
Slide 17-6
Did You Know That…
 The European Central Bank oversees
the EMU money supply, including
transaction account balances held
within the member nations?
 The level of the money supply in an
economy will affect the position of the
aggregate demand curve?
Slide 17-7
What’s So Special About Money?
 Money is the product of a “social
contract” in which we all agree to:
– Express all prices in terms of a common
unit of account, which in the United
States we call the dollar
– Use a specific medium of exchange for
market transactions
Slide 17-8
What’s So Special About Money?
 Anything that affects the amount of
money in existence is going to affect all
markets.
 Holding money
– To use money, one must hold money.
 If people desire to hold money, there is
a demand for money.
Slide 17-9
What’s So Special About Money?
 The demand for money: the amount of
money people wish to hold
– Transactions demand
– Precautionary demand
– Asset demand
Slide 17-10
What’s So Special About Money?
 Transactions Demand
– Holding money as a medium of
exchange to make payments
– The level varies directly with nominal
national income
Slide 17-11
What’s So Special About Money?
 Precautionary Demand
– Holding money to meet unplanned
expenditures and emergencies
– The level varies with the interest rate
Slide 17-12
What’s So Special About Money?
 Asset Demand
– Holding money as a store of value
instead of other assets
– The level varies with the interest rate
Slide 17-13
What’s So Special About Money?
 The demand for money curve
– The amount of money demanded for
transactions purposes is fixed given the
level of income
– Precautionary and asset demand are
determined by the opportunity cost of
holding money (the interest rate)
Slide 17-14
Interest Rate
The Demand for Money Curve
Md
Quantity of Money
Figure 17-1
Slide 17-15
The Demand for Money Curve
B
Interest Rate
r2
• When the interest rate rises the
opportunity cost of holding money
increases and the quantity of money
demanded falls
• The location of Md is determined by
the level of income
A
r1
Md
Q1
Q2
Quantity of Money
Slide 17-16
The Tools of Monetary Policy
 Open market operations
– The Fed changes reserves by buying and
selling government bonds issued by the
U.S. Treasury.
Slide 17-17
Determining the Price of Bonds
S1
Price of Bonds
P1
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (a)
Slide 17-18
Determining the Price of Bonds
S1
Price of Bonds
P1
S2
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
P2
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (a)
Slide 17-19
Determining the Price of Bonds
Price of Bonds
S1
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
P1
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (b)
Slide 17-20
Determining the Price of Bonds
S3
Price of Bonds
P3
S1
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
P1
D
Quantity of Bonds
per Unit Time Period
Figure 17-2, Panel (b)
Slide 17-21
The Tools of Monetary Policy
 Relationship between the price of
existing bonds and the rate of interest
– What happens to the interest on a bond
when the price of a bond increases
(decreases)?
Slide 17-22
The Tools of Monetary Policy
 Example
– You pay $1,000 for a bond that pays
$50/year in interest
$50
Rate of interest =
= 5%
$1000
Slide 17-23
The Tools of Monetary Policy
 Example
– Now suppose you pay $500 for the same
bond
$50
Rate of interest =
= 10%
$500
Slide 17-24
The Tools of Monetary Policy
 The market price of existing bonds
(and all fixed-income assets) is
inversely related to the rate of interest
prevailing in the economy.
Slide 17-25
The Tools of Monetary Policy
 Changes in the discount rate
 Increasing the discount rate increases the
cost of borrowed funds for depository
institutions that borrow reserves
 Decreasing the discount rate decreases
the cost of borrowed funds for depository
institutions that borrow reserves
Slide 17-26
The Tools of Monetary Policy
 Changes in the discount rate
– Why is the discount rate a less important
monetary tool today that in the 1920s?
– Since 2002, the Fed has kept the discount
rate 1 percentage point above the marketdetermined federal funds rate.
Slide 17-27
The Tools of Monetary Policy
 Changing the discount rate relative to
the federal funds rate
– The Fed has been keeping the discount
rate one percentage point above the
federal funds rate.
– This discourages borrowing from the Fed.
Slide 17-28
The Tools of Monetary Policy
 Changes in the reserve requirements
– An increase in the required reserve ratio
• Makes it more expensive for banks to meet
reserve requirements
• Reduces bank lending
– A decrease in the required reserve ratio
• Makes it less expensive for banks to meet
reserve requirements
• Increases bank lending
Slide 17-29
Effects of an Increase
in the Money Supply
 When the money supply increases,
people have too much money.
– How can this be?
– Have you ever had too much money?
– If you have a savings account, then at
some point you had too much money.
– Money is not the same thing as income.
Slide 17-30
International Example:
Controlling Growth of the Money Supply
 In Zimbabwe, government officials tried
to stem an inflationary growth of the
money supply by no longer printing the
highest denomination currency note.
 But this did not reduce the demand for
money, as citizens simply chose to
hold more lower denomination notes.
Slide 17-31
Monetary Policy During
Periods of Underutilized Resources
 Monetary policy can generate
increases in the equilibrium level
of real GDP.
Slide 17-32
Expansionary Monetary Policy
with Underutilized Resources
Price Level
LRAS
SRAS
• The contractionary gap is
caused by insufficient AD
• To increase AD, use
expansionary monetary policy
• AD increases and real GDP
increases to full employment
E1
120
Recessionary gap
AD1
0
Figure 17-3
11.5
12.0
Real GDP per Year
($ trillions)
Slide 17-33
Expansionary Monetary Policy
with Underutilized Resources
LRAS
SRAS
Price Level
125
• The contractionary gap is
caused by insufficient AD
• To increase AD, use
expansionary monetary policy
• AD increases and real GDP
increases to full employment
E2
E1
120
AD2
Recessionary gap
AD1
0
Figure 17-3
11.5
12.0
Real GDP per Year
($ trillions)
Slide 17-34
Tools of Monetary Policy
 Contractionary monetary policy: effects
on aggregate demand, the price level,
and real GDP
– Question
• What will happen?
Slide 17-35
Contractionary Monetary Policy
via Open Market Operations
Figure 17-4
Slide 17-36
Open Economy Transmission
of Monetary Policy
 The net export effect
– Impact of expansionary monetary policy
•
•
•
•
•
increase the money supply
interest rates fall
value of the dollar falls
net exports increase
the net export effect complements the
effectiveness of monetary policy
Slide 17-37
Open Economy Transmission
of Monetary Policy
 The net export effect
– Impact of expansionary fiscal policy revisited
•
•
•
•
•
•
larger deficit
higher interest rates
attracts foreign capital
value of the dollar appreciates
net exports fall
net export effect reduces the effectiveness of fiscal policy
Slide 17-38
International Policy Example: The Effect
of the Exchange Rate on Net Exports
 In 2003, nominal interest rates in
Switzerland were close to zero, as an
expansionary monetary policy had been
employed to combat a recession.
 The expansionary policy served also to
depreciate the Swiss franc, which stimulated
net exports.
 It was this open economy effect that
accounted for the eventual increase in
aggregate demand, ending the recession.
Slide 17-39
Open Economy Transmission
of Monetary Policy
 Globalization of international money
markets
– How will global money markets impact the
Fed's ability to control the rate of growth
in the money supply?
Slide 17-40
Monetary Policy and Inflation
 Short-run inflation
– Temporarily shocks the SRAS and AD
 Long-run inflation
– The supply of money expands relative to the
demand for money
– Takes more units of money to purchase given
quantities of goods and services (i.e., the price
level has risen)
Slide 17-41
Monetary Policy and Inflation
 The Equation of Exchange
– The formula indicating that the number of
monetary units times the number of times
each unit is spent on final goods and
services is identical to the price level
times output (or nominal national income)
MsV = PY
Slide 17-42
Monetary Policy and Inflation
 The equation of exchange and the
quantity theory: MSV = PY
– MS = actual money balances held by
non-banking public
– V = income velocity of money; the
number of times, on average, cash
monetary units are spent on final goods
and services
Slide 17-43
Monetary Policy and Inflation
 The equation of exchange and the
quantity theory: MSV = PY
– P = price level
– Y = real national output per year
Slide 17-44
Monetary Policy and Inflation
 The equation of exchange as an identity
MsV = PY
PY = nominal national income
MsV = nominal national spending
Slide 17-45
Monetary Policy and Inflation
 The crude quantity theory of money and
prices
– Assume: V is constant
Q is stable
MsV = PY
Slide 17-46
Monetary Policy and Inflation
 The crude quantity theory of money and
prices
– Increases in Ms must be matched by equal
increases in the price level
MsV = PY
Slide 17-47
Adding Monetary Policy
to the Keynesian Model
Interest Rate
MS
M’S
r1
Md
Quantity of Money
Figure 17-7, Panel (a)
Slide 17-48
Adding Monetary Policy
to the Keynesian Model
Interest Rate
MS
M’S
At lower rates, a larger
quantity of money will
be demanded
r1
Interest rate falls
r2
Md
Quantity of Money
Figure 17-7, Panel (a)
Slide 17-49
Interest Rate
Adding Monetary Policy
to the Keynesian Model
r1
I
I1
Planned Investment
Figure 17-7, Panel (b)
Slide 17-50
Interest Rate
Adding Monetary Policy
to the Keynesian Model
The decrease in the
interest rate stimulates
investment
r1
r2
I
I1
I2
Planned Investment
Figure 17-7, Panel (b)
Slide 17-51
Adding Monetary Policy
to the Keynesian Model
LRAS
Price Level
SRAS
E1
AD1
0
Figure 17-7, Panel (c)
11.5 12.0
Real GDP per Year
($ trillions)
Slide 17-52
Adding Monetary Policy
to the Keynesian Model
LRAS
Price Level
SRAS
E2
E1
The increase in
investment shifts the
AD curve to the right
AD2
AD1
0
Figure 17-7, Panel (c)
11.5 12.0
Real GDP per Year
($ trillions)
Slide 17-53
Monetary Policy in Action:
The Transmission Mechanism
 The monetarist’s views of money
supply changes
– Macroeconomists who believe that
inflation is always caused by excessive
monetary growth and that changes in the
money supply affect AD both directly and
indirectly
Slide 17-54
Monetary Policy in Action:
The Transmission Mechanism
 The monetarist’s views of money
supply changes
– Increase in the money supply increases
aggregate demand directly
– Based on the equation of exchange,
prices always rise when the money
supply is increased
Slide 17-55
Monetary Policy in Action:
The Transmission Mechanism
 Monetarists’ criticism of monetary policy
– Time lags are too long to use monetary
policy effectively
– Monetary policy is seen as a destabilizing
force
Slide 17-56
Monetary Policy in Action:
The Transmission Mechanism
 Monetary Rule
– A monetary policy that incorporates a rule
specifying the annual rate of growth
of some monetary aggregate
– Example
• Increase in the money supply smoothly at a
rate consistent with the economy’s long-run
average growth rate
Slide 17-57
Monetary Policy in Action:
The Transmission Mechanism
 What do you think?
– What would happen to the effectiveness
of the monetary rule if the velocity of
money is not stable?
Slide 17-58
Fed Target Choice:
Interest Rates or Money Supply?
 It is not possible to stabilize the money
supply and interest rate simultaneously.
Slide 17-59
Choosing a Monetary Policy Target
M’S
Interest Rate
MS
Md
Quantity of Money
Figure 17-8
Slide 17-60
Choosing a Monetary Policy Target
MS
M’S
Interest Rate
If the Fed selects re,
it must accept Ms
re
r1
A
D
C
B
If the Fed selects M’s,
it must allow the
interest rate to fall
Md
Quantity of Money
Figure 17-8
Slide 17-61
Fed Target Choice:
Interest Rates or Money Supply?
 Target interest rates
– The money supply will be unstable
 Target the money supply
– The interest rate will be unstable
Slide 17-62
Fed Target Choice:
Interest Rates or Money Supply?
 Choosing a target
– Interest rates
• When the demand for money is unstable
– Money supply
• When variations in private spending occur
Slide 17-63
The Way Fed Policy
is Currently Announced
 No matter what the Fed is actually targeting,
it only announces an interest rate target.
 The current strategy is outlined in the FOMC
directive.
 This strategy is implemented through open
market operations conducted by the Trading
Desk of the New York Federal Reserve.
Slide 17-64
Issues and Applications:
Maintaining Federal Reserve Targets
 The Trading Desk of the New York Federal
Reserve Bank implements the Federal Open
Market Committee directives.
 If a lowering of interest rates is called for,
then the Fed will purchase bonds, pumping
reserves into the banking system.
Slide 17-65
Issues and Applications:
Maintaining Federal Reserve Targets
 The Fed sells bonds, drawing reserves
from the banking system, when a
contractionary measure in needed.
 The Fed does not set the federal funds
rate explicitly, but it changes the level
of reserves in depository institutions,
and this influences the money supply.
Slide 17-66
Summary Discussion
of Learning Objectives
 Key factors that influence the quantity
of money that people desire to hold:
– To make transactions
– To hold for precautionary reasons
– To hold as an asset (store of value)
Slide 17-67
Summary Discussion
of Learning Objectives
 How the Federal Reserve’s monetary
policy tools influence market interest
rates
– Open market purchases, reducing the discount
rate, or reducing the required reserve ratio
increases the money supply and lowers the
interest rate.
– Open market sales, raising the discount rate, or
increasing the required reserve ratio decreases
the money supply and raises the interest rate.
Slide 17-68
Summary Discussion
of Learning Objectives
 How expansionary and contractionary
monetary policy affect equilibrium real
GDP and the price level in the short run
– Expansionary monetary policy
• Increase real GDP
• Decrease the price level
– Contractionary monetary policy
• Decrease real GDP
• Decrease the price level
Slide 17-69
Summary Discussion
of Learning Objectives
 The equation of exchange and the
crude quantity theory of money
and prices
– Equation of exchange
• MV = PY
– Crude quantity theory of money and prices
• V is constant and Y is Stable
• Increases in M cause proportionate increases in P
Slide 17-70
Summary Discussion
of Learning Objectives
 Keynesian versus monetarist views
on the transmission mechanism
of monetary policy
– Keynesian transmission mechanism
• Changes in interest rates cause changes in investment
which change equilibrium real GDP
– Monetarist transmission mechanism
• Changes in the money supply change desired spending
Slide 17-71
Summary Discussion
of Learning Objectives
 Why the Federal Reserve cannot
stabilize the money supply and the
interest rate simultaneously
– To target a market interest rate the Fed must
adjust the money supply as necessary when the
demand for money changes
– To target the money supply the Fed must permit
the interest rate to vary when the demand for
money changes
Slide 17-72
End of
Chapter 17
Domestic and
International
Dimensions of
Monetary Policy