Chapter 17
Domestic and
International
Dimensions of
Monetary Policy
Introduction
Why does the Federal Reserve use a
federal funds rate target as its primary
tool of monetary policy, and what are the
implications of its choice?
When you have completed this chapter
you will be able to answer this question.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
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 influence market
interest rates
• Evaluate how expansionary and
contractionary monetary policy actions
affect equilibrium real GDP and the price
level in the short run
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
17-3
Learning Objectives (cont'd)
• Understand the equation of exchange and its
importance in the quantity theory of money
and prices
• Discuss the interest-rate-based transmission
mechanism of monetary policy
• Explain why the Federal Reserve cannot
stabilize both the money supply and interest
rates simultaneously
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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
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17-5
Chapter Outline (cont'd)
• Monetary Policy and Inflation
• Monetary Policy in Action: The
Transmission Mechanism
• Fed Target Choice: Interest Rates or
Money Supply?
• The Way the Fed Policy is
Currently Implemented
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17-6
Did You Know That…
• Bond prices change noticeably during
televised congressional hearings
featuring testimony by Ben Bernanke,
chair of the Fed’s Board of Governors?
• Fed policymaking, which involves
varying the supply of money or the rate
at which it grows, has something to do
with market interest rates on bonds?
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17-7
What’s So Special About Money?
• Money is the product of a “social
contract” in which we all agree to
1. Express all prices in terms of a common
unit of account, which in the United States
we call the dollar
2. Use a specific medium of exchange for
market transactions
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17-8
What’s So Special
About Money? (cont'd)
• Something that changes the amount of
money in circulation will have some
affect on many transactions and thus on
elements of GDP.
 Something that affects the amount
of money in existence is going to affect
all markets.
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17-9
What’s So Special
About Money? (cont'd)
• Holding money
 To use money, one must hold money.
 If people desire to hold money, there is a
demand for money.
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17-10
What’s So Special
About Money? (cont'd)
• The demand for money, what people
wish to hold
 People have certain motivation that causes
them to want to hold money balances.
 There is a demand for money by the
public, motivated by several factors.
 Transactions
demand
 Precautionary demand
 Asset demand
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17-11
What’s So Special
About Money? (cont'd)
• Money Balances
 Synonymous with money, money stock,
and money holdings
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17-12
What’s So Special
About Money? (cont'd)
• Transactions Demand
 Holding money as a medium of exchange
to make payments
 The level varies directly with nominal GDP.
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17-13
What’s So Special
About Money? (cont'd)
• Precautionary Demand
 Holding money to meet unplanned
expenditures and emergencies
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17-14
What’s So Special
About Money? (cont'd)
• Asset Demand
 Holding money as a store of value instead
of other assets such as certificates of
deposit, corporate bonds, and stocks
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17-15
What’s So Special
About Money? (cont'd)
• The demand for money curve
 Assume the amount of money demanded
for transactions purposes is proportionate
to income
 Precautionary and asset demand are
determined by the opportunity cost of
holding money (the interest rate).
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17-16
Figure 17-1
The Demand for Money Curve
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17-17
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
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17-18
The Tools of Monetary Policy
• The Fed seeks to alter consumption,
investment, and aggregate demand as
a whole by altering the rate of growth of
the money supply.
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17-19
The Tools
of Monetary Policy (cont'd)
• The Fed has three tools at its disposal
as part of its policymaking action.
 Open market operations
 Discount rate changes
 Reserve requirement changes
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17-20
The Tools
of Monetary Policy (cont'd)
• Open market operations
 Fed purchases and sells government
bonds issued by the U.S. Treasury
 At
first, there is some equilibrium level of
interest rate (and bond prices).
 An open market operation must cause a
change in the price of bonds.
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17-21
Figure 17-2 Determining the Price
of Bonds, Panel (a)
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
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17-22
Figure 17-2 Determining the Price
of Bonds, Panel (b)
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
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17-23
The Tools
of Monetary Policy (cont'd)
• Relationship between the price of
existing bonds and the rate of interest
 There is an inverse relationship between
the price of existing bonds and the rate
of interest.
• Question
 So what happens to the yield on a
bond when the price of a bond
increases (decreases)?
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17-24
The Tools
of Monetary Policy (cont'd)
• Example
 You pay $1,000 for a bond that pays
$50/year in interest.
Bond yield
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=
$50
= 5%
$1,000
17-25
The Tools
of Monetary Policy (cont'd)
• Example
 Now suppose you pay $500 for the
same bond.
Bond yield
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=
$50
= 10%
$500
17-26
The Tools
of Monetary Policy (cont'd)
• The market price of existing bonds
(and all fixed-income assets) is
inversely related to the rate of
interest prevailing in the economy.
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17-27
The Tools
of Monetary Policy (cont'd)
• Changes in the difference between the
discount rate and the federal funds rate
 The discount rate is kept at 1 percentage
point above the market-determined federal
funds rate.
 Increasing (decreasing) the discount
rate increases (decreases) the cost of
borrowed funds for depository institutions
that borrow reserves.
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17-28
The Tools
of Monetary Policy (cont'd)
• Changes in the reserve requirements
 An increase (decrease) in the required
reserve ratio
 Makes
it more (less) expensive for banks to
meet reserve requirements
 Reduces
(expands) bank lending
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17-29
Effects of an Increase
in The Money Supply
• What if hundreds of millions of dollars
in just-printed bills is dropped from
a helicopter?
• People pick up the money and put it in
their pockets, but how do they dispose
of the new money?
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17-30
Effects of an Increase
in The Money Supply (cont'd)
• Direct effect
 Aggregate demand rises because with an
increase in the money supply, at any given
price level people now want to purchase
more output of real goods and services.
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17-31
Effects of an Increase
in The Money Supply (cont'd)
• Indirect effect
 Not everybody will necessarily spend the
newfound money on goods and services.
 Some of the money gets deposited, so
banks have higher reserves (and they lend
the excess out).
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17-32
Effects of an Increase
in The Money Supply (cont'd)
• Indirect effect
 Banks lower rates to induce borrowing.
 Businesses engage in investment.
 Individuals consume durable goods (like
housing and autos).
 Increased loans generate an increase in
aggregate demand.
 More
people are involved in more spending
(even those who didn’t get money from
the helicopter!).
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17-33
Graphing the Effects of an
Expansionary Monetary Policy
• Assume the economy is operating at
less than full employment
 Expansionary monetary policy can close
the recessionary gap.
 Direct and indirect effects cause the
aggregate demand curve to shift outward.
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17-34
Figure 17-3 Expansionary Monetary
Policy with Underutilized Resources
• The recessionary gap is
due to insufficient AD
• To increase AD,
use expansionary
monetary policy
• AD increases and
real GDP increases
to full employment
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17-35
Graphing the Effects of
Contractionary Monetary Policy
• Assume there is an inflationary gap
 Contractionary monetary policy can
eliminate this inflationary gap.
 Direct and indirect effects cause the
aggregate demand curve to shift inward.
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17-36
Figure 17-4 Contractionary Monetary
Policy with Overutilized Resources
• The inflationary gap is shown
• To decrease AD, use
contractionary monetary policy
• AD decreases and real
GDP decreases
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17-37
International Policy Example:
The People’s Bank of China Learns About
the Real Interest Rate
• In 2003 and 2005 the People’s Bank of China
engaged in monetary policy actions that pushed up
market interest rates for the first time in nine years.
• The objective of the interest rate increase was to try
to reduce the growth of aggregate demand and
thereby prevent higher inflation levels from occurring.
• The problem was that higher inflation expectations
already existed, and so the expected inflation rate
rose faster than nominal interest rates.
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17-38
Open Economy Transmission
of Monetary Policy
• So far we have discussed monetary
policy in a closed economy.
• When we move to an open
economy, monetary policy
becomes more complex.
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17-39
Open Economy Transmission
of Monetary Policy (cont'd)
• The net export effect
 Impact of contractionary monetary policy
 Boosts
the market interest rate
 Higher
rates attract foreign investment
 International
price of dollar rises
 Appreciation
of dollar reduces net exports
 Negative
net export effect
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17-40
Open Economy Transmission
of Monetary Policy (cont'd)
• The net export effect
 Impact of expansionary monetary
 Lower
interest rates
 Financial
capital flows out of the United States
 Demand
for dollars will decrease
 International
price of dollar goes down
 Foreign
goods look more expensive in
United States
 Net
exports increase (imports fall)
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17-41
Open Economy Transmission
of Monetary Policy (cont'd)
• 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?
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17-42
Monetary Policy and Inflation
• Most theories of inflation relate to the
short run and the price index in the
short run can fluctuate due to
 Oil price shocks, labor union strikes
• In the long run, there is a more stable
relationship between growth in the
money supply and inflation.
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17-43
Monetary Policy and Inflation (cont'd)
• Simple supply and demand analysis
can be used to explain
 Why the price level rises when the money
supply is increased
• If the supply of money expands relative
to the demand for money
 It takes more units of money to purchase
given quantities of goods and services
(i.e., the price level has risen)
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17-44
Monetary Policy and Inflation (cont'd)
• 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 real GDP
MsV = PY
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17-45
Monetary Policy and Inflation (cont'd)
• The equation of exchange and the
quantity theory: MSV = PY
 MS = actual money balances held by
nonbanking public
 V = income velocity of money; the
number of times, on average per year,
each monetary unit is spent on final
goods and services
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17-46
Monetary Policy and Inflation (cont'd)
• Income Velocity of Money
 The number of times per year the dollar
is spent on final goods and services;
equal to the nominal GDP divided by
the money supply.
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17-47
Monetary Policy and Inflation (cont'd)
• The equation of exchange and the
quantity theory: MSV = PY
 P = price level or price index
 Y = real GDP per year
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17-48
Monetary Policy and Inflation (cont'd)
• The equation of exchange as
an identity
 Total funds spent on final output MsV
equals total funds received PY
 The value of goods purchased is equal to
the value of goods sold
 MsV = PY = nominal GDP
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17-49
Monetary Policy and Inflation (cont'd)
• Quantity Theory of Money and Prices
 The hypothesis that changes in the money
supply lead to equiproportional changes in
the price level
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17-50
Monetary Policy and Inflation (cont'd)
• The quantity theory of money
and prices
 Assume: V is constant
Y is stable
MsV = PY
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17-51
Monetary Policy and Inflation (cont'd)
• The quantity theory of money
and prices
 Increases in Ms must be matched by equal
increases in the price level
MsV = PY
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17-52
Figure 17-5 The Relationship
Between Money Supply Growth Rates
and Rates of Inflation
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17-53
Monetary Policy in Action:
The Transmission Mechanism
• Recall we talked about the direct and
indirect effects of monetary policy.
 Direct effect: implies increase in money
supply causes people to have excess
money balances.
 Indirect effect: occurs as people purchase
interest-bearing assets, causing the price
of such assets to go up.
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17-54
Figure 17-6 The Interest-Rate-Based
Money Transmission Mechanism
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17-55
Figure 17-7 Adding Monetary Policy
to the Aggregate Demand–Aggregate
Supply Model, Panel (a)
At lower rates, a larger
quantity of money will
be demanded
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17-56
Figure 17-7 Adding Monetary Policy
to the Aggregate Demand–Aggregate
Supply Model, Panel (b)
The decrease in the interest
rate stimulates investment
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17-57
Figure 17-7 Adding Monetary Policy
to the Aggregate Demand–Aggregate
Supply Model, Panel (c)
The increase in investment
shifts the AD curve to the right
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17-58
Fed Target Choice: Interest Rates
or Money Supply?
• It is not possible to stabilize the money
supply and interest rates simultaneously.
• The Fed has often sought to achieve an
interest rate target.
• There is a fundamental tension between
targeting interest rates and controlling the
money supply.
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17-59
Figure 17-8
Choosing a Monetary Policy Target
If the Fed selects re, it
must accept Ms
If the Fed selects M’s,
it must allow the
interest rate to fall
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17-60
Fed Target Choice: Interest Rates
or Money Supply? (cont'd)
• The Fed, in the short run, can select
an interest rate or a money supply
target but not both.
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17-61
Fed Target Choice: Interest Rates
or Money Supply? (cont'd)
• Choosing a policy target
 Money supply
 When
variations in private spending occur
 Interest rates
 When
the demand for (or supply of) money
is unstable
 Interest
rate targets are preferred
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17-62
The Way Fed Policy
is Currently Implemented
• At present the Fed announces an
interest rate target.
• The rate referred to is the federal funds
rate of interest.
• Or, the rate at which banks can borrow
excess reserves from each other.
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17-63
The Way Fed Policy
is Currently Implemented (cont'd)
• If the Fed wants to raise “the” interest
rate, it engages in contractionary open
market operations.
 Fed sells more Treasury securities than it
buys, thereby reducing the money supply.
 This
tends to boost “the” rate of interest.
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17-64
The Way Fed Policy
is Currently Implemented (cont'd)
• Conversely, if the Fed wants to
decrease “the” rate of interest,
it engages in expansionary open market
operations.
 Fed buys more Treasury securities,
increasing the money supply.
 This
tends to lower “the” rate of interest.
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17-65
The Way Fed Policy
is Currently Implemented (cont'd)
• FOMC Directive
 A document that summarizes the
Federal Open Market Committee’s
general policy strategy
 Establishes near-term objectives for the
federal funds rate and specifies target
ranges for money supply growth
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17-66
The Way Fed Policy
is Currently Implemented (cont'd)
• Trading Desk
 An office at the Federal Reserve Bank of
New York charged with implementing
monetary policy strategies developed by
the FOMC
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17-67
The Way Fed Policy
is Currently Implemented (cont'd)
• Taylor Rule
 A suggested guideline for monetary policy
 An equation determining the Fed’s interest
rate target based on
 Estimated
long-run real interest rate
 Deviation of the actual inflation rate from the
Fed’s objective
 Gap between actual real GDP and a measure
of potential GDP
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17-68
Figure 17-9 Actual Federal Funds Rates
and Values Predicted by a Taylor Rule
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17-69
Issues and Applications: How the
Fed Pursues Monetary Policymaking
• The Fed conducts open market operations to
keep the federal funds rate at a target level
called the neutral federal funds rate.
• At this neutral interest level the growth rate of
real GDP tends not to speed up or slow down
in relation to its potential, where all the
economy’s resources are being fully utilized.
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17-70
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)
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17-71
Summary Discussion
of Learning Objectives (cont'd)
• 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.
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17-72
Summary Discussion
of Learning Objectives (cont'd)
• How expansionary and contractionary
monetary policy affect equilibrium real GDP
and the price level in the short run
 Expansionary monetary policy
Pushing up money supply, inducing a fall in
interest rates
 Total planned expenditures rise, AD shifts rightward

 Contractionary monetary policy
Reduces the money supply increasing interest rates
 Total planned expenditures fall, AD shifts leftward

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17-73
Summary Discussion
of Learning Objectives (cont'd)
• The equation of exchange and the
quantity theory of money and prices
 Equation of exchange
 MV
= PY
 Quantity theory of money and prices
V
is constant and Y is stable
 Increases
in M lead to equiproportional
increases in P
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17-74
Summary Discussion
of Learning Objectives (cont'd)
• The interest-rate-based transmission
mechanism of monetary policy
 Operates through effects of monetary
policy actions on market interest rates
 Bring
about changes in desired investment
and thereby affect equilibrium GDP via the
multiplier effect
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17-75
Summary Discussion
of Learning Objectives (cont'd)
• Why the Federal Reserve cannot stabilize
the money supply and the interest
rate simultaneously
 To target the money supply the Fed must permit
the interest rate to vary when the demand for
money changes.
 To target a market interest rate the Fed must
adjust the money supply as necessary when the
demand for money changes.
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17-76
End of
Chapter 17
Domestic and
International
Dimensions of
Monetary Policy