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Interest Rates and Monetary Policy in the Short Run and the Long Run Unit 4 Lesson 6 Activity 41 & 42 Goodman, Rae Jean B.. U.S. Naval Academy Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y Objectives Define the real interest rate and the nominal interest rate Explain the relationship among the real interest rate, the nominal interest rate and the inflation rate. This is also known as the Fisher Equation. Explain the Fisher Effect, or how changes in the money supply are transmitted to the nominal interest rate in the long run. Explain the effects of monetary policy to the short run and the subsequent changes in the model as the economy moves to the long run. Define neutrality of money. Introduction and Description This lesson explores the relationship between the nominal interest rate and the real interest rate, the implications for monetary policy, and the short-run and long-run effects of monetary policy on real output and the price level. You need to understand the relationship between real and nominal interest rates because the real interest rate determines the level of investment, whereas the nominal interest rate determines the demand for money. The Fisher Effect demonstrates how changes in the money supply affect the nominal interest rate in the long run. The discussion of the short-run and long-run effects on interest rates leads to the discussion of the effects of monetary policy in the short-run and long-run. Understanding of the dynamics of the macroeconomic model over time is essential to explaining the effects of monetary policy on the economy. Activity 41 will help you gain an understanding of the difference between nominal interest rates and real interest rates, and the effect of monetary policy on both in the short and long run. Activity 42 is designed to bring the dynamic macroeconomic model together with monetary policy actions and to help you integrate the effects of monetary policy in the short and long run with your understanding of how the economy works. This will help you analyze current monetary policy and understand monetary policy discussions. Nominal and Real Interest Rates The nominal interest rate is the rate that appears on the financial pages of newspapers and on the signs and ads of financial institutions. The real interest rate is the increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future. Nominal vs. Real Interest Rates There are two relationships between the real and nominal interest rates. The ex ante real interest rate, which is the expected interest rate and equals the nominal interest rate minus the expected inflation rate. The ex poste real interest rate, which is the real interest rate actually received and equals the nominal interest rate minus the actual rate of inflation. Nominal vs. Real Interest Rates The ex poste real interest rate will equal the ex ante interest rate, if people accurately anticipate the inflation rate. The relationship between the real and nominal interest rate is called the Fisher Equation. Fisher Effect: The direct relationship between inflation and interest rates. Increasing inflationary expectations result in increasing interest rates Looking at the equation of exchange – the changes in the money supply – holding velocity and real output constant – led to changes in the price level. These changes in the price level change the nominal interest rate once they are anticipated. Complete Activity 41. Real Interest Rates and Nominal Interest Rates If you bought a one-year bond for $1,000 and the bond paid an interest rate of 10% at the end of the year, would you be 10% wealthier? You will certainly have 10% more money than you did a year earlier, but can you buy 10% more? If the price level has risen, the answer is that you cannot buy 10% more. If the inflation rate were 8%, then you could buy only 2% more, if the inflation rate were 12%, you would be able to buy 2% less! The nominal interest rate is the rate the bank pays you on your savings or the rate that appears on your bond or car loan. The actual real interest rate represents the change in your purchasing power. The expected real interest rate represents the amount you need to receive in real terms to forgo consumption now for consumption in the future. The relationship between the nominal interest rate, the real interest rate and the inflation rate can be written as: r=I-π r = real interest rate, I = nominal interest rate π = inflation rate (Yes, it is the ‘pi” sign, but it is only a symbol!) This relationship is called the Fisher Equation In the example on the previous slide with the 10% bond, if the inflation rate were 6%, then you real interest rate (the increase in your purchasing power) would be 4%. Obviously banks and customers do not know what inflation is going to be, so the interest rates on loans, bonds, etc. are set based on expected inflation. The expected real interest rate is re = i – π e π e = expected inflation rate the quotation can be written as: i = re + π e A bank sets nominal interest rate equal to its expected real interest rate plus the expected inflation rate. However, the real interest rate it actually receives may be different if inflation is not equal to the bank’s expected inflation rate. The equation of exchange is MV = PQ. If we assume that velocity (V) is constant, then changes in money supply (M) result in changes in the nominal output (PQ). The equation of exchange can be rewritten in terms of percentage change to be percentage change in money supply + percentage change in velocity = percentage change in price level + percentage change in real output The first term, percentage change in the money supply, is controlled by the monetary authority (Federal Reserve). Assuming that velocity is constant, the second term is zero. The third term is the inflation rate and the fourth term is the growth in real output. Output (Q) is determined by the factors of production, technology and the production function. Output can be taken as given. Therefore, the percentage change in the money supply results in an equal percentage change in the price level. Increases in the money supply by the Federal Reserve will result in increase in the price level, or inflation. Using the Fisher Equation, the increase in inflation would result in an increase in the nominal interest rate or a decrease in the real interest rate or in some combination. This is known as the Fisher Effect, or Fisher Hypothesis. Evidence indicates that increases in the inflation rate result in increases in the nominal interest rate in the long run. Increases in the money supply are translated into increases in the price level and increase in the nominal interest rate in the long run. We know that: In the short run, increase in the money supply decrease the nominal interest rate and real interest rate In the long run, increases in the money supply will result in an increase in the price level and the nominal interest rate. Activity 41 1. Fig. 41.1 provides the nominal interest rates and inflation rates for the years 1991 through 2001. A. Compute the actual real interest rates for 1991 through 2001. B. Graph the nominal interest rates and the actual real interest rates on Fig. 41.2 Year Nominal Interest Rate Inflation Rate 1991 5.41% 3.12% 1992 3.46 2.30 1993 3.02 2.42 Real Interest Rate 2.29% 1.16 0.60 2.22 1994 4.27 2.05 1995 5.51 2.12 1996 5.02 1.87 3.15 1997 5.07 1.85 3.22 1998 4.78 1.14 3.64 1999 4.64 1.56 3.08 2000 5.82 2.29 3.53 2001 3.39 1.96 1.43 3.39 0 Year 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 Interest rates Fig. 41.2 Real Nominal Interest Rates 7% 6 5 4 3 2 1 C. Has the actual real interest rate stayed No constant? ____ D. If it has not, explain why you think the real rate has not been constant. The actual real interest rate has not been constant because the inflation rate has changed often. The money supply growth rate has also changed during the period shown in the graph E. For what years has the actual real interest rate remained nearly constant? During the 1995 to 2000 period, the actual real interest rate fluctuated within a small range. The result is probably because of the reasonably steady inflation rate and the announced desire by the Fed to control inflation. 2. Frequently, economists argue that the monetary authorities should try to maintain a steady real interest rate. Explain why you think a steady real rate of interest is important to the economy. My interest rate is important to induce firms to invest and expand the capital stock. Fig. 41.3 Expansionary Monetary Policy SRAS Price Level LRAS AD Real GDP 3. Suppose that initially the economy is at the intersection of AD and SRAS as shown. Now the Fed decides to implement expansionary monetary policy to increase the level of employment. A. In the short run, what happens to real output? Explain why. Real output should increase. With the decrease in interest rates because of the expansionary monetary policy, the interest rates sensitive components of AD (Consumption and investment) will increase, thereby increasing output. B. In the short run, what happen to the price level? Explain why. The price level increases because the increase in demand can only be met if firms have the incentive to produce more. An increasing price level provides this incentive. C. In the short run, what happens to employment and nominal wages? Explain why. Employment increases and nominal wages remain the same. Employment increases because firms now have to produce more goods and services and they need people to this. Nominal wages stay the same because people do not realize that the average price level has increased. D. In the short run, what happens to nominal interest rates and real interest rates? In the short run, the nominal and real interest rates decrease. E. In the long-run, what happens to real output? Explain why. In the long-run, the real output will be at the full employment level. So real output will fall relative in to the level of output in the short-run. An employment increases, nominal wages increase, which raises the costs of production and the SRAS curve shifts to the left. The price level increases, and real output will fall back toward the original level. F. In the long-run, what happens to the price level? Explain why. The price level rises in the long-run because the SRAS curve shifted to the left in response to an increase in nominal wages. G. In the long-run, what happens to employment and nominal wages? Explain why. Employment is at full employment and nominal wages have risen so that the real income of people has remained the same. To induce labor to work at the new higher level firms must increase the nominal wage. H. In the long-run, what happens to the nominal interest rate and the real interest rate? In the long run, the real interest rate goes to the long-run level and the nominal interest rate is the real interest rate plus the inflation rate. In the United States, the long-run real interest rate is about 2% to 3%. Monetary Policy Activity 42 You should be able to explain why the curves shift by now. Changes in the money supply over time result in changes in the price level and no change in the output level. Monetary policy is neutral. REVIEW! Factors that shift the AD curve: Changes in autonomous consumption Changes in autonomous investment Changes in government spending Changes in taxes Changes in the money supply Factors that shift the SRAS: Changes in resource prices Changes in technology Changes in capital stock Changes in expectations Do you remember what happens after the initial effects in the AD and AS model? From the Short run to the Long Run LRAS SRAS₁ SRAS Price Level p₂ Initially the economy is at Y*, potential GDP and P. Aggregate demand increases from AD to AD1 and the economy to Y1 and p1 p₁ p AD₁ AD Y* Y*1 Real GDP The final equilibrium is Y* and p2 LRAS Long Run Adjustment SRAS1 SRAS AD AD1 p2 Price Level The economy is initially at full employment output: Y* There is an increase in aggregate demand: p1 p AD1 Output increases to Y1, and the price level increases to P1 AD Y* Y*1 Real GDP The increase in the price level means that real wages have fallen. Labor will push for higher nominal wages to compensate for the higher price level. The increase in nominal wages will shift the aggregate supply curve to the left. Eventually, the economy will return to the potential output level, Y*, but at a higher price level p. This is the process of adjustment over the long run. Monetary Policy Re-read and STUDY the Appendix to Lesson 4 from Unit 4 with Activity 24! We our now going to bring together all of the pieces of the process by which monetary policy is transmitted in the economy, and we examine both the shortrun and the long-run effects of monetary policy. Effects of Monetary Policy Fig. 42.1 LRAS Price Level SRAS AD Real GDP 1. Suppose the initially the economy is at the intersection of AD and SRAS in Fig. 42.1 A. What monetary policy should the fed implement to move the economy to full-employment output? Expansion Monetary Policy ________________________ B. If the Fed is going to use open market operations, it should (buy / sell) Treasury securities. C. What is the effect on Treasury security (bond) prices? Bond prices should rise. D. In the short-run, what is the effect on nominal interest rates? Explain. Nominal interest rates should fall because financial institutions have more funds to lend out because people have sold their Treasury to the Fed. E. In the short-run, what happens to real output? Explain how the Fed’s action results in a change in real output. Real output should increase. With the decrease in interest rates, the increase interest-rate sensitive components of AD (C & I) will increase, thereby increasing output. F. In the short-run, what happens to the price level? Explain how the Fed’s action results in a change to the price level. The average price level increase because the increase in demand can be met only if firms have the incentive to produce more. An increasing price level provides this incentive. Moving to Full Employment Fig. 42.2 LRAS Price Level SRAS AD Real GDP 2. Suppose that initially the economy is at the intersection of AD and SRAS. A. What monetary policy should the fed implement to move the economy to full-employment output? Contractionary Monetary Policy _______________________________ B. If the Fed is going to use open market operations, it should (buy / sell) Treasury securities. C. What is the effect on Treasury security (bond) prices? Bond prices will decline. D. In the short-run, what is the effect on nominal interest rates? Explain. In the short-run, nominal interest rates will increase. When the public buys bonds, they pay for them by reducing their demand deposits, decreasing the supply of money, which means the interest rate will increase. E. In the short-run, what happens to real output? Explain how the Fed’s action results in a change in real output. As a result of the Fed’s actions interest rates have increased; therefore, the interest sensitive components of AD (C & I) will decrease and thus, decrease AD. With a reduced AD, firms will experience an increase in inventories, which in turn leads to a decrease in production. Output ↓ F. In the short-run, what happens to the price level? Explain how the Fed’s action results in a change to the price level. The price level will fall as firms attempt to clear out inventory by reducing prices, having a sale. Fig.42.3 Expansionary Monetary Policy PL LRAS SRAS p AD Y* Real GDP 3. Suppose that in the situation shown in the above fig., the AS and demand curves are represented by LRAS, SRAS and AD. The monetary authorities decide to maintain the level of employment represented by the output level Y1 by using expansionary monetary policy. PL LRAS SRAS p1 p AD1 AD Y* Y1 Real GDP A. Explain the effect of the expansionary monetary policy on the price level and output in the short-run. In the short-run, the monetary authorities (the Fed) will expand the money supply, which in turn increases the AD curve to AD1. The price level and output increase. PL LRAS SRAS1 SRAS p2 p1 p AD2 AD1 AD Y* Y1 Real GDP B. Explain the effect on the price level and output in the long-run. The SRAS will shift leftward, leading to a decrease in output and an increase in price level. Given the Fed’s desire to remain at Y1, the Fed will continue to expand the money supply, shifting AD to AD2. With the decrease in SRAS, the economy might be at a point like the intersection of AD2 and SRAS1. Thus, the price level will continue to rise and the economy will experience inflation. C. Explain what you think will happen to the nominal rate of interest and the real rate of interest in the short run as the Fed continues to increase the money supply. Explain why. In the short run, both the nominal interest rate and the real interest rate will decline. Consumers and financial intermediaries will not have correctly anticipated the inflation, and both interest rates will decline. As consumers and producers recognize that the price level is increasing, they will take steps to maintain their real income. Nominal wages will rise, and the nominal and real interest rates will start to rise. D. Explain what you think will happen to the nominal rate of interest and the real rate of interest in the long run. Explain why. In the long-run, the real interest rate will return to its long-run equilibrium, and the nominal interest rate will be the real interest plus inflation. Since inflation is increasing, the nominal interest rate will increase as well. Producers and consumers will adjust expectations to match reality. 4. Many economists think that moving from short-run equilibrium to long-run equilibrium may take several years. List three reasons why the economy might not immediately move to long-run equilibrium. Wages will adjust slowly to changes in prices (inflation) because of wage contracts. Prices adjust slowly because business is slow to change prices to maintain customer loyalty. Both labor and firms have inaccurate expectations about inflation 5. In a short paragraph, summarize the long-run impact of an expansionary monetary policy on the economy. In the long-run, increases in the money supply translates into increases in the PL and no long-term increase in output. This is known as the neutrality of money. In the short-run, nominal and real interest rates decline. In the long-run, nominal interest rates follow the Fisher Equation and equal the real rate plus the inflation rate. Real interest rates return to their long-run level; the rate people require to forgo consumption now for consumption in the future.