ECON CH 13 Monetary Policy PDF

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CHAPTER 13: MONETARY POLICY: - How money supply is controlled to target interest rates in economy LOOSENING MONETARY POLICY: - Reducing interest rates → increases consumption & investment → increases aggregate demand - EXPANSIONARY MONETARY POLICY: ● Fed actions designed to: 1.) increase money supply 2.) Lower interest rates ● Purpose: - Stimulate economy - Expand income & employment - ↑ AD ● EX: Fed conducts open market operations → buying gov’t bonds from banks using money it creates → put more money into economy → expand money supply & reduce interest rates TIGHTENING MONETARY POLICY: - Raising interest rates → decreases consumption & investment → decreases aggregate demand - CONTRACTIONARY MONETARY POLICY: ● Fed actions designed to: 1.) Decrease money supply 2.) Raise interest rates ● Purpose: - Shrink income & employment - Fight inflation - Decrease AD ● EX: Fed sells bonds → takes money out of economy → reduce money supply & raise interest rates

SHORT-RUN: - SRAS curve - Upward-sloping ● Higher prices cause temporary increases in output - Due to sticky wages & prices LONG-RUN: - LRAS curve - Vertical ● Output is always fixed in long-run @ full employment output when wages are flexible - ONLY shifted by factors that increase productivity of inputs LONG-RUN: CLASSICAL THEORY: - Wages, prices, & interest rates = flexible ● Allows labor,product, & capital markets to adjust to keep economy @ full employment - QUANTITY THEORY OF MONEY ● VELOCITY: - Avg. # of times per year a dollar is spent on goods & services ● EQUATION OF EXCHANGE: - MxV=PxQ ● M = supply of money ● V = velocity ● P = price level ● Q = economy’s real output level - V = fixed - Q = fixed @ full employment - Any change in M will translate directly to change in P ● Aka INFLATION

SHORT-RUN EFFECTS OF MONETARY POLICY: - Effect on real economy, NOT just price level 1.) MONEY ILLUSION & STOCKY WAGES & PRICES: - MONEY ILLUSION: ● Misconception of wealth ● Caused by focus on ↑ in nominal wages, but NOT ↑ in prices - Wages & prices tend to react slowly to changes in economy → STICKY ● Workers’ wages do not change w/ every paycheck ● Prices of many goods/services do not change every day 2.) KEYNESIAN MODEL: - John Maynard Keynes → Great Depression (1930s) - ↑ money supply today leads more people to buy interest-earning assets (bonds) = ↑ price of bonds = ↓ interest rate = ↑ investment = ↑ AD = ↑ income, output, & employment - ONLY occurs when economy is healthy - During times of recession: ● People buy less → excess business capacity = ↓ business investment - LIQUIDITY TRAP: ● ↑ money supply does NOT ↓ interest rates → NO change in investment → NO change in income/output ● Monetary policy = ineffective → Fiscal policy is needed to get out of recession ● Very low interest rates → people hoard money since it is not worth holding bonds that pay little interest 3.) MONETARIST MODEL: ● Milton Friedman ● Gov’t spending inherent to fiscal policy must be financed by ↑ taxation and/or ↑ borrowing ● ↑ taxation = consumers & firms have less money to consume & invest ● ↑ borrowing = ↑ interest rates = ↓ consumption & investment ● Crowding-out effect makes fiscal policy effective ● PERMANENT INCOME HYPOTHESIS: - Consumption = based on: 1.) Income 2.) Wealth - ↑ money supply = ↓ interest rates = individuals rebalance asset portfolios by exchanging money for other assets (cars, homes, etc.) = ↑ investment/consumption = ↑ AD = ↑ income, output, & price level ● Monetary policy can be effective in short-run - ↑ money supply = ↑ prices in long-run

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“Inflation is always and everywhere a monetary phenomenon.” -- Milton Friedman

SUMMARY OF EFFECTIVENESS OF MONETARY POLICY: - LONG-RUN: ● Δ money supply show up directly as ↑ in price level - b/c Velocity & output are considered fixed ● Equation of Exchange - (M x V = P x Q) ● Classical economists saw no use for monetary policy - Economy self-correct to equilibrium in long-run - SHORT-RUN: ● Keynes: - When economy is well below full employment, monetary policy is ineffective ● Investment is more influenced by business expectations about interest rates - Once interest rates = very low, monetary policy might confront :liquidity trap” ● Money = hoarded - Fiscal Policy > Monetary Policy ● Monetarists: - Role for monetary policy - In short-run: ● Δ money supply = ↓ interest rates = stimulate investment & consumption - Consumer spending = related to wealth ● NOT just income ● Δ interest rates = Δ consumer spending for durable goods

MONETARY POLICY & ECONOMIC SHOCKS: - DEMAND SHOCKS: ● CAUSES: 1.) ↓ consumer demand 2.) ↓ investment 3.) ↓ gov’t spending 4.) ↓ exports 5.) ↑ imports ● Reduces AD - ↓ price level - ↓ output - Negative demand shock - EXPANSIONARY monetary policy ● POSITIVE DEMAND SHOCK: - ↑ output - ↑ price - CONTRACTIONARY monetary policy

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SUPPLY SHOCKS: ● CAUSES: 1.) Δ resource costs - EX: drought causes ↑ food prices 2.) Δ inflationary expectations 3.) Δ technology ● NEGATIVE SUPPLY SHOCK: - Worse price stability, output, & income - Difficult to counteract ● Doubly negative results IMPLICATIONS FOR SHORT-RUN MONETARY POLICY: ● Monetary policy should: 1.) Focus on price stability in long-run 2.) Focus on output or income in short-run

EXPANSIONARY MONETARY POLICY: - Fed actions designed to ↑ excess reserves & ↑ money supply - PURPOSE: ● Stimulate economy - AKA: ● Easy Money ● Quantitative Easing ● Accommodative Monetary Policy CONTRACTIONARY MONETARY POLICY: - Fed actions to ↓ excess reserves - PURPOSE: ● Shrink income & employment - Fight inflation - AKA: ● Tight Money ● Restrictive Monetary Policy - HOW: ● Selling bonds - Therefore reducing reserves from financial system FEDERAL FUNDS TARGET RATE = (Target Inflation) + (Current Inflation Rate) + ½(Inflation Gap) + ½(Output Gap)

FORMULAS: - QUANTITY THEORY OF MONEY ● EQUATION OF EXCHANGE: - MxV=PxQ -

FEDERAL FUNDS TARGET RATE = ● (Target Inflation) + (Current Inflation Rate) + ½(Inflation Gap) + ½(Output Gap)

QUIZZES/VIDEOS: - https://mru.org/courses/principles-economics-macroeconomics/gdp-per-capitapurchasing-power-parity-example -

https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/apfinancial-sector/monetary-policy-apmacro/v/monetary-policy-tools-ap-macroeconomicskhan-academy...