Chapter 13: Modern Macroeconomics and Monetary Policy


Prior to the 1970s, most economists thought fiscal policy was far more important than monetary policy. See opening quote, page 327. Fiscal policy is based on the illusion that you can confiscate the wealth/income of one group of people and give it to another group of people, and raise the standard of living of everybody. "Redistribution creates wealth."

Now the consensus is that monetary policy is more important than fiscal policy. Current expansion is far more because of stable monetary policy than any fiscal stimulus. In fact, Bush and Clinton both RAISED taxes.

We now look at how monetary policy works - how changes in monetary policy/MS affect int rates, output, ex-rates and prices.


DEMAND FOR MONEY

Money as cash or non-interest checking. MD is the amount of cash/checking that people/businesses are willing to hold at any given time. MD is inversely related to the Interest Rate - think of Int Rate as the Int Rate on bonds or savings or CDs. Int rate if the Opp Cost of holding cash balances. If you weren't holding cash, you could be getting interest by buying a bond, CD or putting cash into a svgs. acct.

MD is positively related to income (GDP) and negatively related to int rates. As income rises, the MD for transactions, emergencies, and speculation increases. If your income doubled, your MD would increase. As int rates rise, the opp cost of holding money increases, so people would minimize MD during periods of high int rates. Example: Tbills were 15.5% in 1981.

MD is also influenced by technology/innovation. Examples: credit cards and ATM machines allow us to carry less cash, reduces MD. Int on checking would increase MD. Also, income is more predictable now compared to 100 yrs. ago when the economy was more farm-based. Income was received two or three times a year and the timing and the amount was unpredictable.

MS is fixed/determined by the FRS, and is independent of the interest rate, so it is shown as a vertical line on page 329.


How does monetary policy influence the price level and output?

Start with the Quantity Theory of Money. Developed in the early 1900s by economist Irving Fisher.

Equation: PY = GDP = MV, where

P = price level
Y = real output
PY = nominal GDP
M = MS/M1
V = velocity or turnover rate of money. The average number of times a dollar is used during the year to purchase final goods/services.

In 1995, GDP was $7,246B, M1 was $1.125B, M2 was $3,660B. Velocity of M1 was 6.4 times and Velocity of M2 was 2x. Velocity = GDP/M1. V is inversely related to MD. If people hold less cash and GDP is the same, then velocity is greater. Velocity increases as technology increases - more efficient financial/banking system - faster check clearing, etc. Also as we use credit cards, ATMs, MD is lower, V is higher. We can get by with less cash, as Velocity increases, and money circulates faster. V has generally been increasing as we move towards a cashless economy.

Convert to percentage changes, we get the Equation of Exchange:

%Y + %P(inflation) = %M1 + %V

If we assume that %Y is "fixed" in SR, and determined by real factors like technology, productivity, resource base, skill of workforce, etc, independent of the MS. Also, we can assume that V is fixed in the short run, or changes very slowly in response to financial innovations, credits cards, ATMs, etc.

If %Y and %V are fixed in the short run, then %P = %M, meaning that increases in the MS lead a corresponding increase in inflation.

If we assume a growth in real output of 3%, then an inc in the MS of 3% would lead to 0 inflation.

%P = %M1 - %Y
  0  =   3    -     3
 2   =   5    -     3
20  =  23   -     3

Fixed growth rule - Fix MS growth at 3% per year, or 5%/year, etc.

Keynesian view of Money - Emphasized fluctuations in AD as the source of econ instability, policy conclusion - activist, discretionary fiscal policy to stabilize AD. No role for money, monetary policy. Didn't think econ instability, fluctuations were caused by money, Didn't think that monetary policy would stimulate AD. And if M went up, but V went down by the same amount, monetary policy wouldn't do anything.

Monetarists - led by Milton Friedman, starting in the 1950s. Emphasized: 1) the strong link between MS and inflation and 2) the link between econ instability and monetary instability. Emphasized the strong role that money and monetary policy play in the economy, especially the negative, harmful role of erratic monetary policy. See quote of Friedman, page 332. Even though they emphasize the role of monetary policy, they do not advocate activist, discretionary monetary policy. Monetarists generally favor passive policy based on specified rules or formulas - fixed growth rule.

Monetarists emphasized the problems of lags - recognition lag, policy lag, effectiveness lag. With monetary policy, the policy lag is much shorter, but the effectiveness lag is still long. It takes 6-18 months for a change in monetary policy to affect output, and 12-36 months to affect the price level. By the time the policy takes affect, the economy will most likely have already changed. Timing is critical and also practically impossible. Lengthy and unpredictable time lags prevent discretionary monetary policy from working.

See bio of Friedman, page 333.


MODERN VIEW OF MONETARY POLICY

Combination of influences by Keynesians and monetarists, the modern view of monetary policy explains the transmission of monetary policy as follows:

See page 334.

1. Fed increases MS from S1 to S2 - expansionary monetary policy - by buying bonds in an open market operation. This expansion of MS lowers int rates - panel a.

2. Banks now have excess reserves and they start making additional loans, increase the supply of credit, or loanable funds - panel b. The increased supply of credit lowers the real int rate.

In addition, the FRS is supplying credit directly to the credit market by buying bonds, increasing the supply of credit, shifting out the supply curve.

3. The lower interest rates, both nominal and real, stimulate the economy and move the AD curve out, increase AD, shift out AD in panel c.


AD shifts out for four reasons:

1. Lower interest rates stimulate consumption spending by consumers and investment spending by businesses. AD goes up.

2. Lower int rates lead to a depreciation of the dollar, appreciation of foreign currency. Exports increase. AD goes up.

3. Lower interest rates increase asset/security prices. Reasons: a) lower interest rates lower costs of debt and make businesses more profitable, raising stock prices.
b. Also, stock market competes with bond market. As int rates fall in the bond market, stocks are more attractive, prices get bid up. Wealth effect increases AD.

4. The increase in bank reserves makes it easier for small companies to get credit. For many small companies, they don't have access to the stock and bond markets, so they rely heavily on bank loans. Increases in bank reserves increases loans to small companies, stimulates AD.

Lower int rates stimulate AD - AD1 to AD2. Prices goes up and real GDP goes up. page 334.

Expansionary monetary policy has to be unexpected to really work. The economy moves from Y1 to Y2 in Exhibit 13-2 because the expansionary policy is unanticipated. We move along the SRAS from a to b, because the price level is higher than expected, improving profit margins, expanding output. Retail prices are flexible, costs of production are fixed in SR.

For example: see page 336, panel a. Economy is at Y1 (e1), less than full output/full employment. Fed implements unanticipated expansionary monetary policy to get the economy back to Yf. Prices rise immediately, costs are fixed (wages, leases, contracts, etc) and rise slowly. Profits are increased in SR to get output to expand to E2.

Panel b - expansionary monetary policy when the economy is at full employment results in temporarily higher output in SR (e2), higher prices and full employment output in the LR (E2).


RESTRICTIVE MONETARY POLICY

See page 337. MS goes down, from S1 to S2. Fed sells bonds, reduces bank reserves. Lower reserves means fewer loans, and the supply of credit shift back, decreases, which raises the int rate and lowers AD.

Page 338, panel a. Use of restrictive monetary policy to control inflation. Restrictive policy shifts AD from AD1 to AD2, output goes from e1 to E2.

Panel b - If restrictive policy takes effect when the economy is at full output, then the economy would go into a recession - E1 to e2, Y2.

As mentioned, proper timing of monetary policy is critical, and almost impossible due to lags. To be effective, we need expansionary monetary policy during a recession and restrictive policy during an inflationary expansion.

However, there is a 12-18 month lag for expansionary policy to affect output and employment, and a 36 month lag to affect prices. Without perfect foresight, it is unlikely to ever have monetary policy timed correctly.

If it is not timed perfectly, expansionary policy that takes affect when the economy is already recovered is like adding gasoline to a fire - inflationary.

Restrictive policy that takes affect on an economy moving toward recession will make it worse - like adding water during a flood.


MONETARY POLICY IN LONG RUN

In SR, expansionary monetary policy can temporarily stimulate the econ, increase AD, output and employment. In LR, however, the effects of rapid money growth are higher inflation and higher interest rates. Money growth cannot reduce un or inc real output in the LR. Money is neutral in the long run. Or possibly negative if it is erratic. Money growth/inflation can be like drinking alcohol - the initial result is favorable, but if we consume too much, there is a bad hangover.

Point: For money growth to be expansionary in the SR, it has to be unexpected. People have to be fooled. Only surprise money matters. The expansionary effect is because retail prices rise faster than input prices - wages, rents, leases, supply contracts, int rates, etc - increasing profits and expanding output. The rising prices catches workers, landlords, suppliers and lenders off guard, and real wages, real rents, real input prices and real int rates fall.

If workers, landlords, lenders and suppliers fully anticipate the future inflation, there will be no change in output, employment at all. See page 343. Monetary policy would be neutral if fully anticipated. Retail prices and input/resource prices would both increase by the same amount and the result would be a higher price level, but no real affect on output, employment.

See page 343. If monetary policy is fully anticipated and resource suppliers have fully incorporated inflationary expectations into their decisions, output is not affected even in the short run. "Policy ineffectiveness theory." Policy is neutralized, monetary policy is ineffective. Economy goes from E1 to E2, output stays the same, at a higher price level.


Classical dichotomy = Nominal changes only affect nominal variables, Real Changes only affect real vars.

How would resource costs adjust? - escalator clauses/COLAs - tied to inflation, for wages, rents, input prices, etc. For loans - adjustable rate loans protect the lender from unanticipated inflation.

How likely are people to anticipate monetary policy? Topic of Debate. People didn't anticipate the inflation of the 70s very well. Stagflation demonstrated that inflation doesn't just cause a redistribution of wealth/income, but it can actually be harmful for everyone. We had four recessions between 1970 and 1982, largely because of monetary instability. Stock market was basically flat for ten years.

Point: unexpected inflation doesn't necessarily stimulate the economy.

It is easy to write in an escalator clause/COLA to a wage contract, lease, or supply contract. So even if people don't always accurately anticipate inflation, it is fairly easy to protect yourself.


INTEREST RATES AND MONETARY POLICY

Confusing issue - we have to distinguish between SR and LR and between short term rates and long term rates. In the long run, increases in the MS will lead to higher inflation and higher interest rates for both short and long term rates.

In the SR, inc in MS will usually lower short term rates. Fed conducts OMO, buys tbills, increases bank reserves, lowers the FFR, overnight market for banks lending reserves. MS/MD graph and Inc Sc diagram.

As FFR falls, other short term rates may fall TEMPORARILY - CDs, svgs. accounts, three mo tbills, etc. However, the LR effect on short-term rates is higher int rates due to increased inflation.

The effect of monetary policy on long term rates is much less predictable and much less certain. If people expect higher inflation as a result of expansionary monetary policy, long term rates may increase in response to expansionary policy. People/businesses make major investment decisions based on long term rates, not short term rates - 30 years mortgage rates, 30 year bond rates, etc. If expansionary monetary policy raises long term rates, the policy wont stimulate the economy, it will slow it down, contract it.


SUMMARY OF MONETARY POLICY

See page 346 for a Thumbnail Sketch of the effects of monetary policy. Separate the effects in 1) short run when policy is unanticipated and 2) short run when anticipated and 3) in long run. If anticipated, there is no difference between SR and LR. The adjustment process happens immediately. It is only surprise money that affects the econ differently in SR and LR.

In the LR, or if policy is anticipated, the only effects of more money are higher int rates and higher inflation. Real int rates, real output, real employment will be the same.

Does everyone have to anticipate future inflation? No. Just like not everyone checks the difference in prices between Target and Wal-Mart, or Meijer and Kessels and IGA.

If expansionary policy is surprise, int rates and un rate will decrease temporarily and output will increase.


SIX MAJOR PREDICTIONS:

1. Unexpected expansionary (contractionary) monetary policy will temporarily inc (dec) output.

2. Expansionary monetary policy will stimulate an economy in recession toward full employment. If the economy is at full employment, expansionary policy will be inflationary.

3. Persistent growth in the MS will cause inflation.

4. Inflation will increase nominal interest rates.

5. Due to lags, it takes time for changes in monetary policy to affect output and prices. 6 months - 3 years. There may not always be a close short-run relationship between changes in monetary policy and changes in output, inflation and interest rates due to lags.

6. Monetary and price level stability will reduce econ uncertainty and promote production, output and employment.


EMPIRICAL EVIDENCE

1. Monetary policy and real output - page 349. There appears to be a strong link between money growth and real output growth. During periods of econ expansion, there is an increase in money growth - expansionary monetary policy.

During recessions, there is monetary contraction - restrictive policy. However, association is not the same as causation. Did monetary policy "cause" output growth to change, or did output growth "cause"monetary policy to change?

Higher growth/income raises the demand for money, lower growth lowers the demand for money?

2. Money supply and inflation, see page 350. Fairly close link between M2 growth and inflation three years later. Comparing M2 growth in 1954 with inflation in 1957, to allow three years time for money to have its full effect on inflation.

1980s - M2 was growing at about 10% and inflation was only growing about 4- 5%. Why? i) Real output was growing very rapidly, as high as 4% and ii) velocity was falling due to int on checking. When checking accounts paid interest, people were willing to hold more cash. MD goes up, V goes down.

MV = PY, if M goes up, but V goes down, the effect of M on P is dampened.

3. Inflation rate and Nominal Interest Rates - see page 351. Very strong link between inflation rate and the nominal int rate.

4. International evidence of the link between MS growth and inflation. Strong link between MS and inflation over a ten year period. MS figures are Growth Rate in MS minus the Growth Rate in Real Output. see page 352.


GREAT DEPRESSION

See page 402. Given a background in fiscal and monetary policy, what are the correct policies during a recession?

1. Fiscal policy - inc G or lower taxes, run a deficit. Gov raised taxes during a recession.

2. Gov also raised tariffs by 50%, drastically reduced foreign trade. Gov Rev from tariffs also decreased because intl trade almost stopped completely.

3. Monetary policy - stimulate AD with expansionary monetary policy. Gov reduced money supply by 1/3, implemented restrictive monetary policy. Result - falling prices and falling output.

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