Ec103 Week 09 and 10 s14
Ec103 Week 09 and 10 s14
Ec103 Week 09 and 10 s14
policy
Every major contraction in this
Figure 15.2
The money demand curve slopes downward because lower interest rates cause households
and firms to switch from financial assets, such as U.S. Treasury bills, to money.
All other things being equal, a fall in the interest rate from 4 percent to 3 percent will increase
the quantity of money demanded from $900 billion to $950 billion.
An increase in the interest rate will decrease the quantity of money demanded.
The interest rate is the opportunity cost, or what you forgo, to hold money.
Figure 15.3
Changes in real GDP or the price level cause the money demand curve to shift.
1.An increase in real GDP or an increase in the price level will cause the money demand
curve to shift from MD1 to MD2.
2.A decrease in real GDP or a decrease in the price level will cause the money demand
curve to shift from MD1 to MD3.
Figure 15.4
Figure 15.5
The long-term real rate of interest r is the interest rate that is most
relevant when:
Savers consider purchasing a long-term financial investment
Firms borrow to finance long-term investment projects
Households take out mortgage loans
When conducting monetary policy, however, the short-term nominal
interest rate i is most relevant because it is the interest rate most
affected by increases and decreases in the money supply.
In the loanable funds mkt, banks use their new reserves to offer new
loans to households and businesses, so the supply of loanable funds
(shifting S1 to S2), and r .
Money
interest
rate
Real
interest
rate
S1 S2
i1
r1
i2
r2
S1
S2
D1
Qs
Qb
Quantity
of money
D
Q1
Q2
Qty of
loanable
funds
Price
Level
S1
AS1
S2
r1
P2
P1
r2
D
Q1
Q2
AD2
Qty of
loanable
funds
AD1
Y1 Y2
Goods &
Services
(real GDP)
But notice
Monetar
y
expansi
on
with
slack
Price
Level
LRAS
SRAS1
P2
P1
E2
e1
AD1
Y 1 YF
AD2
Goods & Services
(real GDP)
Monetar
y
expansio
n
at Yf
Price
Level
LRAS
SRAS1
P2
P1
e2
E1
AD1
YF Y2
AD2
And in
the
Long
Run
Price
Level
LRAS
SRAS2
SRAS1
P3
E3
P2
P1
e2
E1
AD1
YF Y2
AD2
Timing is everything
Figure 15.8
The upward-sloping straight line represents the long-run growth trend in real GDP.
The curved red line represents the path real GDP takes because of the business cycle.
If the Fed is too late in implementing a change in monetary policy,
real GDP will follow the curved blue line.
The Feds expansionary monetary policy results in too great an increase in aggregate
demand during the next expansion, which causes an increase in the inflation rate.
Making
the
Connection
In addition to the other problems the Federal Reserve encounters in successfully conducting
monetary policy, it must make decisions using data that may be subject to substantial
revisions.
MyEconLab Your Turn:
Test your understanding by doing related problems 3.13 and 3.14 at the end of this chapter.
But remember:
i = r + expected inflation
Over time, increases in M (or M growth)
inflation that is built into expectations
So: M i in SR, but P and eventual i
Fed has to be careful not to over-expand M
20
While the Fed can affect real interest rate r in the short
term, its impact on long-term rates is limited to nominal
rate i and not necessarily in a good way!
I.e., its naive to advocate, e.g., that the Fed should cut
interest rates so I can afford a house in a few years!
In the long run, expansionary monetary policy leads
to inflation and high nominal interest rates, rather than
low interest rates.
Similarly, restrictive monetary policy, when pursued
over a lengthy time period, leads to low inflation and
low nominal interest rates.
I.e., monetary policy tends to be neutral in the long
run with respect to real variables (like r)
The arrows point to the steps involved in the policy that occur relative to what
would have happened without the policy.
Why Doesnt the Fed Target Both the Money Supply and the Interest
Rate?
Figure 15.11
24
25
26
27
28
29
Compounding factors
30
1933-37 Recovery
31
32
34
punch?
What function does Wall Street serve?
What
good are financial instruments like stocks?
What good are more sophisticated
instruments like options or mortgage-backed
securities?
What institutional changes did we make that
created problems in the markets for these
instruments?
35
Moral hazard
Adverse selection
Inflation, 1998-2009
As inflation rose in 2005-2006, the Fed shifted toward restriction and pushed
short-term interest rates upward; the Feds low interest rate policy (2002-2004),
followed by its more restrictive policy (2005-2006), contributed to the boom and
bust in housing prices, and the Crisis of 2008.
Connection
10%
10%
20
50
50
10
100
100
200
200
The equity in your house is the difference between the market price of the house and the
amount you owe on a loan; if the latter is greater than the former, you have negative equity,
and are said to be upside down on your mortgage.
MyEconLab Your Turn:
Test your understanding by doing related problem 6.8 at the end of this chapter.
AN
INSIDE
LOOK
AT
POLICY
The average annual rates for federal funds, 30-year mortgages, and 10- and 30-year
Treasury securities from 2001 through September 2011.