Macroeconomics
Session 9
11-1
Monetary Policy
11-2
The US Economy
11-3
Fiscal and Monetary Policy
• Fiscal policy has its initial impact in the goods market
• Monetary policy has its initial impact mainly in the assets
markets
® Because the goods and assets markets are interconnected, both
fiscal and monetary policies have effects on both the level of
output and interest rates
® Expansionary/contractionary monetary policy moves the LM
curve to the right/left
® Expansionary/contractionary fiscal policy moves the IS curve to
the right/left
11-4
Expansionary/Contractionary MP
LM1
E1
i1
Interest Rate
Y1
Income, Output
11-5
Expansionary/Contractionary FP
IS1
Interest Rate
i1
E1
Y1
Income, Output
11-6
Monetary Policy Transmission
• Transmission of a CBs MP action to the ultimate
objective of stable inflation and growth
• Change in policy rate (repo/reverse repo)
• Change in inter-bank lending rate
• Change in deposit/lending rate
• Change in bond yields
• Change in asset prices – stock and house prices
• Ultimate impact on inflation and growth
11-7
Channels of MP Transmission
• Primary channels:
• Interest rate channel
• Credit channel
• Exchange rate channel
• Asset price channel
11-8
Interest Rate Channel
• Reduced policy interest rate
• Reduction in banks’ cost of funds
• Reduction in lending rates
• Increased demand for credit from households and firms
• Increased demand for goods and services
• Increased demand for factors of production
• Increase in factor incomes
• Increase in overall demand and output and income in an
economy
11-9
Credit Channel
• Assumption – Bank’s balance sheet are strong
• Weak balance sheet hinder monetary transmission
• Ever-greening of bad loans, lending to distressed firms at
subsidized rates to avoid loan defaults
11-10
Asset Price Channel
• Housing and stocks available at cheaper borrowing costs
• Increased household and corporate wealth
• Enhanced value of the collateral or net worth of the
borrowers
• Enhanced capacity to borrow more
• Reinforces the impulses to aggregate demand
11-11
Exchange rate channel
• Lower domestic interest rates depreciates the domestic
currency
• Exports become competitive in the global market
• Increased exports, increased output and income
11-12
The Keynesian Transmission
Mechanism: Indirect
Keynesian Transmission Mechanisms
Because the Keynesian transmission mechanism is indirect,
both interest insensitive investment demand and the liquidity
trap may occur.
Monetary Policy
• The Federal Reserve is
responsible for monetary
policy in the U.S.
conducted mainly through
open market operations
• Open market operations:
buying and selling of
government bonds
Fed buys bonds in exchange
for money increases the
stock of money
Fed sells bonds in exchange
for money paid by
purchasers of the bonds
reducing the money stock
11-15
Monetary Policy
• Consider the process of adjustment to
the monetary expansion
Interest Rate
Income, Output
11-16
Transition Mechanism
• Two steps in the transmission mechanism (the process by which
changes in monetary policy affect AD):
1. An increase in real balances generates a portfolio
disequilibrium
• At the prevailing interest rate and level of income, people are holding more
money than they want
• Portfolio holders attempt to reduce their money holdings by buying other
assets changes asset prices and yields
• The change in money supply changes interest rates
2. A change in interest rates affects AD
11-17
The Liquidity Trap
• Two extreme cases arise when discussing the effects of
monetary policy on the economy first is the liquidity
trap
• Liquidity trap = a situation in which the public is prepared, at a
given interest rate, to hold whatever amount of money is
supplied
• Implies the LM curve is horizontal changes in the quantity of
money do not shift it
• Monetary policy has no impact on either the interest rate or the
level of income monetary policy is powerless
• Possibility of a liquidity trap at low interest rates is a notion that
grew out of the theories of English economist John Maynard
Keynes
11-18
What leads to Liquidity Trap
• Burst of an economic bubble
Economic Slump
Falling aggregate demand
Falling Output
Falling prices (persistent deflation)
CB responds initially with a cut in interest rates (above zero
level) to stimulate investment, output, demand and prices
Firms and businesses unresponsive to falling interest rates
Interest rates reach zero level
CB goes for quantitative easing (expansion of monetary base)
CB also commits “close to zero” interest rates for a certain
future period
11-19
r MS
Md (Y3)
Md (Y2)
Interest Rate
Md (Y1)
B A Interest Rate C B A
r0 r0 LM
C
Real Balances M/P Y1 Y2 Y3
Income, Output
11-20
• Second case is Banks’ reluctance to lend
• as interest rates decline, banks are reluctant to increase their
lending
• Increasing bad loans as borrowers fail to repay
• banks show little enthusiasm to lend more to new, perhaps risky,
borrowers
• they prefer to lend to the government, by buying securities such
as Treasury bills
• Fed open market purchase and an increase in aggregate demand
and output is put out of action
11-21
The Classical Case
• Typically the money demand equation is a function of
both real income/GDP (Y) and the interest rate (i).
• What if money demand only depends on income?
• There is no demand for money for speculation
M purpose
kY hi
• P
interest rate may be so high that nobody expects it to rise any
further).
• How would the LM curve look?
M k(P Y )
11-22
The Classical case
11-23
The Classical Case
• When the LM curve is vertical
1. A given change in the quantity of money has a maximal effect on the
level of income
2. Shifts in the IS curve do not affect the level of income
When the LM curve is vertical, monetary policy has
a maximal effect on the level of income, and fiscal
policy has no effect on income.
• Vertical LM curve implies the comparative effectiveness of
monetary policy over fiscal policy
• “Only money matters” for the determination of output
11-24
LM Curve with Different Ranges
IS6 LM
IS5
Classical Range
Interest Rate
H
IS4
IS3
IS1 IS2
Intermediate Range
K
Keynesian Range
Income, Output
11-25
Problem 1
From the following information, calculate the equilibrium values of
investment (I), net exports (NX), and money demand (md).
expenditure sector: money sector:
S = - 200 + (1/5)YD ms = 400
TA = (1/8)Y - 40 md = (1/4)Y + 100 - 5i
TR = 60
I = 300 – 10i
G = 70
NX = 150 - (1/5)Y
11-26
Solution
C = YD - S = YD – [-200 + (1/5)YD] = 200 + (4/5)YD
Sp = C + I + G + NX = 200 + (4/5)[Y‑ (1/8)Y + 40 + 60] + 300 ‑ 10i + 70 + 150 -
(1/5)Y
= 720 + (4/5)(7/8)Y + (4/5)100 ‑ 10i - (1/5)Y = 800 + [(7/10) – (2/10)]Y – 10i
= 800 + (1/2)Y ‑ 10i
Y = Sp ==> Y = 800 + (1/2)Y ‑ 10i ==> (1/2)Y = 800 ‑ 10i
Y = 2(800 ‑ 10i) ==> Y = 1,600 ‑ 20i IS‑curve
ms = md ==> 400 = (1/4)Y + 100 ‑ 5i ==> (1/4)Y = 300 + 5i ==> Y = 4(300 + 5i)
==> Y = 1,200 + 20i LM‑curve
IS = LM ==> 1,600 ‑ 20i = 1,200 + 20i ==> 40i = 400 ==> i = 10 Y = 1,400
==> I = 300 - 10*10 = 200; NX = 150 - (1/5)1,400 = - 130
md = ms = 400
11-27
