1 ECON 2133 Class Outline 6 Chap 12 The Monetary Model Review your Chap 11 notes The monetary model is a demand supply model 1 Demand for money Md in the model the money Q Md is related to the rate i Fig 1 p 316 The relationship is i e the Q Md decreases as i increases and vice versa Why Because the of holding wealth as money increases as i increases pgs 314 315 Md also depends on The price level P higher P leads to Md and vice versa Real income Yr Yr leads to greater Md and vice versa pg 314 315 Interpreting Md graphically A change in i changes the of money demanded movement along a given Md curve But a change in P or Yr the Md curve change in Md Fig 2 Fig 3 p 317 2 Money supply Ms is set by the Fed and is of the interest rate Fig 4 p 318 So monetary equilibrium is defined by the interest rate at which quantity of M demanded quantity of M supplied 2 Equilib Q Md Q Ms Fig 5 p 319 3 How equilibrium is reached In Fig 5 if i 9 then Q Ms Q Md and people will convert some to non monetary e g buy bonds see pg 314 320 322 This will interest rates How 1 Using excess money to buy bonds bond prices 2 The effective yield actual i rate on bonds is EY coupon bond mkt P 100 3 So if bond mkt P increases EY i rate on bonds must decrease the coupon value is fixed Returning to Fig 5 if i 3 then Q Md Q Ms and people will bonds to get more money in hand This will bond prices and interest rates Steps 1 3 above in reverse What s the point 4 The Fed can use the principles of the Md Ms relationship to in the economy The Fed s tool to do this is OMOs Review pg 296 300 303 305 To lower i rates the Fed U S Treasury bonds on the open mkt which 1 the Ms so that Q Ms Q Md 2 prompts investors to bonds with the excess M 3 3 so that i rates in the bond mkt See Fig 6 pg 323 Note Bonds are 1 3 of the world s non monetary financial assets so anything that affects i rates on bonds will affect i rates in general To raise i rates the Fed U S Treasury bonds on the open mkt which 4 the Ms so that Q Ms Q Md 5 prompts investors to sell bonds to get M 6 so that i rates in the bond mkt Study pg 322 323 What purpose does manipulating i rates serve 5 How i affects the economy A lower i rate will business and housing investment and consumer durables spending pg 324 325 i e shifts the AE line and increases Yr Fig 7 pg 325 Bottom line Monetary policy that increases the Ms and lowers i rates will stimulate increased Yr in the short run And monetary policy that decreases the Ms and raises i rates will Yr Study pg 326 327 6 Monetary policy in practice pg 327 330 A In normal times when the economy is at near its potential full employment output level The Fed will maintain a steady i rate to 4 Keep in Md from disturbing the economic equilibrium by Increasing the Ms when Md and vice versa Fig 8 pg 328 B But if the economy is in recession the Fed will its i rate target by the Ms which decreases i rates to Encourage investment and debt financed consumption spending Fig 9 pg 330 C If the economy is overheated output well above the full employment level the Fed will do the opposite of B Why Because Y Yfe can significantly increase So the Fed imposes a restrictive monetary policy to cool the economy and control inflation Read 1 Two Theories of the Interest Rate pg 330 331 2 Using the Theory pg 331 333 Chap 12 Appendix A When the Fed changes the Ms the effects on i are not as great as the previous analysis Fig 7 suggests Why Because increasing the Ms not only increases AE but also increases So that the decrease in i and increase in AE will be dampened by the increase in Md Fig A 1 pg 337 B Monetary effects of fiscal policy Since G is part of AE then a in G will AE and can Yr even more through the review pg 264 269 5 But this multiplier effect is not as as the simple spending multiplier 1 1 mpc see pg 265 would imply in part because of changes in the Why 1 An increase in G will Yr and national saving S 2 An increase in Yr will Md 3 Increased Md with given Ms will i also decreased S will increase i 4 And increased i will investment spending and also debtfinanced C spending I e the contributions of I and C to AE decrease Fig A 2 p 339 This is how increased G other spending in the economy Pg 339 340 also pg 184 188 Chap 7 Bottom line Increased G may be expected to have large effects on Yr only if 1 The economy is in a prolonged recession which would likely lead to low interest rates and much wealth being held as money and 2 The investment demand DLF curve is highly inelastic so that an increase in the interest rate will not reduce investment spending I very much crowding out of I is minimized Disc Illus XXX Chap 12