Monetary PolicyMonetary PolicyMonetary PolicyElias YannopoulosNovember 2, 2012Elias Yannopoulos Monetary PolicyMonetary PolicyBank Runs and FDICKeeping part of the deposits on reserve works fine when only afew people need some of their money each dayBut there is one problem, Bank run!Bank run is when everyone tries to get their money out atonce, and since the bank has only a fraction of the depositson hand some people can’t get their money and the bank hasto closeTo prevent this government-backed insurance of deposits wascreatedFederal Deposit Insurance Corporation (FDIC) - providesinsurance on deposits in commercial banks up to $250,000This insures just deposits not mutual funds or stocksWith the FDIC you don’t have to worry about not gettingyour money so there are no more runs on the banksNew problem: Moral Hazard - the lack of incentive to guardagainst risk where one is protected from its consequencesElias Yannopoulos Monetary PolicyMonetary PolicyMonetary Policy ImpactHow does Monetary Policy impact the real economy?Ex: Government announces that each US dollar is worth 10US dollars, effectively multiplying your money by 10If all prices can adjust right away then all the prices become10 times what they were, only a nominal changeIf some prices are stuck then there can be real impacts on theeconomyUsing the AS/AD model we can show what will happen in theshort run to monetary policyFirst we have to look at the market for loanable funds, Ex:the Fed makes and OM purchaseElias Yannopoulos Monetary PolicyMonetary PolicyMonetary Policy ImpactWith an OM Purchase, there is an increase in the moneysupply directly to banksThe banks lend this money out which results in a increase inthe supply of loanable funds ⇒↓ interest rateThe reduction in the interest rate leads to more investment(movement along the demand curve) and a increase inconsumption (movement along the supply curve)Increase in Investment and Consumption leads to a shift outin AD ⇒↑ P ↑ Y ↓ uShort Run effects from money supply increase = ↓ R ↑ P(output prices) ↑ Y ↓ u ↓ Real WagesMonetary policy has real effects in the short runElias Yannopoulos Monetary PolicyMonetary PolicyLong Run Effects of Monetary PolicyRelationship between the price level and the real value ofmoney ex: gold from South America to EuropeIn the long run all prices have time to adjust SRAS moves asinput prices adjust Ex: AS/AD graphAlso as prices adjust the interest rate also return to its normallevelIn the long run money has no real effect it only affects theprice levelWhat if everyone expects the change in the money supply,also called fully anticipatedIf everyone knows the money supply is going to change someday in the future then they will prepare and adjust their pricesexactly in line with the money supply increase and no realeffects on the economyElias Yannopoulos Monetary PolicyMonetary PolicySummaryWhat if interest rates are already zero? Ex: graphUnexpected Monetary policy has real effects on the short runbut only nominal on the long runFully anticipated monetary policy has no real effect on theshort or long run, has only a nominal effectElias Yannopoulos Monetary PolicyMonetary PolicyElias Yannopoulos Monetary
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