Chapter 15Chapter 15

Monetary PolicyMonetary Policy

© West Publishing Company 1996

EQUATION OF EXCHANGEEQUATION OF EXCHANGE

M V = P Q M is the money supply V is the velocity of money P is the price level Q is the real GDP

INFLATIONINFLATION

Inflation refers to an increase in the general price level.

One-shot inflation is a one-time increase in the price level.

Continued inflation is continuous increases in the price level (CPI rises each year)

CONTINUED INFLATIONCONTINUED INFLATION

YEAR 1992 1993 1994 1995 1996

CPI 100 108 120 133 150

CONTINUED INFLATIONCONTINUED INFLATION

Continued inflation results from continued increases in AD.

What causes these continued increases in AD?

Usually continued increases in the Money Supply

COSTS OF INFLATIONCOSTS OF INFLATION

Inflation is a “tax” on peoples moneyholdings.

Inflation lowers the real return on your savings.

Inflation redistributes purchasing power from lenders to borrowers.

COSTS OF INFLATIONCOSTS OF INFLATION

Inflation can lead to social tension Inflation creates greater uncertainty Inflation leads people to divert money away

from productive activities.

INTEREST RATESINTEREST RATES

REAL RATE - the rate of return banks must have to cover costs and provide a return to investors

NOMINAL RATE - real rate plus the expected rate of inflation

DEMAND FOR MONEYDEMAND FOR MONEY

The inverse relationship between the quantity of money balances and the interest rate

the interest rate is the opportunity cost of holding money

Demand for, and Supply of Demand for, and Supply of Money Money

Exhibit 1Exhibit 1Interest Rate

Quantity of Money

M20

Interest Rate

Quantity of Money

0M1

i2

i1

Demand for Money

Supply of Money

(a) (b)

Equilibrium in the Money Equilibrium in the Money Market Market Interest Rate

Quantity of Money

D1

0 M1

i2

i1

Excess Demandfor Money

S1Excess Supplyof Money

i3

Equilibrium in themoney market

BONDS AND INTEREST BONDS AND INTEREST RATESRATES

bonds have a face value bonds pay a fixed interest payment each

year (coupon pmt) bond prices are determined by the

relationship between current interest rates and the bond’s rate

BONDS AND INTEREST BONDS AND INTEREST RATESRATES

Bond Prices are inversely related to the current interest rate.

If current interest rates are higher than the bond’s rate then the bond will sell below face value

If interest rates fall, bond prices rise

APPROPRIATE POLICIESAPPROPRIATE POLICIES

What are the appropriate monetary policies to close a recessionary gap?– buy bonds– decrease discount rate– decrease reserve requirement

APPROPRIATE POLICIESAPPROPRIATE POLICIES

What are appropriate monetary policies to close an inflationary gap?– sell bonds– increase the discount rate– increase reserve requirements