Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 17 Domestic and International Dimensions of Monetary Policy

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 17

Domestic and International Dimensions of Monetary Policy


17-2

Effects of an Increase in The Money Supply

• What if hundreds of millions of dollars in just-printed bills is dropped from a helicopter?

• People pick up the money and put it in their pockets, but how do they dispose of the new money?


17-3

Effects of an Increase in The Money Supply (cont'd)

• Direct effect

– Aggregate demand rises because with an increase in the money supply, at any given price level people now want to purchase more output of real goods and services.


17-4


• Indirect effect

– Not everybody will necessarily spend the newfound money on goods and services.

– Some of the money gets deposited, so banks have higher reserves (and they lend the excess out).


17-5


• Indirect effect

– Banks lower rates to induce borrowing. • Businesses engage in investment.• Individuals consume durable goods (like housing and

autos).

– Increased loans generate an increase in aggregate demand.

• More people are involved in more spending (even those who didn’t get money from the helicopter!).


17-6


Graphing the Effects of an Expansionary Monetary Policy

• Assume the economy is operating at less than full employment

– Expansionary monetary policy can close the recessionary gap.

– Direct and indirect effects cause the aggregate demand curve to shift outward.


17-7

Figure 17-1 Expansionary Monetary Policy with Underutilized Resources

• The recessionary gap isdue to insufficient AD

• To increase AD, use expansionary monetary policy

• AD increases and real GDP increases to full employment


17-8


Graphing the Effects of Contractionary Monetary Policy

• Assume there is an inflationary gap

– Contractionary monetary policy can eliminate this inflationary gap.

– Direct and indirect effects cause the aggregate demand curve to shift inward.


17-9

• The inflationary gap is shown

• To decrease AD, use contractionary monetary policy

• AD decreases and real GDP decreases

Figure 17-2 Contractionary Monetary Policy with Overutilized Resources


17-10

Open Economy Transmission of Monetary Policy

• So far we have discussed monetary policy in a closed economy.

• When we move to an open economy, monetary policy becomes more complex.


17-11

Open Economy Transmission of Monetary Policy (cont'd)

• The net export effect of contractionary monetary policy

• Boosts the market interest rate

• Higher rates attract foreign investment

• International price of dollar rises

• Appreciation of dollar reduces net exports

• Negative net export effect


17-12

Open Economy Transmission of Monetary Policy (cont'd)

• The net export effect of expansionary monetary policy

• Lower interest rates

• Financial capital flows out of the United States

• Demand for dollars will decrease

• International price of dollar goes down

• Foreign goods look more expensive in United States

• Net exports increase (imports fall)


17-13

Monetary Policy in Action: The Transmission Mechanism

• Recall we talked about the direct and indirect effects of monetary policy

– Direct effect: implies increase in money supply causes people to have excess money balances.

– Indirect effect: occurs as people purchase interest-bearing assets, causing the price of such assets to go up.


17-14

Figure 17-4 The Interest-Rate-Based Money Transmission Mechanism


17-15

Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (a and b)

At lower rates, a larger quantity of money will be demanded

The decrease in the interest rate stimulates investment


17-16

Figure 17-5 Adding Monetary Policy to the Aggregate Demand–Aggregate Supply Model, Panel (c)

The increase in investment shifts the AD curve to the right

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Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 17 Domestic and International Dimensions of Monetary Policy