MONETARY POLICY AND AD

Introduction
▪ Earlier we covered:
▪ the long-run effects of fiscal policy on interest rates, investment,
economic growth
▪ the long-run effects of monetary policy on the price level and
inflation rate
▪ Focuses on the short-run effects of monetary policy,
which work through aggregate demand.
Aggregate Demand
▪ Recall, the AD curve slopes downward for three reasons:

▪ The wealth effect

▪ The interest-rate effect
▪ The exchange-rate effect – important effect

Lower price level reduces the interest rate, investors move some of their funds overseas in search of
higher returns. This will cause the real value of domestic currency. Domestic goods become less
expensive. This change in real exchange rate stimulates spending on net exports and this increases the
qty of G&S demanded.

▪ Next:
A supply-demand model that helps explain the interest-rate effect and how monetary policy
affects aggregate demand.
The Theory of Liquidity Preference

▪ A simple theory of the interest rate (denoted r).

▪ r adjusts to balance supply and demand for money.
▪ Money supply: assume fixed by central bank, does not depend
on interest rate.
The Theory of Liquidity Preference
▪ Money demand reflects how much wealth
people want to hold in liquid form.
▪ For simplicity, suppose household wealth
includes only two assets:
▪ Money – liquid but pays no interest
▪ Bonds – pay interest but not as liquid
▪ A household’s “money demand” reflects its
preference for liquidity.
▪ The variables that influence money demand:
Y, r, and P.
Money Demand
▪ Suppose real income (Y) rises. Other things equal, what happens to
money demand?
▪ If Y rises:
▪ Households want to buy more g&s, so they need more money.
▪ To get this money, they attempt to sell some of their bonds.
▪ I.e., an increase in Y causes an increase in money demand, other
things equal.
 Demand and Supply of Money, Part 1
• Money supply
– Controlled by the Central Bank (CB)
– Quantity of money supplied
• Fixed by CB policy
• Doesn’t vary with interest rate
– CB alters the money supply
• Changing the quantity of reserves in the banking system
– Purchase and sale of government bonds in open-market operations
 Demand and Supply of Money, Part 2
• Money demand
– Money – most liquid asset
• Can be used to buy goods and services
– Interest rate – opportunity cost of holding money
– Money demand curve – downward sloping
• Increase in the interest rate
– Raises the cost of holding money
– Reduces the quantity of money demanded
 Demand and Supply of Money, Part 3
• Equilibrium in the money market
– Interest rate – adjusts to balance the supply and demand
for money
– Equilibrium interest rate
– Quantity of money demanded exactly balances the
quantity of money supplied
 Demand and Supply of Money, Part 4
• If interest rate > equilibrium
– Quantity of money people want to hold
• Less than quantity supplied
– People holding the surplus
• Buy interest-bearing assets
– Lowers the interest rate
– People - more willing to hold money
– Until: equilibrium
 Demand and Supply of Money, Part 5
• If interest rate < equilibrium
– Quantity of money people want to hold
• More than quantity supplied
– People - increase their holdings of money
• Sell - interest-bearing assets
– Increase interest rates
– Until: equilibrium
 Equilibrium in the Money Market
According to the theory of liquidity
preference, the interest rate
adjusts to bring the quantity of
money supplied and the quantity of
money demanded into balance. If
the interest rate is above the
equilibrium level (such as at r1),
the quantity of money people want
to hold (Md1) is less than the
quantity the Fed has created, and
this surplus of money puts
downward pressure on the interest
rate.

Conversely, if the interest rate is below the equilibrium level (such as at r2), the quantity of money people want to hold (Md2) is
greater than the quantity the Fed has created, and this shortage of money puts upward pressure on the interest rate. Thus, the
forces of supply and demand in the market for money push the interest rate toward the equilibrium interest rate, at which people
are content holding the quantity of money the Fed has created.
How r Is Determined

Interest MS curve is vertical:

rate MS
Changes in r do not
affect MS, which is
r1 fixed by the Fed.
Eq’m MD curve is
interest downward sloping:
rate MD1 A fall in r increases
money demand.
M
Quantity fixed
by the Fed
How the Interest-Rate Effect Works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s demanded.

 Monetary Policy and Aggregate Demand
▪ To achieve macroeconomic goals, the Fed/CB can use monetary
policy to shift the AD curve.
▪ The CB’s policy instrument is MS.
▪ The news often reports that the CB targets the interest rate.
▪ More precisely, the CB/federal funds rate, which banks charge
each other on short-term loans
▪ To change the interest rate and shift the AD curve,
the CB conducts open market operations
to change MS.
The Effects of Reducing the Money Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

Liquidity Trap
It is a contradictory economic situation in which interest rates are
very low and saving rates are high, rendering monetary policy
ineffective. Consumers choose to avoid bonds and keep their funds
in cash savings.
Eg: In 1990s Japan faced a liquidity trap (negative interest rate)
Under a negative interest rate policy, central banks encourage lending by requiring
banks to pay interest for keeping excess reserves with it. Hence, banks offer a negative
interest rate on customer deposits, making customers pay to deposit money with
banks, to encourage spending and discourage saving.
Liquidity traps
▪ Monetary policy stimulates aggregate demand by
reducing the interest rate.
▪ Liquidity trap: when the interest rate is zero
▪ In a liquidity trap, mon. policy may not work, since
nominal interest rates cannot be reduced further.
▪ However, central bank can make real interest
rates negative by raising inflation expectations.
▪ Also, central bank can conduct open-market ops
using other assets—like mortgages and corporate
debt—thereby lowering rates on these kinds of
loans. The Fed pursued this option in 2008–2009.
Key takeaways – Negative Interest rate

Negative interest rates are a form of monetary policy that sees interest rates fall
below 0%.
Central banks and regulators use this unusual policy tool when there are strong
signs of deflation.
Borrowers are credited interest instead of paying interest to lenders in a
negative interest rate environment.
Central banks charge commercial banks on reserves in an effort to incentivize
them to spend rather than hoard cash positions.
Although commercial banks are charged interest to keep cash with a nation's
central bank, they are generally reluctant to pass negative rates onto their
customers.
 Aggregate Demand
• The downward slope of the AD curve
1. A higher price level
– Raises money demand
2. Higher money demand
– Leads to a higher interest rate
3. A higher interest rate
– Reduces the quantity of goods and services demanded

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 Figure 2
The Money Market and the Slope of the Aggregate-Demand Curve

An increase in the price level from P1 to P2 shifts the money-demand curve to the right, as in panel (a). This increase in money demand causes the
interest rate to rise from r1 to r2. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods
and services demanded from Y1 to Y2. This negative relationship between the price level and quantity demanded is represented with a downward-
sloping aggregate-demand curve, as in panel (b).

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 Monetary Policy Influences AD, Part 1
• Aggregate-demand curve shifts
– Quantity of goods and services demanded changes
– For a given price level
• Monetary policy
– Increase in money supply
– Decrease in money supply
– Shifts aggregate-demand curve

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 Monetary Policy Influences AD, Part 2
• The Fed increases the money supply
– Money-supply curve shifts right
– Interest rate falls
– At any given price level
• Increase in quantity demanded of goods and services
– Aggregate-demand curve shifts right

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 Figure 3
A Monetary Injection

In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest
rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate
raises the quantity of goods and services demanded at a given price level from Y1 to Y2. Thus,
in panel (b), the aggregate-demand curve shifts to the right from AD1 to AD2.
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 Monetary Policy Influences AD, Part 3
• The Fed decreases the money supply
– Money-supply curve shifts left
– Interest rate increases
– At any given price level
• Decrease in quantity demanded of goods and services
– Aggregate-demand curve shifts left

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 Monetary Policy Influences AD, Part 4
• Federal funds rate
– Interest rate
– Banks charge one another
– For short-term loans
• The Fed
– Targets the federal funds rate
• The FOMC – open-market operations
– Adjust money supply

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 Monetary Policy Influences AD, Part 5
• Changes in monetary policy
– Aimed at expanding aggregate demand
• Increasing the money supply
• Lowering the interest rate
• Changes in monetary policy
– Aimed at contracting aggregate demand
• Decreasing the money supply
• Raising the interest rate

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 Why the Fed Watches the Stock Market
(and Vice Versa), Part 1
• Fluctuations in stock prices
– Sign of broader economic developments
– Economic boom of the 1990s
• Rapid GDP growth and falling unemployment
• Rising stock prices (fourfold)
– Deep recession of 2008 and 2009
• Falling stock prices
– From November 2007 to March 2009, the stock
market lost about half its value

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 Why the Fed Watches the Stock Market
(and Vice Versa), Part 2
• The Fed
– Not interested in stock prices themselves
– Monitor and respond to developments the
overall economy
• Stock market boom expands the AD
– Households – wealthier
• Stimulates consumer spending
– Firms – want to sell new shares of stock
• Stimulates investment spending

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 Why the Fed Watches the Stock Market
(and Vice Versa), Part 3
• The Fed’s goal: stabilize AD
– Greater stability in output and price level
• The Fed’s response to a stock-market
boom
– Keep money supply lower
– Keep interest rates higher
• The Fed’s response to a stock-market fall
– Increase money supply
– Lower interest rates
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 Why the Fed Watches the Stock Market
(and Vice Versa), Part 4
• Stock-market participants
– Keep an eye on the Fed
– The Fed can
• Influence interest rates and economic activity
• Alter the value of stocks
• The Fed - raises interest rates
– Less attractive owning stocks
• Bonds - earning a higher return
• Reduced demand for goods and services
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