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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
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)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
- 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 Δ in G will Δ AE ______, and can Δ Yr even more through the “______”
(review pg. 264 – 269)
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 debt-financed 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. ]