Econ 201, Week 15 (Monetary Policy)
Econ 201, Week 15 (Monetary Policy) ECON 201
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This 5 page Class Notes was uploaded by Ekene Tharpe on Monday May 2, 2016. The Class Notes belongs to ECON 201 at University of Tennessee - Knoxville taught by Donna Bueckman in Fall 2015. Since its upload, it has received 16 views. For similar materials see Intro Economics: Survey Course in Economcs at University of Tennessee - Knoxville.
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Date Created: 05/02/16
Econ 201: Week 15 2 Big AD Shifts 1. The Great Depression (1929-‐1933) • Money supply falls 28% because of banking system problems • Stock market prices fall 90%: C and I reduce • Y fell 27% • P fell 22% 2. The World War II Boom (1939-‐1944) • G rose from $9.1 bil to $91.3 bil • Y rose 90% • P rose 20% SRAS 2 • U fell from 17% to 1% LRAS SRAS 1 Economic Fluctuations (4 steps): Event-‐ oil prices rise B 1. Increase costs, SRAS shifts P 2 2. SRAS shift left P 1 3. SR eqm at point B. A a. P higher, Y lower, U higher From A to B: Stagfication-‐ period of falling output and rising prices Y 2 N Accommodations and Adverse Shift in SRAS • Policy makers do nothing: o U = lower wages o SRAS shift right until LR eqm at A • Policy makers make policy o Increase AD and accommodate the AS shift (Keynes) o Y back to YN, P permanently higher 1970s Oil Stock and Their Effects 1973-‐75 1978-‐80 Real Oil Price +138% +99% CPI +21% +26% Real GDP -‐.7% +2.9% # Unemployed +3.5 mil +1.4 mil Suggests accommodations Case Study: 08-‐09 Recession • Dec. 2007-‐ June 2009: real GDP fell 4% • Housing market played central role • Policy response: o Fed Reserve buys mortgage-‐backed securities and other private loans o US treasury injects capital into banking system: increases bank liquidity; hope to start ‘credit crunch’ o Fiscal policymaker increased govt spending and reduce taxes by $800 billion John Maynard Keynes: 1883-‐1996 • General Theory of Employment, Interest, and Money (1936) o Argues depression and recession can result from inadequate demand o Policy makers should shift AD The Influence of Monetary Policy • Monetary policy: setting of money supply by policy makers in the central bank o Expansionary: get $$ into economy o Contractionary: take $$ from economy • Central bank: institution that oversees the banking system and regulates the money supply Who’s in Charge? • Federal Reserve (Fed): o Central bank of the US o Conduct monetary policy (auctions) • Dual mandate: Price Stability and Maximum Employment o Supervise banks o Fiscal agent for U.S govt o Processes checks and electronic payments o Conduct economic research o Lender of Last Resort Federal Reserve System: • Board of governors-‐ on top o 7 members; in Washington DC • 12 Regional Fed Banks-‐ second o located around U.S • Federal open market Committee (FOMC) o Includes board of governors and presidents of some regional Fed banks o Decides monetary policy Circular Flow of Banking Deposits: Assets of public liabilities of banks Public OMO Fed Discount rate Banks Loans: Assets of banks liabilities of public Monetary Policy Tools: • Open-‐Market Operations/OMO: o Purchase and sale of U.S govt securities (T-‐bills) by the fed § Expansionary: purchase securities § Contractionary: sell securities • Fed loans: make loans to bank, increasing their reserves o Traditional method: adjust the Discount Rate § The interest rate on loans the Fed makes to banks o Federal Funds Rate: interest rate banks charge each other for loans; rate “set” by the Fed § Expansionary: lower rate § Contractionary: increase rate • Reserve Requirement: set by Fed o Regulations on the min amount of reserves banks must hold against deposits *All 3 tools create excess reserves for the banks. Allows them to create money through making loans Monetary Policy and AD M I C P real GDP M I C P real GDP a.) Expansionary monetary policy b.) Contractionary monetary policy get $$ out there/ liquidity into economy • Problems with Controlling Money Supply: o Households could hold their money as currency and not put in the banking system o If banks hold more reserves than required; few loans, lower money supply • Fed compensates for households and bank behavior o Retains ‘fairly’ precise control over the money supply Bank Runs and Money Supply • 1929-‐33 bank runs and closings cause money supply to fall 28% • Fed deposits insurance, help prevent bank runs in the U.S A New Fed Response: • Quantitative easing (QE) o Nov. 2008 (QE1) o Buy more govt securities (LR) o Buy “toxic” assets The Viscosity of Money • The number of transactions in which the average dollar is used • Notion: o P x Y= nominal GDP = (price level) x (real GDP) o M = money supply o V = Velocity • Velocity formula: o V = (P x Y)/(M) *Velocity is fairly stable over time Example w/ one good: pizza in year 2006 • Y = real GDP=3000 pizzas • P = price level= price of pizza = $10 • P x Y = nom. GDP= value of pizzas = $30,000 o M = money supply = $10,000 o V = Velocity= $30,000/10,000 = 3 • The avergage dollar was used in 3 transactions The Quantity Equation of Money • Multiply both sides of viscosity formula by M: o M x V = P x Y 5 steps to the Quantity Equation of Money: 1. Quantity equation: M x V = P x Y 2. Change in M causes nominal GDP (P x Y) to change by the same % 3. Change in M doesn’t affect Y; money is neutral 4. P changes the same percentage as P x Y and M 5. Fast money supply growth causes rapid inflation. The quantity of money determines its value Quantity: The Bottom Line The Theory of money… • If real GDP is constant, then inflation = money growth rate • If real GDP is growing, then inflation < money growth rate • Bottom line: o Ecomonic growth increases the number of transactions o Some money growth is needed for the extra transactions o Excessive money growth causes inflation Example with one good: corn • The economy has enough labor, capital, and land to produce Y = 800 bushels of corn • V is constant • In 2008: MS = $2000; P = $5/bushels • Compute nominal GDP and velocity in 2008 o Nom GDP = P x Y = $5 x 800 = $4000 o Velocity = (P x Y)/(M) = (4000/2000) = 2
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