1. MONETARY POLICY
GT01003
Macroeconomics

2. Learning Objectives
1. Analyze how changes in real interest rates affect
planned aggregate expenditures (PAE) and short-run
equilibrium output
2. Show how the demand for money and the supply of
money determine equilibrium nominal interest rate
3. Discuss how central bank uses control of the money
supply to influence nominal and real interest rates

3. Introduction: Monetary Policy
• Monetary policy is a major stabilization tool
• Quickly decided and implemented
• More flexible and responsive

6. Introduction: Central Banks
• Responsibilities of Central Banks are
• Conduct monetary policy
• Oversight and regulation of financial markets
• Central to solving financial crises

7. Introduction: Central Bank and the
Economy
Eliminate output gaps by changing the
money supply
Changes in money supply cause
changes in nominal interest rate
Interest rates affect planned
aggregate expenditures, PAE

8. HOW DOES INTEREST RATE
AFFECT PAE & SHORT-RUN
EQUILIBRIUM OUTPUT??

9. PAE and Real Interest Rate
• Planned Aggregate Expenditures have components that
are affected by r
• Savings decisions of households
• More saving at higher real interest rates
• Higher saving means less consumption
• Investment by firms
• Higher interest rates mean less investment
• Investments are made if the cost of borrowing is less than the return on the
investment
• Both consumption and planned investment decrease
when the interest rate increases

10. Interest in the Keynesian Model – An
Example
• Components of aggregate spending are
C = 640 + 0.8 (Y – T) – 400r
IP = 250 – 600 r
G = 300
NX = 20
T = 250
• If r increases from 0.04 to 0.05 (that is, from 4% to 5%)
• Consumption decreases by 400 (0.01) = 4
• Planned investment decreases by 600 (0.01) = 6
• A one percentage point increase in r reduces planned
spending by 10 – before the multiplier is considered

11. Planned Aggregate Expenditures
PAE = C + IP + G + NX
PAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r + 300
+ 20
PAE = 1,010 – 1,000 r + 0.8 Y
• In this example, planned aggregate expenditure depends
on both the real interest rate and the level of output
• Equilibrium output can only be found once we know the value of r

12. Planned Aggregate Expenditures
PAE = 1,010 – 1,000 r + 0.8 Y
• Suppose the real interest rate is 5%, or 0.05
• Planned aggregate expenditures becomes
PAE = 1,010 – 1,000 (0.05) + 0.8 Y
PAE = 960 + 0.8 Y
• Short-run equilibrium output is PAE = Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800
• The graphical solution is the same as before

13. Can Central Bank Control the Real
Interest Rates?
• Central Bank controls the money supply to control
nominal interest rates, i
• Investment and saving decisions are based on the real
interest rate, r
• Central bank has some control over the real interest rate
r = i -
where is the rate of inflation
• Central Bank has good control over i
• Inflation changes relatively slowly
• Changes in nominal rates become changes in real rates

14. Monetary Policy and Economic
Fluctuations
r C, IP PAE
Y via the
multiplier
r C, IP PAE Y via the
multiplier
Recessionary Gap
Expansionary Gap

15. Central Bank Fights a Recession
Output (Y)
Plannedaggregateexpenditure(PAE)
Y = PAE
E
Expenditure line (r = 5%)
4,800
A reduction in r shifts the
expenditure line upward and
closes the recessionary gap
5,000
Y*
Expenditure line (r = 1%)
F

16. Central Bank Fights Inflation
• Expansionary gap can lead to inflation
• Planned spending is greater than normal output levels at the
established prices
• Short-run unplanned decreases in inventories
• If gap persists, prices will increase
• Central bank attempts to close expansionary gaps
• Raise interest rates
• Decrease consumption and planned investment
• Decrease planned aggregate expenditures
• Decrease equilibrium output

17. Monetary Policy for an Expansionary Gap
PAE = 1,010 – 1,000 r + 0.8 Y
• The real interest rate, r, is 5%
• Short-run equilibrium output is $4,800
• Potential output is $4,600
• Expansionary gap is $200
• Monetary policy can be used to decrease PAE
• The Central Bank should decrease the real interest rate to
9%

18. Central Bank Fights Inflation
Output (Y)
Plannedaggregateexpenditure(PAE)
Y = PAE
E
Expenditure line (r = 5%)
4,800
An increase in r shifts the
expenditure line down and
closes the expansionary gap
4,600
Y*
Expenditure line (r = 9%)
G

19. Central Bank Fights Inflation
r
Planned C and I
PAE
Y
r
Planned C and I
PAE
Y
Expansionary Gap Recessionary Gap

20. HOW DO CENTRAL BANKS
CONTROL INTEREST RATES?

21. Central Bank and Interest Rates
• Controlling the money supply is the primary task of a
central bank:
• Money supply and demand determine the interest rate
• Central bank manipulates supply to achieve its desired interest rate
• To better understand how the central bank determines
interest rates, we will look first at the market for money –
the demand for money and the supply of money.

22. Demand for Money
• Demand for money is sometimes called
an individual's liquidity preference
• The Cost – Benefit Principle indicates people
will balance the marginal cost of holding
money versus the marginal benefit
• Money's benefit is the ability to make
transactions
• Quantity of money demanded increases with
income
• Technologies such as online banking and
ATMs have reduced the demand for money
• M1 has decreased from 28% of GDP in 1960 to
12% in 2004

23. Demand for Money
• Demand for money depends on
• Nominal interest rate (i)
• The higher the interest rate, the lower the quantity of money demanded
• Real income or output (Y)
• The higher the level of income, the greater the quantity of money
demanded
• The price level (P)
• The higher the price level, the greater the quantity of money demanded

24. Demand for Money
• The marginal cost of holding money is the interest
foregone
• Most forms of money pay little or no interest
• Assume the nominal interest rate on money is 0
• Alternative assets such as stocks or bonds have a positive nominal
interest rate
• The higher the nominal interest rate, the smaller the
quantity of money demanded
• Business demand for money is similar to individuals'
• Businesses hold more than half of the money stock

25. The Money Demand Curve
• Interaction of the aggregate demand for money and the
supply of money determines the nominal interest rate
• The money demand curve shows the relationship
between the aggregate quantity of money demanded, M,
and the nominal
interest rate
• An increase in the
nominal interest rate
increases the
opportunity cost of
holding money
• Negative slope
Money (M)
Nominalinterestrate(i)
MD

26. The Money Demand Curve
• Changes in factors other than the nominal interest rate
cause a shift in the money demand curve
• An increase in demand for money can result from
• An increase in output
• Higher price levels
• Technological advances
• Financial advances
• Foreign demand for
dollars
Money (M)
Nominalinterestrate(i)
MD
MD'

27. Supply of Money
• Central bank primarily controls the supply of money with
open-market operations
• An open-market purchase of bonds by central bank increases the
money supply (expansionary monetary policy)
• An open-market sale of
bonds by central bank
decreases the money
supply (contractionary monetary policy)
• Supply of money is vertical
• Equilibrium is at E
Money
(M)
MD
E
MS
M
i
Nominalinterestrate(i)

28. Central Bank Controls the Nominal
Interest Rate
• Initial equilibrium at E
• Central Bank increases the money
supply to MS'
• New equilibrium at F
• Interest rated decrease to i'
to convince the market
to hold the new, larger
amount of money
Money (M)
MD
MS
M
Ei
Nominalinterestrate(i)
Fi'
M'
MS'

29. Central Bank (CB) Controls the Nominal
Interest Rate
CB sells
bonds to
the public
Supply of
bonds
increases
Price of
bonds
decrease
Interest
rate
increases
To Decrease the Money Supply
CB buys
bonds
from the
public
Demand
for bonds
increases
Price of
bonds
increase
Interest
rate
decreases
To Increase the Money Supply

30. The US Federal Funds Rate, 1970-2008

31. 0
0.5
1
1.5
2
2.5
3
3.5
4
Malaysian Overnight Policy Rates
Overnight Policy Rates

32. Additional Controls over the Money
Supply
• Open market operations are the main tool of
money supply
• Central bank offers lending facility to banks
• If a bank needs reserves, it can borrow from the
Central Bank at the discount rate
• The discount rate is the rate the Central Bank
charges banks to borrow reserves
• Lending increases reserves and ultimately
increases the money supply
• Changes in the discount rate signal
tightening or loosening of the money supply

33. Additional Controls over the Money
Supply
• Central Bank can also change the reserve requirement
for banks
• The reserve requirement is the minimum percentage of bank
deposits that must be held in reserves
• The reserve requirement is rarely changed
• The Central Bank could increase the money supply by
decreasing the reserve requirement
• Banks would have excess reserves to loan
• The Central Bank could decrease the money supply by
increasing the reserve requirement

35. Conclusion
Keynesian
Model
Open Market
Operations
Discount Rate
Reserve
Requirement
Money
Market
Monetary
Policy
Demand
for Money
Supply of
Money
Central
Bank
Stabilization
Policy
Interest Rates