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INTHISLECTURE
The Monetarist Transmission Mechanism
Bond Prices and Interest Rates
Topic 13: Monetary Policy and Interest Rate
The Activist-Non-activist Debate
Non-activist (or Rules-Based) Monetary
Proposals
Dr. Mohd Razani Mohd Jali
Room 0.55 Economic Building
School of Economics, Finance and Banking
Nominal and Real Interest Rates
razani@uum.edu.my
04-928 6792
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The routes, or channels, that ripple How demand for and supply of money
effects created in the money market affect:
travel to affect the goods and services Interest rates
market (represented by the aggregate Market for goods and services
demand and aggregate supply curves in
the AD-AS framework).
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M1 AD
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2. According to the Keynesian transmission Second, even if the money market is not in the liquidity
mechanism, as the money supply rises, trap, a rise in the money supply affects the goods and
services market not directly, but indirectly: The rise in the
there is a direct impact on the goods and money supply lowers the interest rate, causing
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services market. Do you agree or disagree investment to rise (assuming investment is not interest
with this statement? Explain your answer. insensitive). As investment rises, the AD curve shifts
We disagree for two reasons. First, if the money market is in rightward, affecting the goods and services market. In
the liquidity trap, a rise in the money supply will not affect other words, there is an important intermediate market
interest rates and therefore will not affect investment or between the money market and the goods and
the goods and services market. market can affect the services market in the Keynesian transmission
goods and services market only indirectly. mechanism. Thus, the money market can affect the
(continued) goods and services market only indirectly.
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BOND PRICES, INTEREST RATES, AND BOND PRICES, INTEREST RATES, AND
THE LIQUIDITY TRAP THE LIQUIDITY TRAP
The liquidity trap, or the horizontal section of The market interest rate is inversely related to
the demand curve for money, seems to come the price of old or existing bonds. As interest
out of the clear blue sky. Why might the rates rise, he price of a an already issued (old)
demand curve for money become horizontal at bond decreases and vice-versa.
some low interest rate? To understand the At a low interest rate, the money supply
explanation, you must first understand the increases but does not result in an excess
relationship between bond prices and interest supply of money. Interest rates are very low,
rates. and so bond prices are very high. Would-be
For a basic buyers believe that bond prices are so high
understanding of bonds, that they have no place to go but down. So
click below
https://en.wikipedia.org individuals would rather hold all the
/wiki/Bond_(finance) additional money supply than use it to buy
bonds.
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recessionary gap, but this is not known to Central
gap than contractionary monetary Bank officials. Thinking that the economy is stuck in a
policy to eliminate an inflationary recessionary gap, the Central Bank increases the
money supply. When the money supply is felt in the
gap? goods and services market, the AD curve intersects
Keynesians believe that prices and wages are the SRAS curve (that has been moving rightward,
unbeknownst to officials) at a point that represents
inflexible downward but not upward. They believe it
an inflationary gap. In other words, the Central Bank
is more likely that natural forces will move an has moved the economy from a recessionary gap to
economy out of an inflationary gap than out of a an inflationary gap instead of from a recessionary
recessionary gap. gap to long-run equilibrium at the Natural Real GDP
level.
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Largely in response to the charge that Federal funds rate target = 1.5 (inflation rate) + 0.5
(GDP gap) + 1
velocity is not always constant, some
Inflation rate- This is the current inflation
non-activists prefer the following rule: rate.
The annual growth rate in the money 12 output gap - The output gap is the
percentage difference between actual Real
supply will be equal to the average GDP and its full-employment or natural level.
annual growth rate in Real GDP minus
the growth rate in velocity.
%M = %Q %V
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This requires the Central Bank to try to price stability?
keep the inflation rate near a
The answer to this open-ended question
predetermined level. depends on many factors. First, the answer
Major issues: depends on what the rule specifies
A specific Rate or range? because not all rules are alike. Second, it
depends on the stability and predictability
If so, what range or rate? of velocity.
Announce rate or not? (continued)
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For example, suppose the rule specifies that each year 2. Suppose the inflation rate is 4 percent and
the money supply will rise by the average annual the GDP gap is 5 percent. What is the Taylor
growth rate in Real GDP. If velocity is constant, this kind
of rise will produce price stability. But if velocity is
rule recommendation for the federal funds
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extremely volatile, changes in it might offset changes in rate target?
the money supply, leading to deflation instead of price
stability. For example, suppose Real GDP rises by 3
percent and the money supply increases by 3 percent, Here is the Taylor rule specification:
but velocity decreases by 3 percent. The change in Federal funds rate target = 1.5 (4 percent) +0.5 (5 percent) +
velocity offsets the change in the money supply, 1 = 9.5 percent.
leaving a net effect of a 3 percent rise in Real GDP. This,
then, would lead to a 3 percent decline in the price
level.
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WHAT HAPPENS TO THE INTEREST RATE WHAT HAPPENS TO THE INTEREST RATE
AS THE MONEY SUPPLY CHANGES? AS THE MONEY SUPPLY CHANGES?
Point 1 in time: Central Bank says it will A change in the money supply affects
increase the growth rate of the money supply. the economy in many ways.
Point 2 in time: If the expectations effect kicks
Changing the supply of loanable funds
in immediately, then . . .
directly, changing Real GDP and
Point 3 in time: Interest rates rise.
therefore changing the demand for and
Point 4 in time: Liquidity effect kicks in.
supply of loanable funds, changing the
Point 5 in time: As a result of what happened
at point 4, the interest rate drops.
expected inflation rate, and so on. The
The interest rate is now lower than it was at
timing and magnitude of these effects
point 3. determine the changes in the interest
rate.
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Expectations Effect
i%
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2. Is it possible for the nominal interest rate to 3. The Central Bank only affects the interest
immediately rise following an increase in rate via the liquidity effect. Do you agree or
the money supply? Explain your answer. disagree? Explain your answer.
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Reference:
Arnold, Roger A. (2016), Ch. 15 & 14