04-Dec-16

The Keynesian Transmission Mechanism

BEEB1013 Principles of Economics

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

CH 15 2

TRANSMISSION MECHANISM THE MONEY MARKET

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).

CH15 3 CH 15 4

DEMAND FOR MONEY THE SUPPLY OF MONEY

Represents the inverse The supply curve of

relationship between the
quantity demanded of
money is a vertical
money balances and the line at the quantity of
price of holding money money, which is
balances.
largely, but not
Interest rate is the price
(opportunity cost) of
exclusively,
holding money balances. determined by the
Central Bank.

CH 15 5 CH 15 6

1
 04-Dec-16

EQUILIBRIUM IN THE MONEY MARKET

At an interest rate of Keynesian Transmission Mechanism

i 1, the money market

is in equilibrium: There For a tutorial on the Keynesian Transmission Mechanism click below.
is neither an excess http://www.swlearning.com/economics/graphingworkshop/archive_tutor
supply of money nor ials/generic2003/043_ktm.html

an excess demand for

money

CH 15 7 CH 15 8

KEYNESIAN TRANSMISSION KEYNESIAN MECHANISM MAY GET

MECHANISM BLOCKED
The Keynesian transmission mechanism
allows the link between the money
market and the goods and services
market to be broken in two places if:
Investment is totally interest-
insensitive, and
The money market is in the
(a) An increase in the money supply brings on a lower interest rate. liquidity trap
(b) As a result, investment increases.
(c) As investment increases, total expenditures rise and the aggregate demand
curve shifts rightward. Real GDP rises from Q1 to Q2.
CH 15 9 CH 15 10

KEYNESIAN MECHANISM MAY GET

KEYNESIAN MECHANISM MAY GET
BLOCKED INTEREST INSENSITIVE
INVESTMENT BLOCKED LIQUIDITY TRAP

If investment is totally Liquidity Trap - The horizontal

portion of the demand curve
interest-insensitive, a for money.
change in the interest If the money market is in the
rate will not change liquidity trap, an increase in the
money supply will not lower the
investment; therefore,
interest rate.
aggregate demand
It follows that there will be no
and Real GDP will not change in investment,
change. aggregate demand or Real
GDP.

CH 15 11 CH 15 12

2
 04-Dec-16

THE KEYNESIAN VIEW OF MONETARY THE MONETARIST TRANSMISSION

POLICY MECHANISM SHORT & DIRECT
Changes in the money market directly
affect aggregate demand in the goods
and services market.
For example, an increase in the money
supply leaves individuals with an excess
supply of money that they spend on a
wide variety of goods.

M1 AD
CH 15 13 CH 15 14

THE MONETARIST TRANSMISSION 1. Explain the inverse relationship

MECHANISM between bond prices and interest
rates.
SELFTEST
Kahn buys a bond for a face value of $10,000 that
promises to pay a 10 percent interest rate each year
for 10 years. In one year, though, bonds are offered
for a face value of $10,000 that pay an 11 percent
interest rate each year for 10 years. If Kahn wants to
sell his bond, he wont be able to sell it for $10,000
because no one today will pay $10,000 for a bond
that pays a 10 percent interest rate when a $10,000,
11 percent bond is available. Kahn has to lower the
price of his bond if he wants to sell it. Thus, as interest
rates rise, bond prices decrease (for old or existing
bonds).

CH 15 15 CH 15 16

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
SELFTEST

SELFTEST

services market. Do you agree or disagree
with this statement? Explain your answer.
We disagree for two reasons. First, if the money market is in
the liquidity trap, a rise in the money supply will not affect
interest rates and therefore will not affect investment or
the goods and services market. market can affect the
goods and services market only indirectly.
(continued)
investment to rise (assuming investment is not interest
insensitive). As investment rises, the AD curve shifts
rightward, affecting the goods and services market. In
other words, there is an important intermediate market
between the money market and the goods and
services market in the Keynesian transmission
mechanism. Thus, the money market can affect the
goods and services market only indirectly.

CH 15 17 CH 15 18

3
 04-Dec-16

3. Explain how the monetarist MONETARY POLICY

transmission mechanism
SELFTEST

works when the money Expansionary - The

Central Bank increases
supply rises. the money supply to
address a recessionary
A rise in the money supply brings gap.
about an excess supply of money in
the money market that flows to the
Contractionary - The
goods and services market, Central Bank decreases
stimulating aggregate demand. the money supply to
address an inflationary
gap

CH 15 19 CH 15 20

MONETARY POLICY AND MONETARY POLICY AND

A RECESSIONARY GAP AN INFLATIONARY GAP

CH 15 21 CH 15 22

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.
CH 15 23 CH 15 24

4
 04-Dec-16

THE CASE FOR ACTIVIST

ACTIVISTS & FINE-TUNING
MONETARY POLICY
Activists - Persons who argue that The economy does not always
monetary and fiscal policies should be equilibrate quickly enough at Natural
deliberately used to smooth out the Real GDP.
business cycle. Activist monetary policy works; it is
Fine Tuning - The (usually frequent) effective at smoothing out the business
use of monetary and fiscal policies to cycle.
counteract even small undesirable Activist monetary policy is flexible;
movements in economic activity. non-activist (rules-based) monetary
policy is not.

CH 15 25 CH 15 26

THE CASE FOR NON-ACTIVIST

NON-ACTIVISTS
MONETARY POLICY
Persons who argue against the In modern economies, wages and prices
deliberate use of discretionary fiscal are sufficiently flexible to allow the
and monetary policies. economy to equilibrate at reasonable
speed at Natural Real GDP.
They believe in a permanent, stable,
Activist monetary policies may not
rule-oriented monetary and fiscal work.
framework.
Activist monetary policies are likely to
be destabilizing rather than stabilizing;
they are likely to make matters worse
rather than better.

CH 15 27 CH 15 28

EXPANSIONARY MONETARY POLICY MONETARY POLICY MAY DESTABILIZE

AND NO CHANGE IN REAL GDP THE ECONOMY
If expansionary monetary policy The SRAS curve is shifting
is anticipated (thus, a higher price rightward (ridding the economy
level is anticipated), workers may of its recessionary gap), but
bargain for and receive higher Central Bank officials do not
wage rates. realize this is happening.
It is possible that the SRAS curve They implement expansionary
will shift leftward to the same monetary policy, and the AD
degree that expansionary curve ends up intersecting SRAS2
monetary policy shifts the AD at point 2 instead of intersecting
curve rightward. SRAS1 at point 1'.
Result: No change in Real GDP. Central Bank officials end up
moving the economy into an
inflationary gap and thus
destabilizing the economy.

CH 15 29 CH 15 30

5
 04-Dec-16

1. Why are Keynesians more likely to 2. How might monetary policy

advocate expansionary monetary destabilize the economy?
policy to eliminate a recessionary Suppose the economy is regulating itself out of a
SELFTEST

SELFTEST
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.

CH 15 31 CH 15 32

3. If the economy is stuck in a NON-ACTIVIST MONETARY PROPOSALS

CONSTANT-MONEY-GROWTH-RATE RULE
recessionary gap, does this make the
case for activist (expansionary)
SELFTEST

One version of the rule is: The annual money

monetary policy stronger or weaker?
Explain your answer.
Being stuck in a recessionary gap makes the case
stronger, ceteris paribus. If the economy cant get
itself out of a recessionary gap, then the case is
stronger for the Central Bank to take action.
However, this is not to say that expansionary
monetary policy will work ideally. There may still be
problems with the correct implementation of the
policy.
supply growth rate will be constant at the
average annual growth rate of Real GDP.
Critics of the constant-money-growth-rate rule
point out that it makes two assumptions: (1)
Velocity is constant. (2) The money supply is
defined correctly.
However, there have been periods when
velocity has not been constant. And it is not
clear which definition of the money supply
(M1, M2, or some broader monetary measure)
is the proper one to use.

CH 15 33 CH 15 34

NON-ACTIVIST MONETARY PROPOSALS

A PREDETERMINED-MONEY-GROWTH-RATE RULE
TAYLOR RULE A MIDDLE GROUND

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

CH 15 35 CH 15 36

6
 04-Dec-16

INFLATION TARGETING 1. Would a rules-based

monetary policy produce

SELFTEST
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)

CH 15 37 CH 15 38

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
SELFTEST

SELFTEST
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.

CH 15 39 CH 15 40

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.

CH 14 41 CH 14 42

7
 04-Dec-16

HOW THE CENTRAL BANK AFFECTS THE

NOMINAL INTEREST RATE
INTEREST RATES
The interest rate actually charged (or
Liquidity Effect
paid) in the market; the market
interest rate.
Income Effect Nominal interest rate = Real interest
rate + Expected inflation rate.
Price Level Effect

Expectations Effect
i%

CH 14 43 CH 14 44

REAL INTEREST RATE 1. If the expected inflation rate is 4 percent

and the nominal interest rate is 7 percent,
what is the real interest rate?
SELFTEST
The nominal interest rate minus the
expected inflation rate. When the
expected inflation rate is zero, the real
interest rate equals the nominal Three percent.
interest rate.
Real interest rate = Nominal interest
rate Expected inflation rate

i% CH 14 45 CH 14 46

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.
SELFTEST

SELFTEST

Certainly, the Central Bank directly affects the supply of

loanable funds and the interest rate through an open
Yes, it is possible if the expectations effect market operation. But it works as a catalyst to indirectly
affect the loanable funds market and the interest rate via
immediately sets in and outweighs the the changes in Real GDP, the price level, and the
liquidity effect. expected inflation rate. We can say this: The Central Bank
directly affects the interest rate by means of the liquidity
effect, and it indirectly affects the interest rate by means
of the income, price-level, and expectations effects.

CH 14 47 CH 14 48

8
 04-Dec-16

End of todays lesson

Questions or comments?

Reference:
Arnold, Roger A. (2016), Ch. 15 & 14

There are those who make things happen,

those who let things happen, and
those who wonder what happened.