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Monetary and Fiscal Policy 2 Theory of Liquidity Preference and Monetary Policy - YouTube
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- So, in this video segment,
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I'm going to talk
about what's called the Theory
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of Liquidity Preference.
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And this was invented by Keynes,
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the sort of founder
of modern macro-economics,
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short run
modern macro-economics.
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And the idea here
is what causes people
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to want to hold liquid money.
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Now, we already have one way of
looking at this that went back
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to the idea of the classical
theory of money demand,
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and that was the idea that
money demand is proportional
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to the price level and real
GDP divided by this idea
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of the philosophy of money.
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So that's the idea
of classical money demand.
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Where money is a function,
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money demand is a function
of the price level.
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Now we think that's probably
true and important and we think
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this is probably especially true
and most relevant
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in the long run when the price
level has time to adjust.
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But the whole thing
about short run macro-economics,
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is that the price level
doesn't have time to adjust.
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So money supply and money demand
aren't going to be able
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to come into balance
as a result of the price level.
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So instead, Theory of Liquidity
Preference looks at money demand
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as a function of
the nominal interest rate.
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And we're going to now be
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talking about what's sometimes
called The Money Market.
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And the Money Market is the idea
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of what is the interest rate
on very short term loans.
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Something like, you know,
30 day-90 day loans.
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And our model of the Money
Market is going to go ahead
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and have the nominal
interest rate
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on this axis and the quantity
of money on this axis.
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And we think that when
interest rates are high,
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people are going to try to
economize on their use of money
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because they don't want to have
to pay to borrow that money,
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or they would rather put
their money in a savings account
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where it gets an interest
rate that's pretty high.
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But when interest rates are low,
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then people want
to demand more money.
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They're more willing
to have money just sort of sit
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there in their checking account,
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because they're not passing up
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on very much interest
by having it sit there.
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And then we think that
the actual nominal interest rate
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in equilibrium is determined
by where the money
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supply curve intersects
the money demand curve.
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So there's our predicted
equilibrium interest rate.
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And this is one way
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of understanding
that interest rate effect
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that I talked about
in the last video.
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So a given level of interest
rate is going to produce
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a given level of GDP demanded.
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In particular, when interest
rates are relatively high,
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then that discourages
all kinds of economic activity,
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discourages consumers borrowing,
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discourages business borrowing
to finance investment,
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so GDP is relatively level.
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AS the money supply grows,
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then that's going to go ahead
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and give us lower
interest rate here,
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and people are
going to be willing
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to demand more GDP even
at the same price level.
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So a change in the money
supply causes a change
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in the aggregate demand curve.
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So far, so good.
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And maybe we could even shift it
out all the way to M3 over here,
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and that would give us yet
another aggregate demand curve.
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But notice there's
a potential issue
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that comes up that we might
eventually run into
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a situation where we push
the money supply out,
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and we push it out so
far that it's greater
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than the amount people demanded.
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And so interest rates are
already at zero percent,
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and further increases
in the money supply
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don't do much
to increase aggregate demand.
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And this is what's known
as the Zero Lower Bound Problem.
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The idea is that
interest rates are bounded,
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they're limited at zero.
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That's as low as they can go.
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So, increases in the money
supply can produce increases
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in the aggregate demand curve up
to a certain point.
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But then further increases
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in the money supply
may not do much,
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so the shift from AD3
to AD4 is relatively low.
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So after interest rates
already zero,
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further increases
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in money supply do little
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to increase aggregate demand.
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So again, that's the idea
of the Zero Lower Bound Problem.
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Alright, so that's the overall
idea of monetary policy.
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Monetary policy is the idea
that we can use a change
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in the money supply to influence
the level of aggregate demand.
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In that last slide,
you saw that an increase
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in money supply causes lower
interest rates,
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and if we were going to track
the actual components
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of GDP that are impacted,
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we think that it's going
to increase consumption spending
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because consumers are
going to find it cheaper
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and easier to borrow to finance,
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or at least they're going
to find the rewards
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to saving are going to be lower.
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And it's also going to increase
investment spending by firms,
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because they can more
easily finance to borrow
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and execute
their investment projects.
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Another thing is that lower
interest rates make
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the US less attractive
for foreign investors,
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because their money now
earns a lower rate of return.
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So this makes U.S. assets
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less appealing
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And in turn that's going
to mean there's less demand
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for U.S. assets and therefore,
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less demand for U.S. dollars.
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So we're going to get
a weaker dollar,
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versus foreign exchange.
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This will in turn cause
U.S. exports to go up
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and U.S. imports to go down.
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So we can see
all of these things
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over here are going
to push up aggregate demand,
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and all of those things are
going to push
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up aggregate demand.
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So this is what happens if we
have what's called
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an expansionary monetary policy.
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So an expansionary monetary
policy has as its objective,
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increasing aggregate demand.
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And that's typically
what we would want
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to do if we wanted to try
and get out of a recession.
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We could also run a
contractionary monetary policy.
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Where basically everything is
going to go in reverse.
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A contractionary monetary policy
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has as its objective
decreasing inflation,
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whereas this one had as its
objective increasing GDP.
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Of course there
was a side effect here,
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that if we increase
aggregate demand,
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we're also going
to make inflation worse.
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There's going to be
a side effect here
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that we're going to go ahead
and cause GDP to go down.
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And essentially,
everything is the opposite here.
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So, an expansionary
monetary policy,
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we have an increase
in the money supply,
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a contractionary
monetary policy,
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we're going to have a decrease
in the money supply.
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Remember that an increase in
the money supply is accomplished
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by the Federal Reserve
or other central bank,
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buying U.S. government bonds
in an open market operation.
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A contractionary monetary
policy is executed
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by the Federal Reserve
selling U.S. government bonds
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in an open market operation.
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So if it sells bonds,
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that's going to go ahead
and push bond prices down,
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and push interest rates up.
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We could also use that Theory
of Liquidity Preference model
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and shift the money supply curve
to the left
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and see that the interest rate
would move up in that diagram.
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Higher interest rates are
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going to tend to depress
people's consumption spending.
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Either they won't
borrow as much,
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or they'll maybe even
actually save more.
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It's also going
to discourage firms
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from engaging
in investment projects,
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because their cost
of capital have gone up.
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These higher
interest rates make U.S. assets
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more appealing
to foreign investors,
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because when they
put their money
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in U.S. bonds for instance,
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they get a higher rate of return
than they otherwise would.
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They're going to need
U.S. dollars to buy U.S. bonds,
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and so they're going to need
to buy U.S. dollars,
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and the dollar is going to rise
versus foreign currencies.
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That is going to tend
to push U.S. exports down,
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and push U.S. imports up.
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And you can see, all of
these are going to combine
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to cause aggregate demand
to go down.
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So and we have sort of effects
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here on prices
and output up top.
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