Lecture: Monetary Policy, Interest Rates & Aggregate Demand
Lecture script · about 15–20 minutes spoken · Week 11
Opening
Here's a question worth asking out loud. How does a decision about bonds, made by a committee you'll probably never meet, reach your paycheck?
Think about who's listening for the answer. A bakery owner is pricing a new oven on a bank loan. A couple is shopping for a used car on credit. A construction worker is waiting to hear whether a developer will break ground on new apartments. Every one of them is watching the same number: the interest rate.
Here's where we are. In Week 5, Aggregate Demand & Aggregate Supply, you learned to name which curve moves and read where the price level and output land. In Week 7, Fiscal Policy, you met the spending multiplier. In Week 9, Money & the Banking System, you built the money supply from the monetary base. And in Week 10, The Federal Reserve & Monetary Policy, you watched the Fed's bond trades move the money supply and set an interest rate. In this lecture we connect all of it into one chain.
Here's the plan. I'll restart from the money market, name the five links of the chain, and size each one with the course's numbers. Then we'll run the chain backward, check who really sets the interest rate, and meet the delays that make the real thing messier. We'll finish with an honest debate about how often a central bank should use this chain. The spending and output numbers in this lecture are illustrative, built for this course, and measured in billions of dollars.
1. The Fed buys bonds, and the rate falls
Think of the interest rate as the price of borrowing. Like any price, it moves when supply changes. When the Fed adds money to the banking system, borrowing gets cheaper.
Let's restart from last week's illustrative money market. Money demand slopes down: the higher the interest rate, the less money people want to hold. The money supply is a vertical line at the amount the Fed sets. With a money supply of 1,050 dollars, the two lines cross at an interest rate of 6 percent.
Now the Fed buys bonds. It pays with new reserves, so the monetary base rises from 105 to 110. Multiply by the money multiplier of 10, and the money supply becomes 1,100 dollars. Picture the vertical line sliding to the right. The crossing slides down the money demand line, and the new rate works out to 4 percent. That's a fall from 6 percent to 4 percent.
Pause and try this. The Fed buys bonds. Does the money supply line move left or right, and does the interest rate rise or fall?
Picture the vertical line before you answer.
Here's the answer. The line moves right, and the rate falls. Buying bonds adds reserves, so there's more money, and the price of borrowing drops from 6 percent to 4 percent.
2. The transmission mechanism
A rate change at the central bank doesn't reach your paycheck in one jump. It travels like a message passed down a line of people. If anyone in the line drops it, the message never arrives.
Here's the term. The transmission mechanism is the chain of links that carries a monetary-policy move to the whole economy: the money supply moves the interest rate, which moves investment, which the spending multiplier scales into a shift of aggregate demand.
Say the five links with me, in order. One, the Fed changes the money supply. Two, the interest rate moves. Three, investment responds. Four, the spending multiplier scales that change. Five, aggregate demand shifts, and the price level and real output move together.
Notice where each multiplier lives. The money multiplier belongs to link one, where the base becomes the money supply. The spending multiplier belongs to link four, where new spending becomes output. Keep them in their own links.
Pause and try this. A headline says, "The Fed cut rates, so output rose." Which link did the headline skip?
Run the five links in your head.
Here's the answer. It skipped investment, link three. A lower rate raises output only because someone borrows and spends more, so without that link you can't say how much output changes, or why.
3. The investment link
Go back to the bakery. The owner wants a 50,000-dollar oven and would borrow the full price. The oven would bring in an extra 2,500 dollars a year. At 6 percent, a year's interest is 3,000 dollars, so the loan costs more than the oven earns, and the owner waits. At 4 percent, the interest is 2,000 dollars, and now the oven earns more than it costs. Nothing about the oven changed. Only the price of borrowing did.
Here's the term. Interest-sensitive spending is spending that is usually paid for with borrowed money, such as business equipment, new buildings, new homes, and cars bought on credit, so it rises when interest rates fall and falls when they rise.
To size this link for the whole economy, the course uses one engineered rule. It's illustrative, built for this course, not a real-world estimate. Investment rises 20 for each one-point fall in the interest rate. Remember, that's in billions of dollars. The rate fell from 6 percent to 4 percent, two percentage points, so the change in investment is 2 times 20, which is 40.
Pause and try this. Using the course's rule, what would a fall from 6 percent to 4 percent do to investment, and in which direction?
Say the rule to yourself first: 20 per point.
Here's the answer. Investment rises by 40, because the rate fell two percentage points, and 2 times 20 per point is 40. A lower rate makes borrowing cheaper, so the change is a rise.
4. The output link and the spending multiplier
That new investment doesn't stop where it lands. The oven maker hires workers. The workers spend part of their pay at shops. The shop owners spend part of theirs. You've seen this chain before. It's the spending multiplier from Week 7.
In the illustrative economy, the marginal propensity to consume is 0.8, so a household spends 80 cents of each extra dollar. The spending multiplier is 1 divided by 1 minus 0.8, which is 1 divided by 0.2, which is 5. Multiply the new investment of 40 by 5, and you get 200. That 200 is how far aggregate demand shifts to the right at the old price level.
Here's the trap. This chain has two multipliers in it. The money multiplier of 10 is fresh in your mind from Week 9, so it's tempting to grab it here. That gives 10 times 40, which is 400, twice the right answer.
Pause and try this. Which multiplier belongs on the investment change, the 5 or the 10, and why?
Ask yourself what's being multiplied.
Here's the answer. The 5, the spending multiplier. Link four turns new spending into output, and that's the job of 1 divided by 1 minus the MPC. The money multiplier already did its job back in link one.
5. The last link on the AD–AS diagram
Now put the chain on the diagram you've used since Week 5. Real output runs along the bottom. The price level runs up the side. Aggregate demand slopes down from upper left to lower right. Short-run aggregate supply slopes up.
New investment is new spending at every price level. So the whole aggregate demand curve shifts right. The supply curve stays put. The crossing moves up and to the right along short-run aggregate supply, so the price level rises and real output rises, together.
Here's the term for the whole sequence. Expansionary monetary policy is a central-bank move that raises the money supply, such as buying bonds, so the interest rate falls, investment rises, and aggregate demand shifts right; in the short run the price level and real output rise.
One caution. Week 5's interest-rate effect also talked about interest rates, but it came from a change in the price level, which moves you along the curve. Here, the Fed started the story, not the price level. So this is a shift.
Pause and try this. After the Fed's bond purchase, do the price level and real output move in the same direction or opposite directions?
Think about which curve moved.
Here's the answer. The same direction. Aggregate demand shifted right along a fixed supply curve, and a demand shift always moves the price level and output together.
6. Contractionary policy: every arrow reversed
Now run the film backward. Suppose prices are climbing fast and the Fed wants to cool things down. It sells bonds. Banks pay with reserves, so reserves leave the system.
Think of the couple and their 20,000-dollar car loan. At 6 percent, a year's interest is 1,200 dollars. At 8 percent, it's 1,600 dollars, which is 400 more each year. Some couples keep the old car a while longer.
Here's the whole chain. The base falls from 105 to 100, so the money supply falls to 1,000 dollars. The rate rises from 6 percent to 8 percent. Investment falls by 40. Output falls by 5 times 40, which is 200. Aggregate demand shifts left, and the price level and real output both fall.
Here's the term. Contractionary monetary policy is a central-bank move that lowers the money supply, such as selling bonds, so the interest rate rises, investment falls, and aggregate demand shifts left; in the short run the price level and real output fall.
Pause and try this. A classmate writes, "The Fed sells bonds, the rate falls, investment rises, and aggregate demand shifts left." What went wrong?
Check each link on its own.
Here's the answer. Only the last arrow got flipped. Selling bonds lowers the money supply, so the rate rises and investment falls. Every link reverses, not only the last one.
7. Who sets the rate
Headlines say "the Fed raised rates" as if the Fed typed a new number into everyone's loan. It's a handy shortcut, but it hides how the thing works.
Here's what happens. The Fed sets the quantity of reserves through its bond trades. It also sets the rate it pays banks on the reserves they keep at the Fed. Banks then set the rates on loans and deposits, and the market rate follows. In your chain, the interest rate moved because the money supply moved.
Picture the money market again. The Fed moves the vertical line. The market finds the new crossing on the money demand line. That crossing is the rate.
Pause and try this. True or false: the Fed sets the market interest rate by decree, the way a store sets a price tag.
Think about which line the Fed controls.
Here's the answer. False. The Fed sets the quantity of reserves and the rate it pays on them, and the market rate follows from the money market.
8. Lags and expectations
On paper, the chain takes five quick lines. In a real economy it takes time, and it can weaken along the way.
First, someone has to notice the problem. Data on output and jobs arrive late and get revised. Then the Fed's committee has to meet and decide. Here's the term. An inside lag is the time between a change in the economy and a policy decision about it: the time it takes to recognize the problem in the data and to decide on a response. The Fed's committee can act without a new law, so its decision step skips the legislature. Compare that with Week 7, where a spending bill needed a vote.
Second, even after the Fed acts, the developer doesn't pour concrete the next morning. There's a budget to redraw, a loan to line up, permits to get, and a crew to hire. An outside lag is the time between a policy decision and its effect on the economy, while households and firms change their borrowing and spending and output responds.
Then there's the wild card: expectations. A firm borrows to build when it expects customers to show up. Suppose the bakery owner now expects the new oven to bring in only 1,800 dollars a year, because the neighborhood is losing jobs. Even at 4 percent, the loan costs 2,000 dollars, so the owner still waits.
Pause and try this. The Fed cuts rates, but firms expect weak sales. Which link of the chain is likely to be weaker than the course's rule says?
Think about who has to say yes.
Here's the answer. Link three, investment. Firms borrow to build only when they expect buyers, so gloomy expectations can blunt the response to a cheaper loan.
9. Fine-tuning versus rules
So should the Fed lean against every wobble in the economy, or follow a steady plan? Both sides use the same chain. They disagree about how long the lags are and about what matters most.
Here are the terms. Fine-tuning is an activist approach to stabilization in which the central bank adjusts policy often, leaning against each gap as it appears, to keep output close to potential. A policy rule is a predictable guide for setting policy that is announced in advance and followed from one period to the next, offered as an alternative to case-by-case discretion.
The Keynesian case for activism, at full strength: in a recessionary gap, workers and machines sit idle, and sticky wages and prices can keep them idle a long time. The central bank can move quickly. Leaning against the gap shortens the time people spend out of work.
The monetarist critique, at full strength, is associated with Milton Friedman. Long and variable lags is the monetarist argument that the effects of monetary policy arrive late and after delays that differ from one episode to the next, so a move made now may land after the economy has already turned. If that's right, a well-meant move can add to the swings it meant to calm, and a predictable rule gives households and firms steadier expectations.
Notice what's shared. Both sides agree a bond purchase lowers the rate and shifts aggregate demand right. How long the lags run is a positive question for evidence. Whether jobs now are worth the risk of a mistimed move is a normative question of values. This course leaves the verdict to you.
Pause and try this. "Shortening a spell of unemployment is worth the risk of a mistimed move." Is that statement positive or normative?
Look for a value word.
Here's the answer. It's normative. "Worth the risk" weighs one good against another, and that's a value judgment no data set can settle on its own.
Closing
Let me pull it together, in the order we built it. A Fed bond purchase raises the money supply and lowers the interest rate. That's the start of the transmission mechanism, five links said in order. Cheaper borrowing raises interest-sensitive spending, and the course's rule sizes it at 40. The spending multiplier of 5 turns that into a 200 shift in aggregate demand, and the money multiplier stays in link one. On the diagram, aggregate demand shifts right, so the price level and output rise together. Contractionary policy flips every arrow. The Fed sets reserves and the rate it pays on them, and the market rate follows. Inside and outside lags, plus expectations, slow and weaken the chain. And the fine-tuning versus rules debate shares the model while differing on evidence and values.
Next in this module, you'll find the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. Then Week 12, Inflation, the Phillips Curve & Expectations, asks whether the output this chain adds lasts once people's expectations catch up.
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