1 chapter 26 monetary policy ©2002 south-western college publishing key concepts key concepts...

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Chapter 26 Monetary Policy

©2002 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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What are the three schools of economic thought?

• Classical• Keynesian• Monetarist

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What is the Keynesian view of money?

People who hold cash or checking account balances incur an opportunity cost in foregone interest or profits

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According to Keynes, why would people hold money?• Transactions demand• Precautionary demand• Speculative demand

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What is the transactions demand

for money?The stock of money people hold to pay everyday predictable expenses

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What is the precautionary demand

for money?The stock of money people hold to pay unpredictable expenses

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What is the speculative demand for money?

The stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other nonmoney financial assets

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How does a change in interest rates affect

speculative demand?As the interest rate falls, the opportunity cost of holding money falls, and people increase their speculative balances

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What is the demand for money curve?

A curve representing the quantity of money that people hold at different possible interest rates, ceteris paribus

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How do interest rates affect the

demand for money?There is an inverse relationship between the quantity of money demanded and the interest rate

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What gives the demand for money a

downward slope?The speculative demand for money at possible interest rates

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What determines interest rates in

the market?The demand and supply of money in the loanable funds market

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16%

12%

8%

4%

500 1,000 1,500 2,000

A

B

The Demand for Money Curve

MD

Inte

rest

Rat

e

Billions of dollars

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Decrease in the interest rate

Increase in the quantity of money

demanded

15

16%

12%

8%

4%

500 1,500 2,000

E

The Equilibrium Interest Rate

MD

MSSurplus

Shortage

1,000

Inte

rest

Rat

e

Billions of dollars

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Excess money

demand

People sell bonds

Bond prices fall and the interest

rate rises

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Excess money supply

People buy bonds

Bond prices rise and the interest rate

falls

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Why do bond prices fall as interest rates rise?

Bond sellers have to offer higher returns (lower price) to attract potential bond buyers, or else they will go elsewhere to get higher interest returns

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Why do bond prices rise as interest rates fall?

Bond sellers are put in a better bargaining position as interest rates fall (higher price); potential buyers cannot go elsewhere to get higher interest returns so easily

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How can the Fed influence the equilibrium

interest rate?It can increase or decrease the supply of money

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16%

12%

8%

4%

500 2,000

E1

Increase in the Money Supply

MD

MS1 Surplus

1,000

MS2

E2

1,500

Inte

rest

Rat

e

Billions of dollars

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16%

12%

8%

4%

500 2,000

E1

Decrease in the Money Supply

MD

MS1

1,000

MS2

E2

1,500

ShortageIn

tere

st R

ate

Billions of dollars

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Increase in the money supply

Money surplus and people buy bonds

Decrease the interest rate

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Decrease in the money supply

Money shortage and people sell bonds

Increase in the interest rate

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In the Keynesian Model, what do

changes in the money supply affect?

Interest rates, which in turn affect investment spending, aggregate demand, and real GDP, employment, and prices

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Change in interest rates

Change in the moneysupply

Change in investment

Change in the aggregate demand curve

Change in prices, real GDP, & employment

KeynesianPolicy

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16%

12%

8%

4%

500 2,000

E1

Expansionary Monetary Policy

MD

MS1 Surplus

1,000

MS2

E2

1,500

Inte

rest

Rat

e

Billions of dollars

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16%

12%

8%

4%

A

Investment Demand Curve

I

1,000

B

1,500

Inte

rest

Rat

e

Billions of dollars

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When will businesses make an investment?When the investment projects for which the expected rate of profit equals or exceeds the interest rate

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155

150

E2

AD1

6.0 6.1

Product Market

E1

Pri

ce L

evel

AS

AD2full employment

Billions of dollars

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What is the Classical economic view?

The economy is stable in the long-run at full employment

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How did the Classical

economists view the role of money?

They believed in the equation of exchange

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What is theequation of exchange?An accounting number of times per year a dollar of the money supply is spent on final goods and services

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What is thevelocity of money?

The average number of times per year a dollar of the money supply is spent on final goods and services

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MV = PQ

Money

Velocity

Prices

Quantity

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What is theMonetarist Theory?

That changes in the money supply directly determine changes in prices, real GDP, and employment

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Change in the money supply

Change in the quantityof money

Change in the aggregate demand curve

Change in prices, real GDP, & employment

MonetaristPolicy

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What is the Quantity Theory of Money?

The theory that changes in the money supply are directly related to changes in the price level

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What is the conclusion of the Quantity Theory

of Money?Any change in the money supply must lead to a proportional change in the price level

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Who are theModern Monetarists?

Monetarist argue that velocity is not unchanging, but is nevertheless predictable

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According to the Monetarist, how do we

avoid inflation and unemployment?

We must be sure that the money supply is at the proper level

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Who isMilton Friedman?

In the 1950’s and 1960’s, he was a leader in putting forth the ideas of the modern-day monetarists

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What does Milton Friedman advocate?

The Federal Reserve should increase the money supply by a constant percentage each year to enhance full employment and stable prices

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How do the Keynesians view the velocity of money?

Over long periods of time, it can be unstable and unpredictable

4540 50 60 70 80 90 00

123456

The Velocity of Money7

Year

GD

P/M

1

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What is the conclusion of the

Keynesians?A change in the money supply can lead to a much larger or smaller change in GDP than the monetarists would predict

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What is the crux of the Keynesian argument?

Because velocity is unpredictable, a constant money supply may not support full employment and stable prices

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What is the conclusion of the Keynesian argument?

The Federal Reserve must be free to change the money supply to offset unexpected changes in the velocity of money

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What are the main points of Classical

economics?

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• Economy tends toward a full employment equilibrium

• Prices & wages are flexible• Velocity of money is stable• Excess money causes inflation• Short-run price & wage

adjustments cause unemployment

• Monetary policy can change aggregate demand & prices

• Fiscal policies are not necessary

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What are the main points of Keynesian

economics?

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• The economy is unstable at less than full employment

• Prices & wages are inflexible• Velocity of money is stable• Excess demand causes inflation• Inadequate demand causes

unemployment• Monetary policy can change

interest rates and level of GDP• Fiscal policies may be necessary

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What are the main points of the Monetarists?

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• Economy tends toward a full employment equilibrium

• Prices & wages are flexible• Velocity of money is predictable• Excess money causes inflation• Short-run price & wage

adjustments cause unemployment

• Monetary policy can change aggregate demand & prices

• Fiscal policies are not necessary

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What is thecrowding-out effect?Too much government borrowing can crowd out consumers and investors from the loanable funds market

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What is the Keynesian view of the crowding-out effect?The investment demand curve is rather steep (vertical), so the crowding-out effect is insignificant

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What is the Monetarist view of the crowding-out effect?

The investment demand curve is flatter (horizontal), so the crowding-out effect is significant

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Key Concepts

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Key Concepts• What are the three schools of economic thou

ght?• What is the Keynesian view of money?• How can the fed influence the equilibrium inte

rest rate?• In the Keynesian model, what do changes in t

he money supply effect?• What is the Classical economic view?

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Key Concepts cont.

• How did the Classical economists view the role of money?

• What is the equation of exchange?• What is the velocity of money?• What is the quantity theory of money?• What is the conclusion of the quantity

theory of money?• Who are the modern monetarists?

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Key Concepts cont.• According to the monetarist, how do we

avoid inflation and unemployment?• Who is Milton Friedman?• What does Milton Friedman advocate?• What is Classical economists?• What is Keynesian economists?• What is monetarism?

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Summary

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The demand for money in the Keynesian view consists of three reasons why people hold money: (1) Transactions demand is money held to pay for everyday predictable expenses. (2) Precautionary demand is money held to pay unpredictable expenses. (3) Speculative demand is money held to take advantage of price changes in nonmoney assets.

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The demand for money curve shows the quantity of money people wish to hold at various rates of interest. As the interest rate rises, the quantity of money demanded is less than when the interest rate is lower.

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16%

12%

8%

4%

500 1,000 1,500 2,000

A

B

The Demand for Money Curve

MD

Inte

rest

Rat

e

Billions of dollars

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The equilibrium interest rate is determined in the money market by the intersection of the demand for money and the supply of money curves. The money supply (M1), which is determined by the Fed, is represented by a vertical line.

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An excess quantity of money demanded causes households and businesses to increase their money balances by selling bonds. This causes the price of bonds to fall, thus driving up the interest rate.

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16%

12%

8%

4%

500 1,500 2,000

E

The Equilibrium Interest Rate

MD

MSSurplus

Shortage

1,000

Inte

rest

Rat

e

Billions of dollars

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An excess quantity of money supplied causes households and businesses to reduce their money balances by purchasing bonds. The effect is to cause the price of bonds to rise, and, thereby, the rate of interest falls.

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The Keynesian view of the monetary policy transmission mechanism operates as follows: First, the Fed uses its policy tools to change the money supply. Second, changes in the money supply change the equilibrium interest rate, which affects investment spending. Finally, a change in investment changes aggregate demand and determines the level of prices, real GDP, and employment.

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Monetarism is the simpler view that changes in monetary policy directly change aggregate demand and thereby prices, real GDP, and employment. Thus, monetarists focus on the money supply, rather than on the rate of interest.

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The equation of exchange is an accounting identity that is the foundation of monetarism. The equation (MV = PQ) states that the money supply multiplied by the velocity of money is equal to the price level multiplied by real output.

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The velocity of money is the number of times each dollar is spent during a year. Keynesians view velocity as volatile but monetarists disagree.

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The quantity theory of money is a monetarist argument that the velocity of money (V) and the output (Q) variables in the equation of exchange are relatively constant. Given this assumption, changes in the money supply yield proportionate changes in the price level.

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The monetarist solution to an inept Fed tinkering with the money supply and causing inflation or recession would be to have the Fed simply pick a rate of growth in the money supply that is consistent with real GDP growth and stick to it.

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Monetarists’ and Keynesians’ views on fiscal policy are also different. Keynesians believe the aggregate supply curve is relatively flat, and monetarists view it as relatively vertical. Because the crowding out effect is large, monetarists assert that fiscal policy is ineffective. Keynesians argue that crowding out is small and that fiscal policy is effective.

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