12 monetary policy

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Chapter 26 Monetary Policy

©2000 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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In this chapter, you will learn to solve these economic puzzles:

Why do people wish to hold money balances?

What is a monetary policy transmission

mechanism?

Why would a Nobel Laureate economist suggest replacing the Federal Reserve with an

intelligent horse?

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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

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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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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 money

supply

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 quantity

of 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

4640 50 60 70 80 90 00

12

3

456

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 T

hought?

• What is the Keynesian View of Money?

• How can the Fed influence the Equilibrium Interest Rate?

• In the Keynesian Model, what do changes in the 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. 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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Chapter 26 Quiz

©2000 South-Western College Publishing

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1. Keynes gave which of the following as a motive for people holding money?a. Transactions demand.b. Speculative demand.c. Precautionary demand.d. All of the above.

D. These are the three motives for holding currency and checkable deposits (M1) rather than stocks, bonds, or other nonmoney forms of wealth.

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2. A decrease in the interest rate, other things being equal, causes a (an) a. upward movement along the demand curve

for money.b. downward movement along the demand

curve for money.c. rightward shift of the demand curve for

money.d. leftward shift of the demand curve for

money.B. At a lower interest rate, money is demanded

because the opportunity cost of holding money is lower.

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3. Assume the demand for money curve is stationary and the Fed increases the money supply. The result is that peoplea. increase the supply of bonds, thus driving up

the interest rate.b. increase the supply of bonds, thus driving

down the interest rate.c. increase the demand for bonds, thus driving

up the interest rate.d. increase the demand for bonds, thus driving

down the interest rate.

D.

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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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4. Assume the demand for money curve is fixed and the Fed decreases the money supply. The result is a temporary a. excess quantity of money demanded.b. excess quantity of money supplied.c. increase in the price of bonds.d. increase in the demand for bonds.

A.

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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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5. Assume the demand for money curve is fixed and the Fed increases the money supply. The result is that the price of bondsa. rises.b. remains unchanged.c. falls.d. none of the above.

A. The result is an excess beyond the amount people wish to hold and they buy bonds which drives the price of bonds upward.

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6. Using the aggregate supply and demand model, assume the economy is in equilibrium on the intermediate portion of the aggregate supply curve. A decrease in the money supply will decrease the price level anda. lower both the interest rate and the real

GDP.b. raise both the interest rate and real GDP.c. lower the interest rate and raise real GDP.d. raise the interest rate and lower real GDP.

D. The decrease in money supply increases the interest rate which decreases investment. Since investment is a component of aggregate demand, the aggregate demand curve shifts leftward and real GDP declines.

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7. Based on the equation of exchange, the money supply in the economy is calculated as a. M = V/PQ.b. M = V(PQ).c. MV = PQ.d. M = PQ - V.

C. The equation of exchange is MV = PQ rewritten, M = PQ/V

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8. The V in the equation of exchange represents the a. variation in the GDP.b. variation in the CPI.c. variation in real GDP.d. average number of times per year a

dollar is spent on final goods and services.

D. In the equation of exchange, GDP is defined as PQ and the CPI is an index to measure the price level (P).

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9. Which of the following is not an issue in the Keynesian-monetarist debate?a. The importance of monetary vs. fiscal

policy.b. The importance of a change in the money

supply.c. The importance of a crowding-out effect.d. All of the above are part of the debate.D. Monetarists believe the effects of monetary policy are more powerful than fiscal policy. They view the shape of the investment demand curve as less steep, so the crowding-out effect is significant. Keynesians disagree.

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10. Keynesians reject the influence of monetary policy on the economy. One argument supporting this Keynesian view is that the a. money demand curve is horizontal at any

interest rate.b. aggregate demand curve is nearly flat.c. investment demand curve is nearly vertical.d. money demand curve is vertical.

C. If the investment demand curve is nearly vertical, changes in money supply and resulting changes in interest rate have little effect on investment and aggregate demand.

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8%

6%

4%

2%

200 800

E1

Expansionary Monetary Policy

MD

MS1

400

MS2

E2

600

Inte

rest

Rat

e

Billions of dollars

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11. Starting from an equilibrium at E1 in Exhibit 12, a rightward shift of the money supply curve from MS1 to MS2 would cause an excess a. demand for money, leading people to sell

bonds.b. supply of money, leading people to buy

bonds.c. supply of money, leading people to sell

bonds.d. demand for money, leading people to buy

bonds. B. An excess quantity of money supplied

causes people to buy bonds. The greater demand for bonds causes the price of bonds to increase and the interest rate to decrease.

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12. Beginning from an equilibrium at E2 in Exhibit 12, a decrease in the money supply from $600 billion to $400 billion causes people to a. sell bonds and drive the price of bonds

down.b. buy bonds and drive the price of bonds up.c. buy bonds and drive the price of bonds

down.d. sell bonds and drive the price of bonds up.

A. An excess quantity of money demanded causes people to sell. The greater supply of bonds on the market causes the price of bonds to decrease and the interest rate to increase.

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