Ch26, Lecture

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Chapter 26 Monetary Policy

©2002 South-Western College Publishing

• Key Concepts• Summary

• Practice Quiz• Internet Exercises



2

What are the three schoolsof economic thought?

• Classical• Keynesian

• Monetarist



3

What is the Keynesianview of money?

People who hold cash or checking accountbalances incur an

opportunity cost inforegone interest or profits



4

According toKeynes, why wouldpeople hold money?• Transactions demand• Precautionary demand• Speculative demand



5

What is the

transactions demandfor money?

The stock of money peoplehold to pay everydaypredictable expenses



6

What is the

precautionary demandfor money?

The stock of moneypeople hold to pay

unpredictable expenses



7

What is the speculative

demand for money?The stock of money people

hold to take advantage of expected future changes inthe price of bonds, stocks,or other nonmoneyfinancial assets



8

How does a change ininterest rates affect

speculative demand?

As the interest rate falls,the opportunity cost of

holding money falls, andpeople increase their speculative balances



9

What is the demand for money curve?

A curve representing thequantity of money thatpeople hold at different

possible interest rates,ceteris paribus



10

How do interestrates affect thedemand for money?

There is an inverserelationship between thequantity of moneydemanded and theinterest rate



11

What gives thedemand for money a

downward slope?

The speculativedemand for money at

possible interest rates



12

What determines

interest rates inthe market?

The demand andsupply of money in the

loanable funds market



13

16%

12%

8%

4%

500 1,000 1,500 2,000

AB

The Demand for Money Curve

MD

Interest

Rate

Billions of dollars



14

Decrease in theinterest rate

Increase in thequantity of money

demanded



15

16%

12%

8%

4%

500 1,500 2,000

E

The Equilibrium Interest Rate

MD

MS Surplus

Shortage

1,000

Interest

Rat e

Billions of dollars



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Excessmoney

demand

People sellbonds

Bond prices falland the interest

rate rises



17

Excessmoney

supply

People buybonds

Bond prices

rise and theinterest ratefalls



18

Why do bond prices fallas interest rates rise?

Bond sellers have to offer

higher returns (lower price) to attract potential

bond buyers, or else theywill go elsewhere to gethigher interest returns



19

Why do bond prices rise

as interest rates fall?Bond sellers are put in a

better bargaining positionas interest rates fall (higher price); potential buyers

cannot go elsewhere to gethigher interest returns so

easily



20

How can the Fed

influence theequilibrium

interest rate?It can increase or decreasethe supply of money



21

16%

12%

8%

4%

500 2,000

E1

Increase in the Money Supply

MD

MS1 Surplus

1,000

MS2

E2

1,500

Interest

Rat e

Billions of dollars



22

16%

12%

8%

4%

500 2,000

E1

Decrease in the Money Supply

MD

MS1

1,000

MS2

E2

1,500

Shortage

Interest

Rat e

Billions of dollars



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Increase in themoney supply

Money surplus andpeople buy bonds

Decrease theinterest rate



24

Decrease in themoney supply

Money shortage andpeople sell bonds

Increase in theinterest rate



25

In the Keynesian

Model, what dochanges in the moneysupply affect?

Interest rates, which inturn affect investment

spending, aggregatedemand, and real GDP,employment, and prices



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Change in

interestrates

Change inthe money

supply

Change ininvestment

Change inthe aggregatedemand curve

Change in

prices, real GDP,& employment

Keynesian

Policy



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16%

12%

8%

4%

500 2,000

E1

Expansionary Monetary Policy

MD

MS1 Surplus

1,000

MS2

E2

1,500

Interest

Rat e

Billions of dollars



28

16%

12%

8%

4%

A

Investment Demand Curve

I

1,000

B

1,500

Inte

rest

Rat

e

Billions of dollars



29

When will businessesmake an investment?

When the investmentprojects for which theexpected rate of profit

equals or exceeds theinterest rate



30

155

150

E2

AD1

6.0 6.1

Product Market

E1

PriceLe

vel

AS

AD2full employment

Billions of dollars



31

What is the Classicaleconomic view?

The economy is stable inthe long-run at fullemployment



32

How did the

Classicaleconomists view therole of money?

They believed in theequation of exchange



33

What is theequation of exchange?

An accounting number of times per year a dollar of the money supply is

spent on final goods andservices



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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 andservices



35

MV = PQ

Money

Velocity

Prices

Quantity



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What is theMonetarist Theory?

That changes in themoney supply directlydetermine changes in

prices, real GDP, andemployment



37

Change in

the moneysupply

Change inthe quantity

of money

Change inthe aggregatedemand curve

Change in

prices, real GDP,& employment

Monetarist

Policy



38

What is the QuantityTheory of Money?

The theory that changes inthe money supply aredirectly related to changesin the price level



39

What is the conclusionof the Quantity Theory

of Money?

Any change in the moneysupply must lead to a

proportional change inthe price level



40

Who are theModern Monetarists?

Monetarist argue thatvelocity is notunchanging, but isnevertheless predictable



41

According to theMonetarist, how do we

avoid inflation and

unemployment?We must be sure that

the money supply isat the proper level



42

Who isMilton Friedman?

In the 1950’s and 1960’s,he was a leader inputting forth the ideas

of the modern-daymonetarists



43

What does Milton

Friedman advocate?The Federal Reserve should

increase the money supplyby a constant percentageeach year to enhance fullemployment and stableprices



44

How do theKeynesians view thevelocity of money?

Over long periods of time, it can be unstable

and unpredictable



45

40 50 60 70 80 90 00

1

2

34

56

The Velocity of Money7

Year

G D P / M 1



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What is the

conclusion of theKeynesians?A change in the moneysupply can lead to a muchlarger or smaller change

in GDP than themonetarists would predict



47

What is the crux of theKeynesian argument?Because velocity isunpredictable, a constantmoney supply may not

support full employmentand stable prices



48

What is the conclusion of

the Keynesian argument?The Federal Reserve mustbe free to change themoney supply to offset

unexpected changes inthe velocity of money



49

What are the mainpoints of Classical

economics?



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• Economy tends toward a fullemployment equilibrium

• Prices & wages are flexible• Velocity of money is stable• Excess money causes inflation

• Short-run price & wageadjustments cause unemployment

• Monetary policy can change

aggregate demand & prices• Fiscal policies are not necessary



51

What are the mainpoints of Keynesian

economics?



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• The economy is unstable at lessthan full employment

• Prices & wages are inflexible• Velocity of money is stable•

Excess demand causes inflation• Inadequate demand causesunemployment

• Monetary policy can changeinterest rates and level of GDP• Fiscal policies may be necessary



53

What are the mainpoints of theMonetarists?



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• Economy tends toward a fullemployment equilibrium

• Prices & wages are flexible• Velocity of money is predictable• Excess money causes inflation

• Short-run price & wageadjustments cause unemployment

• Monetary policy can change

aggregate demand & prices• Fiscal policies are not necessary



55

What is thecrowding-out effect?Too much government

borrowing can crowdout consumers and

investors from theloanable funds market



56

What is theKeynesian view of thecrowding-out effect?

The investment demandcurve is rather steep

(vertical), so thecrowding-out effect isinsignificant



57

What is the

Monetarist view of thecrowding-out effect?

The investment demandcurve is flatter (horizontal),

so the crowding-out effectis significant



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Key Concepts



59

Key Concepts

• What are the three schools of economic though• What is the Keynesian view of money?

• How can the fed influence the equilibrium intere

• In the Keynesian model, what do changes in the• What is the Classical economic view?



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Key Concepts cont.

• How did the Classical economists view the rol• 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 o

• Who are the modern monetarists?



61

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

• 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



63

The demand for money in the

Keynesian view consists of threereasons why people hold money:(1) Transactions demand is moneyheld to pay for everyday predictableexpenses. (2) Precautionarydemand is money held to payunpredictable expenses. (3)

Speculative demand is money heldto take advantage of price changesin nonmoney assets.



64

The demand for money curveshows the quantity of moneypeople wish to hold at various rates

of interest. As the interest raterises, the quantity of moneydemanded is less than when theinterest rate is lower.

Th D d f M C



65

16%

12%

8%

4%

500 1,000 1,500 2,000

AB

The Demand for Money Curve

MD

Interest

Rate

Billions of dollars



66

The equilibrium interest rate isdetermined in the money marketby the intersection of the

demand for money and thesupply of money curves. Themoney supply (M1), which isdetermined by the Fed, isrepresented by a vertical line.



67

An excess quantity of moneydemanded causes householdsand businesses to increase their

money balances by sellingbonds. This causes the price of bonds to fall, thus driving up theinterest rate.



68

16%

12%

8%

4%

500 1,500 2,000

E

The Equilibrium Interest Rate

MD

MS Surplus

Shortage

1,000

Inte

rest

Rat

e

Billions of dollars



69

An excess quantity of moneysupplied causes households andbusinesses to reduce their money balances by purchasingbonds. The effect is to cause theprice of bonds to rise, and,thereby, the rate of interest falls.

The Keynesian view of the monetary



70

The Keynesian view of the monetarypolicy transmission mechanism

operates as follows: First, the Feduses its policy tools to change themoney supply. Second, changes inthe money supply change theequilibrium interest rate, whichaffects investment spending. Finally,a change in investment changes

aggregate demand and determinesthe level of prices, real GDP, andemployment.



71

Monetarism is the simpler view thatchanges in monetary policy directlychange aggregate demand and

thereby prices, real GDP, andemployment. Thus, monetaristsfocus on the money supply, rather than on the rate of interest.



72

The equation of exchange is anaccounting identity that is thefoundation of monetarism. Theequation (MV = PQ) states that themoney supply multiplied by thevelocity of money is equal to theprice level multiplied by real output.



73

The velocity of money is thenumber of times each dollar isspent during a year. Keynesiansview velocity as volatile butmonetarists disagree.



74

The quantity theory of money is amonetarist argument that thevelocity of money (V) and the output(Q) variables in the equation of

exchange are relatively constant.Given this assumption, changes inthe money supply yield proportionate

changes in the price level.



75

The monetarist solution to an ineptFed tinkering with the moneysupply and causing inflation or recession would be to have the Fedsimply pick a rate of growth in themoney supply that is consistentwith real GDP growth and stick to it.



76

Monetarists’ and Keynesians’ viewson fiscal policy are also different.Keynesians believe the aggregatesupply curve is relatively flat, andmonetarists view it as relatively

vertical. Because the crowding outeffect is large, monetarists assertthat fiscal policy is ineffective.

Keynesians argue that crowdingout is small and that fiscal policy iseffective.



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Chapter 26 Quiz

©2002 South-Western College Publishing



78

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 checkabledeposits (M1) rather than stocks,bonds, or other nonmoney forms of wealth.

2 A decrease in the interest rate other



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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 isdemanded because the opportunity costof holding money is lower.

3 Assume the demand for money curve is



80

3. Assume the demand for money curve isstationary and the Fed increases themoney supply. The result is that people

a. increase the supply of bonds, thusdriving up the interest rate.

b. increase the supply of bonds, thusdriving down the interest rate.

c. increase the demand for bonds, thusdriving up the interest rate.

d. increase the demand for bonds, thus

driving down the interest rate.D.

E i M t P li



81

16%12%

8%

4%

500 2,000

E1


MD

MS1 Surplus

1,000

MS2

E2

1,500

Inte

rest

Rat

e

Billions of dollars

4 Assume the demand for money curve is



82

4. Assume the demand for money curve isfixed and the Fed decreases the moneysupply. The result is a temporarya. 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.

B.

D i th M S l



83

16%12%

8%

4%

500 2,000

E1

Decrease in the Money Supply

MD

MS1

1,000

MS2

E2

1,500

Shortage

Inte

rest

Rat

e

Billions of dollars

5. Assume the demand for money



84

ycurve is fixed and the Fed increasesthe money supply. The result is that

thea. price of bonds rises.b. price of bonds remains

unchanged.

c. price of bonds falls.d. none of the above.

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

6. Using the aggregate supply and demand model,assume the economy is in equilibrium on the



85

y qintermediate portion of the aggregate supplycurve. A decrease in the money supply will

decrease the price level anda. lower 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 theinterest rate which decreases investment.Since investment is a component of aggregate demand, the aggregate demandcurve shifts leftward and real GDP declines.



86

7. Based on the equation of exchange, themoney supply in the economy is

calculated asa. M = V/PQ.b. M = V(PQ).

c. M = PQ/V.d. M = PQ - V.

C. The equation of exchange is

MV = PQ rewritten,M = PQ/V



87

8. The V in the equation of exchange

represents thea. variation in the GDP.b. variation in the CPI.c. variation in real GDP.

d. average number of times per year adollar is spent on final goods andservices.

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

9. Which of the following is not an issue inthe Keynesian-monetarist debate?



88

t e ey es a o eta st debatea. 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 thanfiscal policy. They view the shape of theinvestment demand curve as less steep,so the crowding-out effect is significant. Keynesians disagree.

10. Keynesians reject the influence of t li th O



89

monetary policy on the economy. Oneargument supporting this Keynesian view

is that thea. money demand curve is horizontal atany interest rate.

b. aggregate demand curve is nearly flat.

c. investment demand curve is nearlyvertical.

d. money demand curve is vertical.

C. If the investment demand curve isnearly vertical, changes in moneysupply and resulting changes in interestrate have little effect on investment andaggregate demand.




90

8%

6%

4%

2%

200 800

E1


MD

MS1

400

MS2

E2

600

Inte

rest

Rat

e

Billions of dollars

11. Starting from an equilibrium at E1 inE hibit 12 i ht d hift f th



91

Exhibit 12, a rightward shift of the moneysupply curve from MS1 to MS2 would cause

an excessa. 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. A decrease in interest rates will cause the

price of bonds to increase, making them abetter asset to sell and the quantity of

money to increase.

12. Beginning from an equilibrium at E1 inE hibit 12 i i th



92

Exhibit 12, an increase in the moneysupply from $400 billion to $600 billion

causes people toa. sell bonds and drive the price of bondsdown.

b. buy bonds and drive the price of bonds

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

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

up.A. As people sell more bonds because of the

higher price, the greater supply of bonds on themarket will cause the price of bonds to decrease.



END

Ch26, Lecture

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