CHAPTER 5 5 Monetary Theory and Policy © 2003 South-W estern/Thom son Learning
Dec 23, 2015
CHAPTER
55Monetary Theory and Policy
© 2003 South-Western/Thomson Learning
Chapter ObjectivesChapter Objectives
Learn the well-known theories of monetary policy
Review the tradeoffs involved in monetary policy
Learn how analysts monitor and forecast Fed’s monetary policy
Monetary PoliciesMonetary Policies
How does money affect the real economy? How does varying money supply growth
impact spending? How does monetary policy in the financial
sector impact real economic sector investment and spending?
Keynesian TheoryKeynesian Theory
Developed by John Maynard Keynes and his students
Initially attempted to explain inadequacy of monetary policy during Great Depression
Effectiveness of monetary policy depends upon the sensitivity (elasticity) of economy to changes in interest rates
Keynesian Theory, cont.Keynesian Theory, cont.
Advocates fiscal policy Focused on government deficit/surplus
spending to impact economic activity Monetary policy transmitted slowly via bank
credit policy and interest rates A proactive economic policy
Exhibit 5.3Exhibit 5.3
Stimulative MonetaryPolicy
Restrictive MonetaryPolicy
Fed
InvestorsBank Funds
IncreaseInterest Rates
Decrease
AggregateSpendingIncreases
$ TreasurySecurities
Fed
InvestorsBank FundsDecrease
Interest RatesIncrease
AggregateSpending
Decreases
$Treasury
Securities
InflationDecreases
Monetary TheoriesMonetary Theories
Quantity theory Based on equation of exchange MV = PGQ
M = amount of money in the economy
V = velocity, average number of times each
dollar changes hands during the year
PG = weighted average price level of goods
and services in the economy
Q = quantity of goods and services sold
Monetary TheoriesMonetary Theories
Quantity theory’s assumptions PGQ is the total value of goods and services
produced Assume V constant or predictable—changing M
impacts total spending M should grow at rate of output capacity, Q Faster M growth increases PG or inflation
Monetary TheoriesMonetary Theories
Monetarists Velocity is affected by
Income levels Frequency income is received Use of credit cards Inflationary expectations
Velocity changes found to be predictable and not related to fluctuations in money supply
Monetarist vs. Keynesian TheoriesMonetarist vs. Keynesian Theories
Monetarist Let economic problems
resolve themselves Low growth reduces
borrowing and lowers interest rates
Problem: It takes time
Keynesian Need to take action to
lower interest rates High money growth to
fix a recession by lowering rates
Problem: Might ignite inflation
Monetarist vs. Keynesian TheoriesMonetarist vs. Keynesian Theories
Monetarist Low, stable growth in
the money supply Focus on maintaining
low inflation and will tolerate what they call natural unemployment
Keynesian Actively manage the
money supply Willing to tolerate
inflation that helps reduce unemployment
Rational Expectations TheoryRational Expectations Theory
Households and businesses act in their own self-interest
Individuals anticipate effects of government policy changes
Expansionary monetary policy signals future inflation and interest rates increase (security prices fall)
Rational expectations may nullify intended effects of monetary policy
Tradeoff of Monetary Policy Goals Tradeoff of Monetary Policy Goals
Goals of the Monetary Policy Steady GDP growth Low unemployment Stable price levels
Tradeoffs Lowering unemployment by stimulating the
economy may increase inflation Lowering inflation by slowing the economy may
increase unemployment
Economic Indicators Monitored by the Economic Indicators Monitored by the FedFed
Indicators of economic growth Gross Domestic Product or GDP Industrial production National income Unemployment
Indicators of Inflation Producer price indexes Consumer price Indexes Other indicators
Economic Indicators Monitored by the Economic Indicators Monitored by the FedFed
How the Fed uses indicators Fed meets to decide course of monetary policy Assesses recent reports on indicators of growth
and inflation Uses indicators to anticipate how the economy
will change Decides the appropriate monetary policy given
possible conditions
Lags in Monetary PolicyLags in Monetary Policy
Recognition lag Most economic problems revealed by statistics, not
observation Fed quick to see changes in economy
Implementation lag Fed acts quickly to implement change in monetary policy Fiscal policy via Congress takes a long time
Impact Lag Takes time for monetary changes to have full impact Fiscal policy tax changes have unpredictable results
Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy
How does the policy change affect financial market participants? Depends on the kinds of securities you trade Depends on your expectations about how the
changes affect on the economy Forecasting money supply movements
Financial market participants look at actual growth compared to Fed targets
Growth outside range could signal Fed policy changes
Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy
Improved communication at the Fed Fed more willing to disclose its intentions since
1999 Immediate feedback to public and financial
markets about “bias” on rates Market reaction to reported money supply
levels Thursday release of money supply data Try to determine future trends in interest rates
Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy
Anticipating reported money supply levels Securities and financial market professionals
cannot profit on information available to all at the same time
Try to forecast and anticipate changes Trying to figure out the future course of interest
rates and Fed policy
Market reaction to discount rate adjustment
Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy
Market reaction to discount rate adjustment Monitor changes to determine policy Some changes are technical or intended to bring
the discount rate in line with market rates Financial market participants try to anticipate
changes Discount rate seems to preceded market interest
rate movements since 1980
Exhibit 5.9Exhibit 5.9
Federal OpenMarket Committee
(FOMC)
Money SupplyTargets
InflationaryExpectations
Demand forLoanable Funds
Cost of Capitalfor Corporations
CorporateExpansion
EquilibriumInterest Rates
ResidentialConstruction
EconomicGrowth
Supply ofLoanable Funds
Cost ofHousehold Credit
(Including MortgageRates)
HouseholdConsumption
Assessing the Impact of Monetary PolicyAssessing the Impact of Monetary Policy
Forecasting the impact of monetary policy Even if financial market participants correctly
anticipate changes in the money supply there are still problems Not a stable relationship between money supply and
economic variables over time Examples include the relationship between economic
growth and the money supply
Integrating Monetary and Fiscal PoliciesIntegrating Monetary and Fiscal Policies
History Executive branch usually most concerned with
employment and growth Fed and administration may differ on priorities of
price stability or growth needs Agreement when inflation and unemployment are
at relatively low levels
Exhibit 5.12Exhibit 5.12
U.S.Monetary
PolicyU.S.
FiscalPolicy
U.S.PersonalIncome
Tax Rates
U.S.BudgetDeficit
U.S.BusinessTax Rates
U.S.HouseholdDemandfor Funds
GovernmentDemandfor Funds
U.S.BusinessDemandfor Funds
U.S.PersonalIncomeLevel
Savingsby U.S.
Households
Supplyof Fundsin U.S.
U.S.Interest
Rate
Demandfor Funds
in U.S.
Integrating Monetary and Fiscal PoliciesIntegrating Monetary and Fiscal Policies
Combined monetary and fiscal policy effects Fiscal policy usually has a larger influence on the
demand for loanable funds Monetary policy usually has a larger influence on
the supply of loanable funds Monetizing the debt
Should the Fed help finance a federal budget deficit created by fiscal policy?
Forecasted surpluses, debt reduction, and U.S. Treasury securities
Integrating Monetary and Fiscal PoliciesIntegrating Monetary and Fiscal Policies
Market assessment of integrated policies Financial markets assess both fiscal and monetary
policy Markets monitor a wide range of information and
data Forecast how loanable funds supply and demand
will change
Global Effects on Monetary PolicyGlobal Effects on Monetary Policy
Impact on the U.S. dollar Value of the dollar relative to other currencies can
affect inflation A weak dollar stimulates U.S. exports, discourages
imports and stimulates the economy Fed less likely to stimulate the economy if the dollar is
weak
Strong dollar Stimulates imports and economic growth Encourages capital flows into U.S. and lower interest
rates
Global Effects on Monetary PolicyGlobal Effects on Monetary Policy
Transmission of interest rates International flow of funds affected by Fed policy Global capital and money markets are integrated
Capital flows to highest real, after-tax, exchange-rate adjusted rate of return
Financial integration improves with Decreased governmental regulation in markets Decreased transaction costs Improved financial technology
Deficits or surpluses in the U.S. have global implications
Global Effects on Monetary PolicyGlobal Effects on Monetary Policy
Fed policy during the Asian crisis Fed realizes the global economy is integrated
U.S. economic conditions affect other countries Other countries economic conditions affect the U.S.
Fed reaction to Asian crisis shows possible complications that result from economic integration
Forecasting Money SupplyForecasting Money Supply
Watch weekly federal reserve data releases Observe changes with announced fed ranges
of money growth Markets attempt to estimate changes in
monetary policy direction and . . . Anticipate interest rate changes
Global Effects on Monetary PolicyGlobal Effects on Monetary Policy
Exchange Rate Levels International Funds Flow Economic Activity of Foreign Countries