Monetary policy:

Monetary policy is the process by which the government, central bank, or monetary authority of
a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or
rate of interest, in order to attain a set of objectives oriented towards the growth and stability of
the economy.

Objectives of Monetary Policy:

price stability:To Raise the Level of Employment:
Economic Growth: Removal of deficit in balance of payments:
Exchange stability:
Maintaining relative:

Types of Monetary Policy:

Expansionary monetary policy is monetary policy that seeks to increase the size of the money
supply. In most nations, monetary policy is controlled by either a central bank or a finance
ministry

Contractionary monetary policy is monetary policy that seeks to reduce the size of the money
supply. They are fiscal policies, like lower spending and higher taxes, that reduce economic
growth. In most nations, monetary policy is controlled by either a central bank or a finance
ministry.

The Classical School of Thought

Quantity Theory of Money:

According to Irving Fisher (1911):

P = f(M)

“Other things remaining the same, as the quantity of money in circulation increases, the
price level also increases in the direct proportion and the value of money decreases and vice
versa.’’ These relations can be graphically shown as follows:
equation of exchange-an identity

 MV=PY

The equation of exchange says that total spending equals total value of what is bought.
This equation is preferred.

Preliminary concepts and assumptions

1. T, V & V’ remains the same.

2. The Proportion of M & M’ remains constant.

3. There is full employment in the economy.

4. The theory is applicable in the long run.

5. There is No barter transaction.

Aggregate demand and supply: a summary

Start with the equilibrium; assume the central bank doubles the
money supply. The liquidity rises. This will cause a rise in aggregate
demand. As the real output cannot expand-at full employment;
doubling of total spending must cause price to double. Result: money
supply doubled, nominal GDP doubled, price level doubled, V is same
as before, and so is real GDP, it will cause inflation.

Conclusion

• Since I=S, under classical school, manipulating the interest rate (cost of loanable funds)
will not influence the real variables (output and employment)

• Also changing the money supply (quantity theory of money) changes prices but does not
influence output…
THE KEYNESIAN MODEL:
The Keynes approach toward the economic equilibrium includes two major portions

• 1: The Keynesians cross

• 2: The liquidity preference theory.

The equilibrium level of output determines the equilibrium level of employment in the model. There
is no reason within the model why the equilibrium level of employment should correspond to full
employment.

The money market:

The interest rate adjusts to bring money supply and money demand into balance. Or the
interest rate is determined by the equilibrium in the money demand and supply. In the money
market

Money demand

The interest rate and the quantity of money demanded is in inverse relation. one way of
explaining this relation is that when the Interest rate increases than people would tend to demand
more the Interest bearing bonds and demand less money supply.

Money Supply

The money supply is determined by the central bank.Since the money supply is a policy variable
determined by the Fed, it is drawn as a vertical line.
The eqillibrium of the money market lies when the both money denmand and supply intersects.
The keynessian cross determines the is curve and the
liquidity prefernce thoery determines the lm curve
intesect of both determines the market equillium

CONCLUSION:

Keynes assumed that the equilibrium of the economy can

be obtained at a level less than full employment level and
the interest rate is determined by the money market. In
the short run prices are kept constant and the equilibrium
is determined by production output and expenditure.

Monetarist View of the Monetary Policy

monetarist Approach:

Hence, changes in the money supply are the single most important factor in determining the
levels of output, employment, and prices.

Important to note:

*As prices are sticky in the short-run, changes in the aggregate demand cause the change in
output level and not prices.

*As prices are flexible in the long-run, changes in aggregate demand cause the change in the
price level.

 Money supply directly changes aggregate demand

o Increasing money supply increases demand
o Decreasing money supply decreases demand
 Changing aggregate demand causes a change in GDP
o An increase in M will increase P or T , or a combination of both
o A decrease in M will decrease P or T, or a combination of both

Monetarists believe that 1) unstable, erratic monetary policy is the main cause of
economic fluctuations (expansions and contractions) and 2) inflation is caused by excess
money creation. 

Explanation

 If the velocity of money is stable than changes in the money supply will directly affect
nominal GDP
 Or if nominal GDP changes it will have an equal change on the money supply
 Velocity of circulation is a result, not a cause. It is commonly a passive resultant of
changes in people's relative valuations of money and goods.
 Velocity of circulation cannot fluctuate for long beyond a comparatively narrow range,
because it is closely tied (except for speculation) to the rate of consumption and
production.
 V does vary with the volume of speculation,
 Actually it is psychological factors — desire to buy and sell, produce and consume —
that determine V.

Conclusion
Monetarists believe that persistent inflations (or deflations) are purely monetary
phenomena brought about by persistent expansionary (or contractionary) monetary
policies. As a means of combating persistent periods of inflation or deflation,
monetarists argue in favor of a fixed money supply rule. They believe that the central
bank should conduct monetary policy so as to keep the growth rate of the money supply
fixed at a rate that is equal to the real growth rate of the economy over time. Thus,
monetarists believe that monetary policy should serve to accommodate increases in real
GDP without causing either inflation or deflation.