Ch.

15: Monetary Policy

Del Mar College John Daly
2003 South-Western Publishing, A Division of Thomson Learning

The Demand for Money

The price of holding money balances is the interest rate. The interest rate is the opportunity cost of holding money. As the interest rate increases, the opportunity cost of holding money increases, and people choose to hold less money.

Supply and Demand for Money

Equilibrium in the Money Supply

The money supply is not exclusively determined by the Fed because both the banks and the public are important players the money supply process. Equilibrium in the money market exists when the quantity demanded of money equals the quantity supplied.

Transmission Mechanisms
The impact that changes in the money market have on the goods and services market and whether that impact is direct or indirect; and the routes and ripple effects created in the money market travel to affect the goods and services market are known as the transmission mechanism.

The Keynesian Transmission Mechanism

The Money Market The Investment Goods Market The Goods and Services Market (AD-AS Framework) When the money supply increases, the Keynesian transmission mechanism works as follows: an increase in the money supply lowers the interest rate, which causes investment to rise and the AD curve to shift rightward. Real GDP increases and the unemployment rate drops.

The Keynesian Transmission Mechanism: Indirect

The Keynesian Mechanism May Get Blocked

Some Keynesian economists believe that investment is not always responsive to interest rates. The Keynesian transmission mechanism would be short-circuited in the investment goods market, and the link between the money market and the goods and services market would be broken. Keynesians have sometimes argued that the demand curve for money could become horizontal at some low interest rate. This is called the Liquidity Trap.

Keynesian Transmission Mechanisms

Because the Keynesian transmission mechanism is indirect, both interest insensitive investment demand and the liquidity trap may occur.

The Keynesian View of Monetary Policy

Bond Prices and Interest Rates

As the price of a bond decreases, the actual interest rate return, or simply the interest rate, increases. The market interest rate is inversely related to the price of old or existing bonds. Consider the Liquidity Trap: the reason an increase in the money supply does not result in an excess supply of money at a low interest rate is that individuals believe bond prices are so high that an investment in bonds is likely to turn out to be a bad deal.

The Monetarist Transmission Mechanism: Direct

In the Monetarist theory, there is a direct link between the money market and the goods and services market. An increase in the money supply means increased Aggregate Demand, Increased Real GDP, increased Prices and a decrease in unemployment. A decrease in the money supply means decreased Aggregate Demand, Decreased Real GDP, decreased Prices and an increase in unemployment.

The Monetarist Transmission Mechanism: Direct

Q&A
Explain the inverse relationship between bond prices and interest rates. According to the Keynesian transmission mechanism, as the money supply rises, there is a direct impact on the goods and services market. Do you agree or disagree with this statement. Explain your answer. Explain how the monetarist transmission mechanism works when the money supply rises.

Monetary Policy and the Problem of Inflationary and Recessionary Gaps

Monetary Policy and an Inflationary Gap

Keynesians, Recession, and Inflation

Most Keynesians believe that the natural forces of the market economy work much faster and more assuredly at eliminating an inflationary gap than a recessionary gap. Keynesians are more likely to advocate expansionary monetary policy to eliminate a stubborn recessionary gap than contractionary monetary policy to eliminate a not-so-stubborn inflationary gap. It has been argued that Keynesian monetary policy has an inflationary bias.

Monetary Policy and the ActivistNonactivist Debate

Activists argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle. They are in favor of economic fine-tuning, which is the frequent use of monetary and fiscal policies to counteract even small undesirable movements in economic activity. Nonactivists argue against the use of deliberate fiscal and monetary policies. They believe the discretionary policies should be replaced by a stable and permanent monetary and fiscal framework and the rules should be established in place of activist policies.

The Case for Activist Monetary Policy

1. The economy does not always equilibrate quickly enough at Natural Real GDP. 2. Activist monetary policy works; it is effective at smoothing out the business cycle. 3. Activist monetary policy is flexible; nonactivist monetary policy, which is based on rules, is not.

The Case for Nonactivist Monetary Policy

1. In modern economies, wages and prices are sufficiently flexible to allow the economy to equilibrate at reasonable speed at Natural Real GDP. 2. Activist monetary policies may not work. 3. Activist monetary policies are likely to be destabilizing rather than stabilizing; they are likely to make matters worse rather than better.

Expansionary Monetary Policy and No Change in the Real GDP

If expansionary monetary policy is anticipated, workers may bargain for and receive higher wage rates. It is possible that the SRAS curve will shift leftward to the degree that expansionary monetary policy shifts the AD curve rightward. Result: no change in Real GDP.

Monetary Policy May Destabilize In this scenario, the the Economy

SRAS curve is shifting rightward, but Fed officials do not realize this is happening. They implement expansionary monetary policy, and the AD curve ends up intersecting SRAS2 at point 2 instead of SRAS1 at point 1. Fed officials end up moving the economy into an inflationary gap and thus destabilizing the economy

Q&A
Why are Keynesians more likely to advocate expansionary monetary policy to eliminate a recessionary gap than contractionary monetary policy to eliminate an inflationary gap? How might monetary policy destabilize the economy? If the economy is stuck in a recessionary gap, does this make the case for activist monetary policy stronger or weaker? Explain your answer.

Nonactivist Monetary Proposals

A monetary rule describes monetary policy that is based on a predetermined steady growth rate in the money supply. Some economists would like the monetary rule to read as follows: The annual money supply growth rate will be constant at the average annual growth rate of the Real GDP. Others would like the monetary rule to read: The annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity. Some Monetary rule proponents claim that even if a monetary rule does not adjust for changes in velocity, there is little cause for concern.

A Gold Standard
The money supply would be tied to the stock of gold. The government sets the price of gold at some dollar amount. The government promises to buy and sell gold at the official price. Critics charge that a gold standard is no guarantee against inflation. Critics also charge that a reduction in national output and an increase in unemployment will result if prices do not fall in the same proportion when the gold-backed money supply is reduced.

A Gold Standard

The Fed and The Taylor Rule

There may be a middle ground between activist and nonactivist monetary policy. The Taylor Rule specifies how policy makers should set the target for the federal funds rate.
Federal funds rate target = Inflation + Equilibrium real federal funds rate + (Inflation Gap) + (Output Gap)

Q&A
Would a monetary rule produce price stability? Explain your answer. How would the gold standard (described in the text) work?