Chapter 5

Monetary Theory and Policy

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
 Monetary theory
 Tradeoff faced by the Fed
 Economic indicators monitored by the Fed
 Lags in monetary policy
 Assessing the impact of monetary policy
 Integrating monetary and fiscal policies
 Global effects of monetary policy

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Monetary Theory
 Pure Keynesian Theory
 One of the most popular theories influencing the Fed
 Developed by John Maynard Keynes
 Suggests how the Fed can affect the interaction
between the demand for money and the supply of
money to influence:
 Interest rates
 The aggregate level of spending
 Economic growth

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Monetary Theory (cont’d)
 Pure Keynesian Theory (cont’d)
 Can be explained by using the loanable funds
framework
 Demand for and supply of loanable funds
determine the equilibrium interest rate
 The business investment schedule illustrates the

inverse relationship between interest rates on

loanable funds and the level of business
investment

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Monetary Theory (cont’d)
 Pure Keynesian Theory (cont’d)
 Correcting a weak economy
 The Fed would use open market operations to increase the
money supply
 A higher level of the money supply would reduce interest
rates
 Lower interest rates encourage more borrowing and
spending
 Keynesian philosophy advocates an active role for the
government in correcting economic problems

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Monetary Theory (cont’d)
Correcting a Weak Economy

S1 S2

i1 i1

i2 i2
D1

B1 B2
Demand and Supply of Loanable Funds Business Investment Schedule

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Monetary Theory (cont’d)
 Pure Keynesian Theory (cont’d)
 Correcting high inflation
 The Fed would sell Treasury securities (decrease
the money supply)
 A lower level of the money supply reduces the level

of spending
 Less spending slows economic growth and

reduces inflationary pressure (demand-pull

inflation)

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Monetary Theory (cont’d)
Correcting High Inflation

S2 S1

i2 i2

i1 i1
D1

B2 B1
Demand and Supply of Loanable Funds Business Investment Schedule

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Monetary Theory (cont’d)
 Pure Keynesian Theory (cont’d)
 Effects of a credit crunch on a stimulative policy
 The economic impact of monetary policy depends on the
willingness of banks to lend funds
 If banks are unwilling to extend credit despite a stimulative
policy, the result is a credit crunch
 A credit crunch can occur during a restrictive policy since
some borrowers will not borrow because of the high interest
rates

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Monetary Theory (cont’d)
 Quantity Theory and the Monetarist approach
 The quantity theory suggests a particular relationship
between the money supply and the degree of economic
activity in the equation of exchange:
MV  PGQ
 Velocity is the average number of times each dollar
changes hands per year
 The right side of the equation is the total value of goods
and services produced
 If velocity is constant, a change in the money supply will
produce a predictable change in the total value of goods
and services

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Monetary Theory (cont’d)
 Quantity Theory and the Monetarist approach
(cont’d)
 An early form of the theory assumed a constant Q
 Assumes a direct relationship between the money supply
and prices
 Under the modern quantity theory of money,
the constant quantity assumptions has been
relaxed
 A direct relationship exists between the money supply
and the value of goods and services

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Monetary Theory (cont’d)
 Quantity Theory and the Monetarist approach
(cont’d)
 Velocity represents the ratio of money stock to
nominal output
 Velocity is affected by any factor that influences
this ratio:
 Income patterns
 Factors that change the ratio of households’ money
holdings to income
 Credit cards
 Inflationary expectations

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Monetary Theory (cont’d)
 Comparison of the Monetarist and Keynesian
Theories
 The Monetarist approach advocates stable, low
growth in the money supply
 Allows economic problems to resolve themselves
 Keynesian approach would call for a loose
monetary policy to cure a recession

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Monetary Theory (cont’d)
 Comparison of the Monetarist and Keynesian
Theories (cont’d)
 Monetarists are concerned about maintaining low
inflation and are willing to tolerate a natural rate of
unemployment
 Keynesians focus on maintaining low
unemployment and are willing to tolerate any
inflation that results from stimulative monetary
policies

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Monetary Theory (cont’d)
 Theory of Rational Expectations
 Holds that the public accounts for all existing information
when forming its expectations
 Suggests that households and business will use historical
effects of monetary policy to forecast the impact of an
existing policy and act accordingly
 Households spend more with a loose monetary policy to avoid
inflation
 Businesses will increase their investment with a loose monetary
policy to avoid higher costs
 Labor market participants will negotiate higher wages with a
loose monetary policy
 Supports the Monetarist view that changes in monetary
policy do not have a sustained impact on the economy

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Monetary Theory (cont’d)
 Which theory is correct?
 The FOMC recognizes the virtues and limitations
of each theory
 The FOMC adjusts monetary growth targets to control
economic growth, inflation, and unemployment
 Recognizing the Monetarist view, the FOMC is
concerned about the inflation resulting from a loose
monetary policy

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Tradeoff Faced by the Fed
 Ideally, the Fed would like:
 Low inflation
 Steady GDP growth
 Low unemployment
 There is a negative relationship between
unemployment and inflation
 Phillips curve
 A tight money policy can curb inflation but increase
unemployment and vice versa

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Tradeoff Faced by the Fed (cont’d)

 Impact of other forces on the tradeoff

 Cost factors such as energy costs and
insurance costs can influence the tradeoff
 When both inflation and unemployment are
high, Fed members may disagree as to the
type of monetary policy that should be
implemented

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Tradeoff Faced by the Fed (cont’d)
 Impact of other forces on the tradeoff (cont’d)
 How the Fed’s focus shifted during the Persian Gulf War
 There were numerous indications of a possible recession in the
summer of 1990
 The abrupt increase in oil prices placed upward pressure on U.S.
inflation
 How the Fed’s emphasis shifted during 2001–2004
 The focus shifted from high inflation to the weak economy over time
 From January to December 2001, the FOMC reduced the targeted
federal funds rate ten times
 In 2002 and 2003, the Fed reduced the federal funds target rate
twice

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Economic Indicators Monitored by
the Fed
 Indicators of economic growth
 Gross domestic product (GDP)
 Measures the total value of goods and services
produced
 Measured each month

 The most direct indicator of economic growth

 Level of production
 A high level indicates strong economic growth and
can result in increased demand for labor

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Economic Indicators Monitored by
the Fed (cont’d)
 Indicators of economic growth (cont’d)
 National income
 The total income earned by firms and individual employees
 A strong demand for goods and services results in a large
amount of income
 Unemployment rate
 Does not necessarily indicate the degree of economic growth
 Can decrease in weak economic growth periods if new jobs
are created

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Economic Indicators Monitored by
the Fed (cont’d)
 Indicators of economic growth (cont’d)
 Industrialproduction index
 Retail sales index
 Home sales index
 Composite index
 Consumer confidence surveys

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Economic Indicators Monitored by
the Fed (cont’d)
 Indicators of inflation
 Producer and consumer price indexes
 The PPI measures prices at the wholesale level
 The CPI measures prices on the retail level

 Both indexes are used to forecast inflation

 Agricultural and housing price indexes also exist

 Other indicators
 Wages, oil prices, transportation costs, the price of
gold, indicators of economic growth

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Economic Indicators Monitored by
the Fed (cont’d)
 How the Fed uses indicators
 The Fed uses indicators to anticipate how
economic conditions will change and then
determines what monetary policy would be
appropriate
 Weak economic conditions suggest an
expansionary monetary policy
 High productivity and employment suggest a
restrictive monetary policy

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Economic Indicators Monitored by
the Fed (cont’d)
 Index of Leading Economic Indicators
 The Conference Board publishes indexes of leading,
coincident, and lagging economic indicators
 Leading economic indicators are used to predict future
economic activity
 Three consecutive monthly changes in the same direction
suggest a turning point in the economy
 Coincident economic indicators reach their peaks and
troughs at the same time as business cycles
 Lagging economic indicators tend to rise or fall a few
months after business-cycle expansions and contractions

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Lags in Monetary Policy
 The recognition lag is the lag between the time
a problem arises and the time it is recognized
 The implementation lag is the lag between the
time a serious problem is recognized and the
time the Fed implements a policy to resolve it
 The impact lag is the lag between the a policy is
implemented and the time the policy has its full
impact on the economy

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Lags in Monetary Policy (cont’d)
 Lags hinder the Fed’s control of the
economy
 By the time a policy is implemented, economic
conditions may have reversed
 Without monetary policy lags, implemented
policies would have a higher rate of success

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Assessing the Impact of Monetary
Policy
 Financial market participants will not all
react to monetary policy in the same
manner
 Different securities are affected differently
 Participants trading the same securities
may still be affected differently
 Expectationsabout the policy’s impact on
economic variables may differ

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Assessing the Impact of Monetary
Policy (cont’d)
 Forecasting money supply movements
 Periodicals sometimes specify the weekly ranges of M1 and M2
based on the Fed’s disclosure of target ranges
 When the actual money supply falls outside the target range, a
change in the Fed’s range has not yet been publicly announced
 Improved communication from the Fed
 Uncertainty about FOMC meeting results prior to 1999 caused
volatile price movements
 Since 1999, the Fed has been more willing to disclose its
conclusions (federal funds rate target changes and possible future
tightening or loosening of the money supply)

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Assessing the Impact of Monetary
Policy (cont’d)
 Forecasting the impact of monetary policy
 Even if market participants correctly anticipate
changes in the money supply, they may not be able to
predict future economic conditions
 The historic relationship between the money supply and
economic variables has not been stable
 Impact of monetary policy across financial markets
 Monetary policy affects the securities traded in all financial
markets due to its effect on interest rates and economic growth

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Integrating Monetary and Fiscal
Policies
 The Fed’s monetary policy is commonly
influenced by the administration’s fiscal policies
 The Fed and the administration often use
complementary policies to resolve economic
problems
 Fiscal policy typically influences the demand for
loanable funds, while monetary policy normally
has a larger impact on the supply of loanable
funds

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Integrating Monetary and Fiscal
Policies (cont’d)
 History
 Presidential
administrations have been more
concerned with maintaining strong economic growth
and low unemployment
 The Fed shared the same concerns in the early 1970s
 By 1980, there was high inflation and unemployment
 The administration cut taxes to stimulate the economy
 The Fed used a tight monetary policy to reduce inflation
 The Fed ultimately loosened the money supply in 1983

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Integrating Monetary and Fiscal
Policies (cont’d)
 Monetizing the debt
 Should the Fed help finance the federal budget deficit
that has been created from fiscal policy?
 Loosening the money supply in response to a higher budget
deficit is called monetizing the debt
 If the Fed does not monetize the debt, a weak economy may
be more likely
 If the Fed monetizes the debt, higher money supply growth is
required

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Integrating Monetary and Fiscal
Policies (cont’d)
 Market assessment of integrated policies
 Market participants must consider both fiscal and
monetary policies when assessing future economic
conditions
 The supply of loanable funds can be affected by the Fed’s
adjustment of the money supply or changes in tax policies
 The demand for loanable funds is affected by changes in the
money supply or government expenditures and possibly tax
revisions
 Once the supply and demand for loanable funds has been
forecasted, interest rate movements can be forecast

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Global Effects of Monetary Policy
 Impact of the dollar
 A weak dollar stimulates exports and discourages
imports, which stimulates the economy
 The Fed is less likely to use a stimulative monetary
policy when the dollar is weak
 Impact of global economic conditions
 When global economic conditions are strong, foreign
countries purchase more U.S. products, which
stimulates the U.S. economy

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Global Effects of Monetary Policy
(cont’d)
 Transmission of interest rates
 Upward pressure on U.S. interest rates may be offset
by foreign inflows of funds
 A high U.S. budget deficit may lead to higher interest
rates in other countries
 Global crowding out
 Fed policy during the Asian Crisis
 The Fed may have lowered interest rates more than it
would have without the crisis
 Offset the lower demand for U.S. exports and helped to
sustain U.S. demand for foreign exports

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