Monetary Policy

Ch.15, Macroeconomics, R.A. Arnold

The Money Market
Demand for money: The inverse relationship between the quantity
demanded of money (i.e. demand for holding money) and the price of
holding money (i.e. interest rate).
Interest rate is the price we have to pay for holding money (i.e. keeping
money in our wallets and homes) since we could have earned interest
payment if we had not demanded the money and kept it in a commercial
bank.
Hence, if the interest rate increases, demand for (holding) money
decreases…therefore the money demand curve is downward sloping.
The supply of money is determined by the central bank and it does not
depend on the interest rate and thus the money supply curve is vertical.
Exhibit 2 p. 336.
Transmission Mechanisms
If the supply or demand for money changes in the money market then it affects the
economy. How? There are two theories to explain the phenomenon. The channel by
which the change affects the economy are called transmission mechanisms.
1) The Keynesian Transmission Mechanism: Indirect (Exhibit 3 p. 337. Important)
Case 1 (as in the text book). The central bank conducts an open market purchase (ch.
13) this increases the reserves of commercial banks. The banks loan out the excess
reserves (i.e. the supply of loanable funds increase) which causes the interest rate to
decrease. A fall in interest rate stimulates investment (i.e. investment increases) and
hence AD increases (shifts right).
Case 2. The central bank conducts an open market sale…(the remaining analysis is just
the opposite case i.e. all changes are just the opposite. This is left to you as an exercise
which you can show me during my office hours or discuss with your class-mates).
The second theory…
2) The Monetarist Transmission Mechanism: Direct (Exhibit 6 p. 341)
The monetarists propose a direct link between the money market and
the goods and service market. Increase in money supply leaves
individuals with an excess supply of money which they use to consume
and/or invest hence AD increases (shifts right).

As evident from the discussion so far, changes in money supply i.e.

monetary policy can affect the aggregate demand and if the economy is
not self-regulatory, it could be used to bring it out of a recessionary or
an inflationary gap. Similar to - how we used fiscal policy for the same
purpose (Ch. 10).
Monetary Policy and the Problems of
Inflationary and Recessionary Gap
In a recessionary gap the real GDP < natural real GDP. Hence to bring
the economy back to the LR equilibrium where real GDP = Natural real
GDP, we must stimulate (increase) aggregate demand. As we have
already seen that can be done by increasing the money supply i.e. by
conducting expansionary monetary policy. Exhibit 7 (c) p. 342.
In an inflationary gap real GDP > natural real GDP. Hence to bring it
back to the long run equilibrium we need to decrease aggregate
demand which can be done using contractionary monetary policy.
Exhibit 8 (c) p. 343.
Consolidation
Classical economists believed that the economy is self-regulatory and
hence Laissez-Faire (not interfering with the economy) is the best policy
Keynesians argue that the economy is not self-regulatory since the wages
and prices are not flexible and hence the government should interfere
with the economy (using fiscal policy)
Monetarists believe that monetary policy (conducted by central bank)
may also be used to address the issue of recessionary and inflationary gap
As we can see the government and the central bank are two very
important institutions who may work together to achieve the economics
goals of: low unemployment, stable prices & economic growth
Some ideas from Ch. 17
But as we can see neither fiscal policy nor monetary policy can increase the
Real GDP (total output) in the long run…that is only possible if we can increase
the long run aggregate supply (i.e. shift the LRAS right). How?
Output is produced using inputs (ch. 1). Hence, to increase the total output in
the economy the total input needs to be increased i.e. capital and labour or
the technology and human capital needs to be improved (both of which
increases the productivity of inputs). In that case LRAS curve shifts right and
the economy may be able to produce a higher Real GDP in the long run. So the
goal of - economic growth (increasing real GDP) - can be achieved by
improving technology, human capital* (which we are trying to do in NSU) and
or increasing the capital stock, number of labour etc.
*The knowledge and skills a person acquires through education, training and
experience
Some ideas from Ch. 22
Comparative Advantage: The advantage a country (or a business firm) has
when it can produce a good at a lower opportunity cost than another
country (or a business firm).
E.g. Bangladesh has a comparative advantage over U.S.A in producing
RMG.
Countries specialize in producing the goods in which they have a
comparative advantage. Hence, BD produces RMG and USA produces air-
crafts and satellites.
Countries (or individuals) trade to make themselves better-off. USA
imports RMG from BD and we import air-crafts from USA. But international
trade may be restricted due to tariff (a tax on imports) and import quota (a
legal limit imposed on the amount of a good that may be imported).