Monetary Policy

1
Monetary Policy

• Monetary policy changes in the money supply to
  achieve macroeconomic goals.
• The Fed increases (or decreases) the money supply
  primarily by buying (or selling) U.S. government
  securities in the open market.
• There are different theories about how changes in
  the money supply affect the economy.

2
Classical Monetary Theory

• Classical economists see a direct relationship
  between the money supply and the price level.
• Velocity of money (V) the average number of
  times a dollar is spent annually.
• V Nominal GDP M
• See Example 1 on page 12-2.

3
The Equation of Exchange

• M x V P x Q
• M is the money supply.
• V is the velocity of money.
• P is the price level.
• Q is Real GDP.

4
The Equation of Exchange

• M x V P x Q
• Classical theory assumes that velocity is
  constant and that Real GDP is constant in the
  short run.
• Thus, there is a directly proportional
  relationship between the money supply and the
  price level.
• See Example 2A on page 12-2.

5
The Equation of Exchange

• In the actual economy, velocity has not been
  constant.
• If velocity is not constant, there will not be a
  directly proportional relationship between the
  money supply and the price level.
• See Example 2B on page 12-3.

6
Monetarism

• Monetarism is an economic theory based on
  classical theory, but with some differences.
  Monetarism holds that
• 1. Velocity is not constant.
• 2. Changes in the money supply and/or in
  velocity can change AD.
• 3. Changes in AD will change both the price
  level and Real GDP in the short run.

7
Monetarism Changes in AD
8
Classical Changes in AD
9
Monetarism

• Monetarism assumes that the economy is
  self-regulating and automatically adjusts back to
  Natural Real GDP.
• Thus, like classical theory, monetarism holds
  that, in the long run, AD affects only the price
  level.

10
Keynesian Monetary Theory

• According to Keynesian theory, monetary policy
  can be used to change TE, in order to change Real
  GDP.
• Keynesian theory holds that changes in the money
  supply affect Real GDP indirectly, through a
  series of steps called the Keynesian monetary
  transmission mechanism.

11
Keynesian Monetary Transmission Mechanism

• 1. An increase in the money supply leads to
• 2. a decrease in interest rates, which leads to
• 3. an increase in investment, which leads to
• 4. an increase in TE, which leads to
• 5. an increase in Real GDP.

12
The Keynesian monetary transmission mechanism may
fail because

• 1. Investment may be interest-insensitive. If
  investors are extremely pessimistic about future
  returns, they may be insensitive to a decrease in
  interest rates.
• See Example 4 on page 12-5.

13
The Keynesian monetary transmission mechanism may
fail because

• 2. The liquidity trap. The liquidity trap means
  that an increase in the money supply does not
  cause a decrease in interest rates. Interest
  rates will only fall so low.
• See Example 5 on page 12-6.

14
Monetarist Transmission Mechanism

• The monetarist transmission mechanism is more
  direct
• 1. An increase in the money supply means
  increased Total Expenditures and Real GDP.
• 2. A decrease in the money supply means
  decreased Total Expenditures and Real GDP.

15
Monetary Policy and Closing Gaps

• Monetary policy can be used to attempt to close a
  recessionary gap or an inflationary gap.
• Expansionary monetary policy (an increase in the
  money supply) would be used to close a
  recessionary gap.
• Contractionary monetary policy would be used to
  close an inflationary gap.

16
Keynesian Theory and the Proper Policies

• Keynesians support the use of both fiscal and
  monetary policy to move the economy toward
  Natural Real GDP.
• Keynesians put more confidence in fiscal policy
  than in monetary policy.

17
Monetarist Theory and the Proper Policies

• Monetarists are generally opposed to activist
  fiscal and monetary policies.
• Activist policies may have a destabilizing effect
  on the economy rather than a stabilizing effect.
• Monetarists favor an annually balanced budget for
  fiscal policy and a monetary rule for monetary
  policy.

18
Monetary Rule

• A monetary rule would link money supply growth to
  Real GDP growth in order to achieve a stable
  price level.
• See Example 6 on page 12-7.

19
The Great Depression

• No downturn in American history was as severe as
  the Great Depression.
• Between 1929 and 1933
• a. Real GDP decreased by 27.
• b. Investment spending collapsed.
• c. The CPI fell by 24.
• d. The unemployment rate increased from 3.2 to
  24.9.
• See Example 8 on page 12-8.

20
Great Depression Keynesian Explanation

• When investors became extremely pessimistic
  following the stock market crash of 1929,
  investment spending collapsed.
• The decrease in investment spending led to a
  multiplied decrease in Real GDP.
• The federal government failed to implement
  expansionary fiscal and monetary policy.

21
Great Depression Keynesian Explanation

• With the coming of World War II, the governments
  fiscal and monetary policy became strongly
  expansionary.
• See Example 9 on page 12-9.

22
Great Depression Classical Explanation

• What began as a normal business downturn was
  turned into a collapse by two government policy
  mistakes
• 1. The Fed allowed a decrease in the money
  supply which caused deflation and led to a
  collapse in investment spending.
• See Example 10 on page 12-9.

23
Great Depression Classical Explanation

• 2. The Smoot-Hawley Tariff led to retaliatory
  tariffs and a collapse in international trade.
• See the appendix at the end of Chapter 7.

24
The Age of Turbulence

• In 2007, Alan Greenspan published The Age of
  Turbulence Adventures in a New World.
• Greenspans tenure as Chairman of the Federal
  Reserve Board of Governors was marked by a number
  of historic events.
• See the list on page 12-10.

25
The Age of Turbulence

• During Greenspans tenure as Fed Chairman, the
  economy enjoyed a remarkable run of economic
  stability , with only two mild recessions (in
  1991 and 2001).
• The annual rate of inflation averaged only 3.1
  from 1988 through 2005, after having averaged
  6.5 from 1970 through 1987.

26
The Age of Turbulence

• Greenspan puts forth observations in the second
  half of the book.
• See the list on pages 12-10 and 12-11.