Download Unit 3.7 c - Aspen High School

Unit 3.7 c
Further Policy Discussion
Classical Economists
Basically, everyone prior to Keynes
Classical economists believed that all markets worked
according to the rules of supply and demand.
– They believed in supply side polices to improve the productive
potential of the economy.
– They did not approve of government intervention in terms of
demand management.
This would distort the free workings of the far more efficient
markets.
Monetarists and neo classical economists are the same
‘neo-classical economists’
– modern economists who believe in, and have revived, the
theories used by the old classical economists.
– Most recent monetarist/classical economist widely cited is Milton
Friedman
Monetarists/Neo-classical
Have strong belief in the growth of an economy’s
money supply being the main determinant of the
economy’s price level (the Quantity Theory of
Money)
MV = PQ
This is the theory of inflation that forms the basis of the
beliefs of monetarist economists.
– Quite simply, the theory states that, given the assumptions of a
fixed velocity of circulation and predictable rate of growth in the
economy, a rise in the money supply will cause a rise in the
price level.
Do not confuse monetarist with Monetary
policy:
– Monetarism/neo classical economic theory is NOT
THE SAME AS MONETARY POLICY
Money Supply
the amount of money in the economy.
The question is, what can one define as money?
– Obviously notes and coins count.
– But what about bank accounts, both current and savings
accounts?
– What about things like Treasury bills?
M1: Cash (aka M0) + the amount in demand deposits
("checking" or "current" accounts).
M2: M1 + most savings, money market, and CD
accounts of under $100,000.
M3: M2 + all other CDs, deposits of eurodollars and
repurchase agreements
– The FED has stopped measuring M3 as of March 2006
Monetary Policy
This is government policy concerned with
the money supply, the rate of interest and the
exchange rate.
At any one time, the government can only
really try to control one of these three things.
Monetary policy in the UK as well as the US
is now centered on three things:
– Ensuring adequate liquidity in the credit markets
Increase money supply
– adjusting the interest rate with the goal of
expanding the economy
– controlling the inflation/deflation rate
Federal Reserve System
Monetary policy is under the control of the
Federal Reserve System (our central bank) and
is completely discretionary.
– Monetary policy is the changes in interest rates and
money supply to expand or contract aggregate
demand.
In a recession, the Fed will lower interest rates
and increase the money supply.
In an overheated expansion, the Fed will raise
interest rates and decrease the money supply.
Federal Open Market Committee
The decisions of the FED are made by the Federal Open
Market Committee (FOMC) which meets every six to
seven weeks.
The policy changes can be done immediately, although
the impact on aggregate demand can take several
months.
A source of conflict is that the Fed is independent and is
not under the direct control of either the President or the
Congress.
– The FED is NOT a government agency
This independence of monetary policy is considered to
be an important advantage compared to fiscal policy.
FOMC
Comprised of
– the Chairman of the FED
Ben Bernanke
– The President of the Federal Reserve Branch
New York
– Five other District Federal Reserve Branch
Presidents who rotate every year
Treasuries
The government, through the U.S.
Treasury Dept, issues treasuries when
they borrow to fund deficit spending
– Treasury Bills have maturities of one year or less.
– Treasury Notes have maturities of two to ten years.
– Treasury Bonds have maturities > than ten years.
FED operations through FOMC:
Monetary Policy tools
Open Market Operations
– Buy and sell Treasuries
Expansionary Policy
– Buy Treasuries on the open market
Increases money in circulation
Reduces interest rates
Contractionary Policy
– Sell Treasuries on the open market
Decrease money in circulation
Increases interest rates
FED operations through FOMC:
Monetary Policy tools
Reserve Requirements
– The U.S. Government requires the FED to
regulate reserves in every bank
Current regulations require the reserve to be at
least 8% but no more than 14%
FED operations through FOMC:
Monetary Policy tools
Discount rate
– The interest rate the Fed charges local banks
for very short term loans
For example, at the Christmas season, the
demand for money increases greatly and suddenly
Fed Funds Rate
– The interest rate that banks charge each
other when they borrow money from each
other to meet the reserve requirement
FED operations through FOMC:
Monetary Policy tools
Newer Fed functions in the last year:
– Direct purchase of mortgage and loan
obligations to relieve banks of that bad debt
– Long term loans to banks and financial
institutions as a way to bridge the economic
trouble brought on by the credit crisis
Exchange Rate Mechanisms related to Monetary Policy
FED says they prefer a strong dollar, but basically do nothing
at all in this area
– The Bush administration won’t say it publicly, but encourage the
declining value of the dollar as a way to reduce our foreign debt as well
as our balance of trade deficit
If the interest rates move higher
– attracts more foreign investment
– Dollar gets stronger
Exports cost more
Imports cost less
– Exacerbating the imbalance of trade
If the interest rates move lower
– Less foreign investment
Dollar gets weaker
Exports cost less
Imports cost more
– Helping the balance of trade
But, if the interest rates move higher to reduce inflation
– Reduces AD
– Worsens balance of trade