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Macro Chapter 14
Modern Macroeconomics and
Monetary Policy
3 Learning Goals
1) Analyze the impact monetary policy has
on the economy
2) Investigate the claim that a rapid
increase in the money supply leads to
inflation
3) Confirm the ideas presented in the
chapter with data from various countries
Daniel Thornton & David Wheelock:
“The conventional wisdom once held that
money doesn’t matter. Now there is wide
agreement that monetary policy can
significantly affect real economic activity in
the short run, though only price level in the
long run.”
Main points of the chapter:
1) Unanticipated changes in the money
supply can change AD
2) Anticipated changes and long run
changes do NOT change AD; only prices
are affected
3) A more rapid increase in the quantity of
money than in the quantity of goods and
services available for purchase will
produce inflation, raising prices in terms of
that money
The Impact of Monetary
Policy on Output and
Inflation
When the Fed increases the money
supply
Interest rates fall
Consumption and Investment increase
The dollar will depreciate, causing
Exports to rise, imports to fall, and net
exports to rise
When the Fed decreases the
money supply
Interest rates rise
Consumption and Investment decrease
The dollar will appreciate, causing
Exports to fall, imports to rise, and net
exports to fall
Unanticipated changes in the
money supply:
Refer back to Chapter 10 regarding the
details of what happens when AD
increases and decreases
The same “story” is told, the only
difference now is the variable that
changed AD
What if AD surprisingly increases?
(1) Higher prices will increase profits
(2) Firms will increase production (move along
SRAS)
– Actual output > potential output
– Actual unemployment < natural rate
(3) Resources prices will begin to rise
(4) Interest rates will rise as demand for
loanable funds increases
(5) Foreigners will purchase more US assets;
the dollar will appreciate
(6) SRAS will begin to fall (shift left) and
consumers will buy less (move along AD)
(7) The economy will return to long run
equilibrium
Q14.1 In the short run, an unanticipated increase
in the money supply will exert its primary impact on
1. output and employment rather than on prices.
2. prices; output and employment will be largely
unaffected.
3. interest rates; rising interest rates will stimulate
additional saving.
4. prices, if the economy operates at an output level
below its long-run supply constraint.
Q14.2 The short run sequence of events following
an unanticipated shift to restrictive monetary policy
would be higher interest rates followed by dollar
1.
2.
3.
4.
depreciation, higher exports, and lower imports.
depreciation, lower exports, and higher imports.
appreciation, lower exports, and higher imports.
appreciation, higher exports, and lower imports.
Monetary Policy in the
Long Run
Milton Friedman:
“Inflation is always and everywhere a
monetary phenomenon”
“Inflation occurs when the quantity of
money rises appreciably more rapidly than
output, and the more rapid the rise in the
quantity of money per unit of output, the
greater the rate of inflation.”
If your income doubled and the
price level doubled, would anything
really change?
The Quantity Theory of Money is used to
support the hypothesis that a rapid
increase in the money supply causes
inflation
Equation of exchange: M V = P Y
M = money supply
V = velocity, how quickly $1 passes
through the economy
P = price level
Y = GDP = output
M V = Total spending
P Y = Total receipts
Implications:
In the short run, Y and V are assumed to
be constant
Therefore an increase in M causes an
increase in Y
The long run effects:
↑M → ↑AD → ↑resource prices → ↓SRAS
Then
↑M → ↑AD → ↑resource prices → ↓SRAS
Then
↑M → ↑AD → ↑resource prices → ↓SRAS
Then …
Q14.3 In an economy in which velocity is constant
and real output grows at an average rate of 3
percent per year, a 5 percent average rate of
growth in the money supply would result in a
1. constant price level.
2. low (approximately 2 percent) rate of inflation.
3. decline in the general level of prices at an
annual rate of approximately 2 percent.
4. rate of inflation of approximately 8 percent.
Q14.4 (PMA) Equilibrium in the loanable funds market is
initially present at a stable price level (zero inflation) and a
nominal (and real) interest rate of 4 percent. If a shift to
expansionary monetary policy eventually leads to actual
and expected inflation of 6 percent,
1)
2)
3)
4)
5)
6)
The nominal interest rate will rise to 10 percent.
The nominal interest rate will stay at 4 percent.
The nominal interest rate will rise to 6 percent.
The real interest rate will rise to 10 percent.
The real interest rate will stay at 4 percent.
The real interest rate will rise to 6 percent.
Do the theories hold up in the real world?
Watch video: Free to Choose-inflation
Time Lags, Monetary Shifts,
and Economic Stability
You may skip the Taylor Rule
Q14.5 In the long-run, the primary effect of
rapid monetary growth is
1.
2.
3.
4.
lower nominal interest rates.
reduced unemployment.
inflation.
an increase in real output.
Question Answers:
14.1 = 1
14.2 = 3
14.3 = 2
14.4 = 1 & 5
14.5 = 3