Download Chapter29

Regan/Lipsey 11th (Chapter 29)
Question 5
a) The choice of the price level (or the rate of inflation) as a long-run policy variable
reflects the Bank of Canada’s belief that monetary policy is neutral in the long run. The
Bank believes that a change in the money supply will have short-run effects on output and
employment that will get reversed by the economy’s automatic adjustment mechanism. The
only long-run effect of the change will be a change in the price level. Thus the Bank
chooses the price level as the policy variable because it believes that it is the only variable
on which it has a long-run effect.
b) Yes, almost certainly. If money were not neutral in the long run, then changes in the
supply of money would have long-run effects on real variables such as output,
employment, investment, or the unemployment rate. In this case, the Bank would probably
choose one (or more) of these variables as a long-run policy target. For example, if
monetary policy had a long-run effect on the level of potential GDP, the Bank would
probably design its policy to keep Y* on some desirable path — such as having Y* grow by
3 percent per year. Of course, it would not be straightforward to determine precisely what
such a desirable path should be, but the Bank could have a target of this type.
Question 6
The interest rate is determined by the demand for and the supply of money. For a given MD
curve, it follows that the equilibrium interest rate must lie along the MD curve. If the Bank
wants to set a target for the money supply, it must accept the resulting interest rate.
Conversely, if the Bank wants to set a target for the interest rate, it must provide the money
supply necessary to make that target interest rate the equilibrium. But two independent
targets — like points A or B in the figure — are not feasible.
b) The increase in money demand leads to a rightward shift in the MD curve, to MD1 in the
figure above. At the initial interest rate, there is now an excess demand for money. Firms
and households try to sell bonds to satisfy their demand for cash, and this reduces bond
prices and increases the interest rate. Interest rates rise to i1, at which point firms and
households are only prepared to hold the available (unchanged) amount of money. The rise
in interest rates leads to a reduction in desired investment spending.
c) See the box on “contractionary” monetary policy in this chapter. Even though the money
supply has not fallen, it has fallen relative to the demand for money. And the effect of this
change is to raise interest rates and reduce desired investment (and thus, through the
multiplier, to reduce real GDP). Thus we think of monetary policy as being contractionary
if supply falls relative to demand. In the face of this MD shift, a neutral monetary policy
would require an increase in money supply so as to keep the interest rate unchanged