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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