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CHAPTER 15
MONETARY THEORY AND POLICY
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
This chapter first introduces the indirect channel of money influence on economic activity, concentrating on
the relationship between money and the rate of interest. It then turns to the direct channel, addressing the
effects of changes in the money supply on the kinds of assets people choose to hold. In the direct channel, the
money supply affects not only the interest rate but also the price level and the demand for homes, cars, and
other real assets.
LEARNING OUTCOMES
15-1 Explain how the demand and supply of money determine the market interest rate.
The opportunity cost of holding money is the higher interest forgone by not holding other financial assets
instead. Along a given money demand curve, the quantity of money demanded relates inversely to the
interest rate. The demand for money curve shifts rightward as a result of an increase in the price level, an
increase in real GDP, or an increase in both.
15-2 Outline the steps between an increase in the money supply and an increase in equilibrium output.
The Fed determines the supply of money, which is assumed to be independent of the interest rate. The
intersection of the supply and demand curves for money determines the market interest rate. In the short
run, an increase in the supply of money reduces the interest rate, which increases investment. This boosts
aggregate demand, which increases real output and the price level.
15-3 Describe the relevance of velocity's stability on monetary policy.
The long-run approach focuses on the role of money through the equation of exchange, which states that
the quantity of money, M, multiplied by velocity, V, the average number of times each dollar gets spent
on final goods and services, equals the price level, P, multiplied by real output, Y. So M × V = P × Y.
Because the aggregate supply curve in the long run is a vertical line at the economy’s potential output, a
change in the money supply affects the price level in the long run but not real output.
15-4 Summarize the specific policies the Fed pursued during and after the Great Recession.
Between World War II and October 1979, the Fed tried to maintain stable interest rates as a way of promoting a stable investment environment. During the 1980s and early 1990s, the Fed paid more attention
to growth in money aggregates, first M1 and then M2. But the velocity of M1 and M2 became so unstable that the Fed shifted focus back to interest rates, particularly the federal funds rate. To pursue its mandated goals of price stability and maximum employment, the Fed uses open-market operations to adjust
the federal funds rate, raising the rate to prevent higher inflation and lowering the rate to stimulate employment.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 16
Monetary Theory and Policy
220
As a result of the financial crisis of September 2008, the Fed broadened its scope of action to include
offering interest on bank reserves at the Fed, bailing out a huge financial institution, increasing discount
loans to banks, investing more than $1 trillion in mortgage-backed securities to keep mortgage rates low,
helping financial regulators perform stress tests on the nation’s largest banks, introducing measures to
help reduce the probability that a giant financial institution will fail, and reducing the impact of such a
failure should one occur. The Fed’s actions during the crisis suggest that it would try to do whatever was
required to ensure the survival of the banking system and the economy.
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDES 2-5 FOR THE FOLLOWING SECTION
The Demand and Supply of Money
The distinction between the stock of money and the flow of income
The Demand for Money: Relationship between the interest rate and how much money people want to hold.
 People demand money to pay for purchases.
 The more active the economy, the more money demanded.
 The higher the economy’s price level, the more money demanded.
Money Demand and Interest Rates: The quantity of money demanded varies inversely with the market
interest rate; the opportunity cost of holding money.
USE POWERPOINT SLIDES 6-9 FOR THE FOLLOWING SECTION
The Supply of Money and the Equilibrium Interest Rate
 A vertical supply curve implies that the quantity of money supplied is independent of the interest rate.
 The equilibrium interest rate is determined by the intersection of the supply of money and the demand for
money.
 An increase (decrease) in the money supply decreases (increases) the market interest rate
USE POWERPOINT SLIDES 10-13 FOR THE FOLLOWING SECTION
Money and Aggregate Demand in the Short Run: In the short run, money affects the economy
through changes in the interest rate.
Changes in the supply of money affect the market rate of interest, which affects investment, a component of
aggregate demand.
Interest Rates and Planned Investment
 Effect of an increase in the money supply, M
M  i  I  AD Y
– The Fed increases the money supply, M, by buying U.S. government bonds in the open market.
– Interest rate, i, falls.
– Investment spending, I, is stimulated.
– Aggregate demand, AD, increases.
– Real GDP, Y, increases.
 Changes in the money supply affect investment if:
– The interest rate is sensitive to changes in the money supply and
– Investment spending is sensitive to changes in the interest rate.
 Size of the spending multiplier: Determines the extent to which a given change in investment affects total
spending.
USE POWERPOINT SLIDES 14-16 FOR THE FOLLOWING SECTION
Adding Short-Run Aggregate Supply: For a given shift of the aggregate demand curve, the steeper the shortrun aggregate supply curve:
 The smaller the increase in real GDP
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Chapter 16
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221
 The larger the increase in the price level
USE POWERPOINT SLIDES 17-19 FOR THE FOLLOWING SECTION
Money and Aggregate Demand in the Long Run: An increase in the supply of money increases
aggregate demand which leads to a higher price level since the economy’s potential output is fixed in the long
run.
The Equation of Exchange: M  V = P  Y – Total spending always equals total receipts
 M: Quantity of money in the economy.
 V: Velocity of money, the average number of times per year each dollar is used to purchase GDP.
V=PY/M
 P: The average price level.
 Y: Real output, real GDP.
The Quantity Theory of Money: If the velocity of money is stable or at least predictable, then the equation of
exchange can be used to predict the effects of changes in the money supply on nominal GDP.
 The quantity theory of money. M  V = P  Y predicts:
– An increase in the money supply results in more spending and a higher nominal GDP (PY).
– An increase in the money supply over the long run (assuming the economy is at potential output) results
only in higher prices.
USE POWERPOINT SLIDES 20-23 FOR THE FOLLOWING SECTION
What Determines the Velocity of Money?
 The customs and conventions of commerce
 Commercial innovations that (ATMs, debit cards) have facilitated exchange
 Frequency with which workers are paid
 Stability of money as a store of value (periods of high inflation results in money being a poor store of
value)
How Stable Is Velocity? Since 1980 the velocity of M1 has been variable and by the early 1990s the velocity
of M2 had grown more volatile. In 1993 the Fed announced money aggregates, including M2, would no
longer be considered reliable guides for monetary policy in the short run. Since 1993, the equation of
exchange has been considered a rough guide linking changes in the money supply to inflation in the long run.
USE POWERPOINT SLIDES 23-29 FOR THE FOLLOWING SECTION
Targets for Monetary Policy
 In the short run, monetary policy affects the economy by influencing interest rates.
 In the long run, changes in the money supply affect the price level.
Contrasting Policies:
 Targeting interest rates, the money supply must increase during economic expansions and decrease during
contractions.
 In targeting the money supply, the interest rate will likely fluctuate, causing undesirable fluctuations in
investment which may add instability to the economy.
Targets Before 1982: The Fed attempted to stabilize interest rates until 1979.
 1979, Paul Volcker targeted growth in the money supply:
– Interest rates fluctuated
– Sharp reduction in money growth caused the recession of 1982
– Inflation declined
– Unemployment rose to 10 %
– October 1982, Volcker announced the Fed will again pay some attention to interest rates.
Targets After 1982:
 In 1987, Greenspan said there wasn’t a close enough link between the money supply and nominal income
to focus single-mindedly on the money supply.
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in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 16
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222
 In 1993, the Fed dropped all targeting of monetary aggregates and focused on the federal funds rate.
 In 1998, the Fed began to track a variety of indicators of inflationary pressure.
Other Fed Actions and Concerns
During 2007-2009 recession:
 Investment in AIG
 Investment of more than $1 trillion in mortgage-backed securities to keep mortgage rates low
 Worked with U.S. Treasury and regulators to stabilize banks and thaw frozen credit lines
 Helped to conduct stress test of the 19 largest banks
Examples of Fed trying to do whatever it takes to keep financial markets from freezing up.
USE POWERPOINT SLIDE 30 FOR THE FOLLOWING SECTION
International Considerations: As national economies grow more interdependent, the Fed has become more
sensitive to the global implications of its action: what happens in the U.S. often affects markets overseas and
vice versa.
CHAPTER SUMMARY
The opportunity cost of holding money is the higher interest forgone by not holding other financial assets
instead. Along a given money demand curve, the quantity of money demanded relates inversely to the interest
rate. The demand for money curve shifts rightward as a result of an increase in the price level and increase in
real GDP, or an increase in both.
The Fed determines the supply of money, which is assumed to be independent of the interest rate. The
intersection of the supply and demand curves for money determines the market interest rate. In the short run,
an increase in the supply of money reduces the interest rate, which increases investment. This boosts aggregate
demand, which increases real output and the price level.
The long-run approach focuses on the role of money through the equation of exchange, which states that the
quantity of money, M, multiplied by velocity, V—the average number of times each dollar gets spent on final
goods and services—equals the price level, P, multiplied by real output, Y. So M  V = P  Y. Because the
aggregate supply curve in the long run is a vertical line at the economy’s potential output, a change in the
money supply affects the price level but not real output.
Between World War II and October 1979, the Fed tried to maintain stable interest rates as a way of promoting
a stable investment environment. During the 1980s and early 1990s, the Fed paid more attention to growth in
money aggregates, first M1 and then M2. But the velocity of M1 and M2 became so unstable that the Fed
shifted focus back to interest rates, particularly the federal funds rate. To pursue its main goals of price
stability and sustainable economic growth, the Fed adjusts the federal funds rate, raising the rate to prevent
higher inflation and lowering the rate to stimulate economic growth.
As a result of the financial crisis of September 2008, the Fed broadened its scope of action to include offering
interest on bank reserves at the Fed, bailing out a huge financial institution, lending more than $100 billion in
discount loans to banks, investing more than $1 trillion in mortgage-backed securities to keep mortgage rates
low, and helping financial regulators perform stress tests on the nation's largest banks. The Fed's actions
during the crisis suggest that it would do whatever was required to ensure the survival of the banking system
and the economy.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 16
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223
TEACHING POINTS
1. The text makes the distinction between monetary theory and monetary policy; the former is the study
of the effect of money on the economy; the latter is the Fed’s role in supplying money to the economy.
2. Early in your discussion you should distinguish between income (a flow) and money (a stock). Most
students will not clearly see the difference because income is measured in dollars and money is used as
the medium of exchange.
3. The next problem in teaching this material is presenting the concept of the demand for money. It is
imperative that students begin to think of money demand as the demand for liquidity (i.e., the demand for
this liquid, relatively low-yielding, and lowrisk asset called money). Thus, the demand for money is directly related to both its medium-of-exchange and store-of-wealth functions.
4. The demand for money will shift whenever there are increases in (a) the price level, (b) wealth, or (c)
income.
5. Exhibits 2 and 3 in this chapter show the basic first steps of the effects of an increase in the money
supply on interest rates, investment, aggregate expenditure, and aggregate demand.
SOLUTIONS TO PROBLEMS APPENDIX
1.
(Money Demand) Suppose that you never carry cash. Your paycheck of $1,000 per month is
deposited directly into your checking account, and you spend your money at a constant rate so that
at the end of each month your checking account balance is zero.
a. What is your average money balance during the pay period?
b. How would each of the following changes affect your average monthly balance?
i. You are paid $500 twice monthly rather than $1,000 each month.
ii. You are uncertain about your total spending each month.
iii. You spend a lot in the beginning of the month (e.g., for rent) and little at the end of the
month.
iv. Your monthly income increases.
a. Your average balance is $500.
b.i. Your money demand would fall because your average balance would decrease to $250.
ii.Your money demand would increase because you would be less likely to let your balance fall to
zero.
iii. Your money demand would decrease because your average balance would decrease.
iv. Your money demand would increase.
2.
(Market Interest Rate) With a diagram, show how the supply of money and the demand for money
determine the rate of interest? Explain the shapes of the supply curve and the demand curve.
The money demand curve, Dm , slopes downward. As the interest rate falls, other things constant, so does the opportunity cost of holding money; the quantity of money demanded increases.
Because the supply of money is determined by the Federal Reserve, it can be represented by
a vertical line. At point a, the intersection of supply of money, Sm , and the demand for money,
Dm , determines the market interest rate, i. Following an increase in the money supply to S′m,
the quantity of money supplied exceeds the quantity demanded at the original interest rate, i.
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People attempt to exchange money for bonds or other financial assets. In doing so, they push
down the interest rate to i′, where quantity demanded equals the new quantity supplied. This new
equilibrium occurs at point b.
3.
(Money and Aggregate Demand) Would each of the following increase, decrease, or have no impact
on the ability of open-market operations to affect aggregate demand? Explain your answer.
a. Investment demand becomes less sensitive to changes in the interest rate.
b. The marginal propensity to consume rises.
c. The money multiplier rises.
d. Banks decide to hold additional excess reserves.
e. The demand for money becomes more sensitive to changes in the interest rate.
a. Decrease: Investment demand changes by smaller amounts, leading to smaller changes in
aggregate demand.
b. Increase: The spending multiplier rises, so a change in investment generates a greater change
in aggregate demand.
c. Increase: Open-market operations lead to greater changes in the money supply, leading to
greater changes in interest rates, investment, and aggregate demand.
d. Decrease: When the money multiplier falls, open-market operations lead to smaller changes in
the money supply and, therefore, smaller changes in interest rates, investment, and aggregate
demand.
e. Decrease: A smaller change in interest rates is required to return the money market to
equilibrium because the quantity of money demanded adjusts more quickly. Therefore, there
are smaller changes in investment and aggregate demand.
4.
(Monetary Policy and Aggregate Supply) Assume that the economy is initially in long-run
equilibrium. Using an AD-AS diagram, illustrate and explain the short-run and long-run impacts of
an increase in the money supply.
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Chapter 16
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The economy is initially in equilibrium at point a. Increasing the money supply shifts the aggregate
demand curve from AD to AD'. The economy moves along the SRAS curve to a new short-run
equilibrium at point b. Both the price level and the level of real GDP rise in the short run. However,
unemployment has fallen below the natural rate of unemployment, and the price level is higher than
the level anticipated when wage contracts were negotiated. Therefore, as wages are renegotiated in
the long run, they rise. The economy slides upward along AD' as higher wage rates cause short-run
aggregate supply to shift upward to the left. The process continues until the actual price level again
equals the expected price level. This occurs at point c, where AD' and SRAS' intersect at potential
output. The final result is a higher price level with no change in real GDP.
5.
(Monetary Policy and an Expansionary Gap) Suppose the Fed wishes to use monetary policy to
close an expansionary gap.
a. Should the Fed increase or decrease the money supply?
b. If the Fed uses open-market operations, should it buy or sell government securities?
c. Determine whether each of the following increases, decreases, or remains unchanged in the
short run: the market interest rate, the quantity of money demanded, investment spending,
aggregate demand, potential output, the price level, and equilibrium real GDP.
a. It should decrease the money supply.
b. It should sell securities.
c. The interest rate increases, the quantity of money demanded decreases, investment decreases,
aggregate demand decreases, potential output does not change, price level decreases, and
equilibrium real GDP deceases.
6.
(Equation of Exchange) Calculate the velocity of money if real GDP is 3,000 units, the average
price level is $4 per unit, and the quantity of money in the economy is $1,500. What happens to
velocity if the average price level drops to $3 per unit? What happens to velocity if the average
price level remains at $4 per unit but the money supply rises to $2,000? What happens to velocity if
the average price level falls to $2 per unit, the money supply is $2,000, and real GDP is 4,000 units?
The velocity of money is the average number of times each dollar is turned over to purchase final
goods and services. Using the equation of exchange (M  V = P  Y), the figures are 8, 6, 6, and 4,
respectively.
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in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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226
(Quantity Theory of Money) What basic assumption about the velocity of money transforms the
equation of exchange into the quantity theory of money? Also:
a. According to the quantity theory, what will happen to nominal GDP if the money supply
increases by 5 percent and velocity does not change?
b. What will happen to nominal GDP if, instead, the money supply decreases by 8 percent and
velocity does not change?
c. What will happen to nominal GDP if, instead, the money supply increases by 5 percent and
velocity decreases by 5 percent?
d. What happens to the price level in the short run in each of these three situations?
The quantity theory of money assumes that velocity is relatively stable and that any changes are
predictable.
a. Nominal GDP rises by 5 percent.
b. Nominal GDP falls by 8 percent.
c. The changes in the money supply and velocity offset each other, so nominal GDP does not
change.
d. In parts (a) and (b), the change in nominal GDP is divided between price level changes and
real GDP changes. The flatter the SRAS curve, the smaller the price change; the steeper the
SRAS curve, the larger the price change. In (a), the price level rises; in (b), the price level
falls; in part (c), there is no change in the price level.
8.
(Great Recession) How did the Fed try to bring the economy back during and after the Great
Recession? What specific policies did it pursue?
Between World War II and October 1979, the Fed tried to maintain stable interest rates as a way
of promoting a stable investment environment. During the 1980s and early 1990s, the Fed paid
more attention to growth in money aggregates, first M1 and then M2. But the velocity of M1 and
M2 became so unstable that the Fed shifted focus back to interest rates, particularly the federal
funds rate. To pursue its mandated goals of price stability and maximum employment, the Fed
uses open-market operations to adjust the federal funds rate, raising the rate to prevent higher
inflation and lowering the rate to stimulate employment.
As a result of the financial crisis of September 2008, the Fed broadened its scope of action to include offering interest on bank reserves at the Fed, bailing out a huge financial institution, increasing discount loans to banks, investing more than $1 trillion in mortgage-backed securities to keep mortgage rates low, helping financial regulators perform stress tests on the nation’s largest banks, introducing measures to help reduce the probability that a giant financial
institution will fail, and reducing the impact of such a failure should one occur. The Fed’s actions during the crisis suggest that it would try to do whatever was required to ensure the survival of the banking system and the economy.
9.
(Money Supply Versus Interest Rate Targets) Assume that the economy’s real GDP is growing.
a. What will happen to money demand over time?
b. If the Fed leaves the money supply unchanged, what will happen to the interest rate over time?
c. If the Fed changes the money supply to match the change in money demand, what will happen
to the interest rate over time?
d. What would be the effect of the policy described in part (c) on the economy’s stability over the
business cycle?
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 16
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227
a. Money demand will increase.
b. If the money supply remains unchanged, the interest rate will also increase.
c. If the Fed increases the money supply at the same rate as money demand is rising, the interest
rate will not change.
d. Following the policy described in part (c) requires the Fed to increase the money supply during
expansions and decrease it during contractions. Thus, during expansions, the Fed is reinforcing
the increasing aggregate demand; during contractions it is reinforcing the decreasing
aggregate demand. Both expansions and contractions would tend to be stronger, thus adding
more instability to the economy
10.
(Quantitative Easing) What’s the difference between ordinary open market purchases and quantitative easing?
Ordinary open market purchases is Fed purchases of government securities to increase the money supply and to reduce interest rates. Quantitative easing is Fed purchases of long-term assets
to stabilize financial markets, reduce long-term interest rates, and improve the investment environment.
11.
(Quantitative easing) Because of quantitative easing, the Fed purchased more than two trillion
dollars of financial assets. Why did the Fed do this? How are these purchases reflected on the
Fed’s balance sheet? And why hasn’t this increased the rate of inflation, at least not as of December 2013?
The Fed typically changes the federal funds rate by buying or selling short-term government
securities. But with interest rates already at rock bottom by late 2008, the Fed was looking for
other ways to help the economy. The Fed’s answer was to buy long-term assets, such as government bonds and mortgage-backed securities. Doing so did not reduce short-term rates,
which could not go lower, but it did bring down long-term rates, making investments more attractive. Purchasing mortgage-backed securities supported the mortgage and housing markets
and helped stabilize financial markets more generally. This known as quantitative easing
which, more formally, is Fed purchases of long-term assets to stabilize financial markets, reduce long-term interest rates, and improve the investment environment.
This has not increased inflation because velocity and aggregate demand is still so weak.
Experiential Assignments
1. A favorite activity of many macroeconomists is Fed watching. Send students to the Federal Reserve
Board’s Web site to look for the most recent Congressional testimony of Janet Yellen, the new
head of the Fed at http://www.federalreserve.gov/newsevents/testimony/2014testimony.htm . Is the Fed
targeting interest rates, the money supply, or something else?
2. The Federal Reserve Bank of Cleveland’s monthly publication Economic Trends is available online at
http://www.clevelandfed.org/Research/index.cfm . Have students choose the current issue and
find “US Economy” or “Monetary Policy.” What are some current developments in monetary policy?
Ask students to try to illustrate them using the AD–AS model.
3. The Federal Reserve Report appears in each Friday’s Wall Street Journal in the Money and Investing
section. In addition to the weekly report, a monthly chart shows the recent performance of money supply
indicators, compared with Fed targets. Have students find these items and determine if the Fed seemed to
have been hitting its targets over the last year. 4. Send students to the Money and Investing section of the
Wall Street Journal to find the current federal funds rate. How has it changed over the past year?
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.