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CHAPTER 16
MONETARY THEORY AND POLICY
In this chapter, you will find:
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Answers to the End-of-Book Questions and Problems for Chapter 16
Supplemental Cases, Exercises, and Problems
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
1
Describe the relationship between the demand and supply of money
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.
2
Explain how changes in the money supply affect aggregate demand in the short run
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.
3
Explain how changes in the money supply affect aggregate demand in the long run
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.
4
Evaluate targets for monetary policy
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. 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.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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Chapter 16
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220
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
 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
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Chapter 16
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221
 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 24-30 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.
 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.
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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 31 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.
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Chapter 16
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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 income (a flow) and money (a stock). Most students will
not clearly see the difference because income is denominated 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 low-risk 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. The fact that a higher
price level increases money demand and therefore increased interest rates is the strongest reason for the
negative slope of the aggregate demand curve. You may wish to review the other reasons at this juncture.
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Chapter 16
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ANSWERS TO END-OF-BOOK QUESTIONS AND PROBLEMS
1.1 (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.
2.1 (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.
2.2 (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.
2.3 (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.
3.1
(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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3.2. (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.
4.1 (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?
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.
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Chapter 16
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SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS
Case Studies
These cases are available to students online at www.cengagebrain.com.
Targeting the Federal Funds Rate
At 2:15 p.m. on December 16, 2008, immediately following a regular meeting, the Federal Open Market
Committee (FOMC) announced that it would lower its target for the federal funds rate to between 0 and 0.25
percent, the tenth reduction in 15 months. In cutting the target rate, the FOMC stated that “The Federal
Reserve will employ all available tools to promote the resumption of sustainable economic growth and to
preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to
warrant exceptionally low levels of the federal funds rate for some time.” True to its words, the FOMC kept
the rate near zero for at least the next two years.
As you know by now, the federal funds rate is the interest rate banks charge one another for overnight
lending of reserves at the Fed. Because lowering the rate reduces the cost of covering any reserve shortfall,
banks are more willing to lend to the public. To execute this monetary policy, the FOMC authorized the New
York Fed to make open-market purchases to increase bank reserves until the federal funds rate fell to the target
level.
For four decades, the Fed has reflected its monetary policy in this interest rate. (For a few years, the Fed
targeted money aggregates, but more on that later.) There are many interest rates in the economy—for credit
cards, new cars, mortgages, home equity loans, personal loans, business loans, and more. Why focus on such
an obscure rate? First, by changing bank reserves through open-market operations, the Fed has a direct lever
on the federal funds rate, so the Fed’s grip on this rate is tighter than on any other market rate. Second, the
federal funds rate serves as a benchmark for determining other short-term interest rates in the economy. For
example, after the Fed announces a rate change, major banks around the country usually change by the same
amount their prime interest rate—the interest rate banks charge their best corporate customers. The federal
funds rate affects monetary and financial conditions, which in turn affect employment, aggregate output, and
the price level. The Fed uses the federal funds rate to pursue its primary goals of price stability and sustainable
economic growth.
A look at the federal funds rate since early 1996 provides a lesson in monetary policy. Between early 1996
and late 1998, the economy grew nicely with low inflation, so the FOMC stabilized the rate in a range of 5.25
percent to 5.5 percent. But in late 1998, a Russian default on its bonds and the near collapse of a U.S. financial
institution created economic havoc, prompting the FOMC to drop the target rate to 4.75 percent. By the
summer of 1999, those fears abated, and instead the FOMC became concerned that robust economic growth
would trigger higher inflation. In a series of steps, the federal funds target was raised from 4.75 percent to 6.5
percent. The FOMC announced at the time that the moves “should markedly diminish the risk of rising
inflation going forward.” Some critics argued that the Fed’s rate hikes contributed to the 2001 recession. In
2001, concerns about waning consumer confidence, weaker capital spending, and the 9/11 terrorist attacks
prompted the FOMC to reverse course. Between the beginning of 2001 and mid-2003, the FOMC cut the rate
from 6.5 percent to 1.0 percent, reflecting at the time the most concentrated monetary stimulus on record. The
rate remained at 1.0 percent for a year. Some economists criticized the Fed for keeping rates too low too long.
They charged that this “easy money” policy overstimulated the housing sector, encouraging some to buy
homes they really couldn’t afford. These home purchases, critics argued, inflated the bubble in housing prices
and sowed the seeds for mortgage defaults that hit years later.
Anyway, after leaving the rate at 1.0 percent for a year, the FOMC began worrying again about inflationary
pressure. Between June 2004 and June 2006, the target federal funds rate was increased from 1.0 percent to
5.25 percent in 17 steps. The FOMC then hit the pause button, leaving the rate at 5.25 percent for more than a
year. This takes us up to September 2007, when troubles in the housing sector, a rising mortgage default rate,
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Chapter 16
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and a softening economy prompted the first in a series of federal funds rate cuts. After 10 cuts over 15 months,
the target rate in December 2008 stood between 0 and 0.25 percent, the lowest in history.
Over the years, the Fed has tried to signal its intentions more clearly to financial markets—to become more
transparent. In 1995, the FOMC began announcing immediately after each meeting its target for the federal
funds rate. Since 2000, the post-meeting statement also included the probable “bias” of policy in the near
term—that is, whether or not its current level or direction of interest rate changes would continue. And in
2005, the FOMC began releasing the minutes three weeks after each meeting. By generating such concrete
news, FOMC meetings became widely followed media events.
If the situation is serious enough, the FOMC may act between regular meetings, and this has a more
dramatic impact, particularly on the stock market. The Fed held six unscheduled meetings in 2008. Still, in
announcing rate changes, the FOMC must be careful not to appear too troubled about the economy, because
those fears could harm business and consumer confidence further. Also, the FOMC must avoid overdoing rate
cuts. As one member of the Board of Governors warned, the FOMC must not cut the rate so much that it “ends
up adding to price pressure as the growth strengthens.” Thus, the FOMC performs a delicate balancing act in
pursuing its main goals of price stability and sustainable economic growth.
Sources: Sewell Chan, “Fed Study Suggests Rates Will Stay at Record Lows Until 2012,” New York Times, 14
June 2010; Michael Derby, “Most Primary Dealers Agree Fed Rate Increases Won’t Come Soon,” Wall Street
Journal, 3 June 2010; and “FOMC Statement on Interest Rates,” “Minutes of the Federal Open Market
Committee,” and “Federal Open Market Committee Transcripts” for various meetings. Find the latest FOMC
statements, minutes, and transcripts at http://www.federalreserve.gov/monetarypolicy/fomc.htm.
The Money Supply and Inflation Around the World
If we view economies around the world as evidence, what’s the link between inflation and changes in the
money supply in the long run? According to the quantity theory, as long as the velocity of money is fairly
stable, there should be a positive relation in the long run between the percentage change in the money supply
and the percentage change in the price level. Economists have plotted the relationship between the average
annual growth rate in M2 and the average annual inflation rate for 85 countries over a 10-year period. The
points fall rather neatly along the trend line, showing a positive relation between money growth and inflation.
Most countries are bunched below an inflation rate of 30 percent. Countries with higher rates of money growth
experience higher rates of inflation.
Argentina, Bolivia, and Israel—countries with inflation of more than 100 percent per year—also
experienced annual money growth exceeding 100 percent. Argentina, which had the highest inflation rate over
the 10-year period in the sample, at 395 percent per year, also had the highest average annual money growth, at
369 percent. Hyperinflation first appeared about a century ago, and in every case it has been accompanied by
rapid growth in the supply of money.
How does hyperinflation end? The central bank must somehow convince the public it is committed to
halting the rapid growth in the money supply. The most famous hyperinflation was in Germany between
August 1922 and November 1923, when inflation averaged 322 percent per month. Inflation was halted when
the German government created an independent central bank that issued a new currency convertible into gold.
Germany had a similar problem after World War II when currency became nearly useless because Allied
victors imposed strict price controls on the country. Experts estimate that the lack of a viable currency cut
German output in half. Germany’s “economic miracle” of 1948 was due largely to the adoption of a reliable
monetary system. Argentina, Bolivia, and Israel all managed to tame the beast of hyperinflation, with inflation
under 3 percent by 2000. Residents of all three countries, perhaps mindful of past hyperinflation, still hold lots
of U.S. dollars as a store of value.
The data discussed reflect averages from 1980 to 1990, but the relationship holds up if we focus on a more
recent decade. From 1992 to 2002, for example, inflation, while generally lower around the world than in the
1980s, was still highest in countries with the highest money growth rates. Brazil, Belarus, Romania, and
Russia experienced hyperinflation and also had extremely high rates of money growth. The highest was in
Brazil, where the inflation and the money supply each grew an average of about 210 percent per year during
the decade. In Venezuela, the money supply increased by 30 percent in 2009 and by July 2010 the annual rate
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Chapter 16
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of inflation was 33 percent, about the highest in the world at the time. As Nobel prize winner Milton Friedman
famously put it, “Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur
without a more rapid increase in the quantity of money than in output.”
Sources: World Development Report 2010 at http://econ.worldbank.org; Greg Ip, “Taking the Measure of the
World’s Cash Hoard,” Wall Street Journal, 3 November 2005; Gerald Dwyer and R. W. Hafer, “Are Money
Growth and Inflation Still Related?” Federal Reserve Bank of Atlanta Economic Review, (Second Quarter
1999): 32–43; “Economic and Financial Indicators,” The Economist, 17 July 2010.
Experiential Exercises
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 the Board Chairperson at
http://www.federalreserve.gov/newsevents/testimony/2011testimony.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?
5. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "Fed maintains status quo." On the
Results page, go to the News Section. Click on the link for the June 23, 2010, article "Fed Maintains Status
Quo." What does the article say about whether the Fed considers international economic conditions when
setting U.S. monetary policy?
After its June 2010 meeting, the Fed expressed concern about the negative effects of "developments
abroad." Investment strategist Alan Gayle said that "Typically the Fed emphasizes domestic factors." The
article stated that the Fed "made no explicit mention of China's revaluation of the Yuan, nor the budget
deficit crisis in the Eurozone."
6. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. Go to the menu at the top of the page and click on the tab for Browse Issues and Topics. Choose
Business and Economy. Click on the link for Central Banks. Find an article about the central bank of a
foreign country. Compare what you read in the article to what you learned about the Federal Reserve in the
chapter.
Student answers will vary, but may discuss interest rate policy, money supply, independence, and so on.
© 2012 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
230
Additional Questions and Problems
(From student Web site at www.cengagebrain.com)
1.
(Demand for Money) Determine whether each of the following would lead to an increase, a decrease, or
no change in the quantity of money people wish to hold. Also determine whether there is a shift of the
money demand curve or a movement along a given money demand curve.
a. A decrease in the price level
b. An increase in real output
c. An improvement in money’s ability to act as a store of value
d. An increase in the market interest rate
a.
b.
c.
d.
2.
Decrease; the money demand curve shifts to the left.
Increase; the money demand curve shifts to the right.
Increase; the money demand curve shifts to the right.
Decrease; there is a movement upward along a given money demand curve.
(Demand for Money) If money is so versatile and can buy anything, why don’t people demand all the
money they can get their hands on?
The demand for money is a relationship between the quantity of money demanded and the market
interest rate. Money is one form of storing wealth. The advantage of money is its liquidity: It can be
directly exchanged for goods and services. However, money either earns no interest or earns interest at
a lower rate than that available on alternative financial assets. Thus, there is an opportunity cost to
holding money—the difference between the interest rate on money and the interest rate on alternative
assets. As the market interest rate rises, the opportunity cost of holding money rises. People become
more willing to forgo the liquidity of money for the higher rates of return on other financial assets.
3.
(Monetary Policy) What is the impact of a decrease in the required reserve ratio on aggregate demand?
If the Fed decreases the required reserve ratio, aggregate demand will rise. First, lowering the required
reserve ratio increases the money supply. The higher money supply in turn creates an excess quantity
supplied at the initial interest rate so people attempt to exchange the excess money for other financial
assets. This causes the interest rate to fall until the quantity of money demanded increases to match the
higher supply. The lower interest rate increases investment. which shifts the aggregate expenditure line
upward and the aggregate demand curve rightward.
4.
(Equation of Exchange) Using the equation of exchange, show why fiscal policy alone cannot increase
nominal GDP if the velocity of money is constant.
The equation of exchange is M × V = P × Y. Fiscal policy does not change the money supply; rather, it
influences aggregate demand. Therefore, if V is stable, fiscal policy cannot change P × Y. Without a
change in M or V, P × Y cannot change.
5.
(Velocity) Why do some economists believe that higher expected inflation will lead to a rise in velocity?
Higher inflation means that money’s usefulness as a store of value declines, so people prefer to hold
other assets that better retain their value. Therefore, people choose to switch more of their wealth into
financial assets such as bonds whose interest rates rise with inflation or into real assets such as housing
whose prices rise with inflation. Holdings of money fall, so a smaller quantity of money is available to
purchase final goods and services, and each dollar must turn over more rapidly—hence, velocity rises.
© 2012 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
6.
231
(Velocity of Money) Determine whether each of the following would lead to an increase or a decrease in
the velocity of money:
a. Increasing the speed of funds transfers
b. Decreased use of credit cards
c. Decreasing the frequency that workers are paid
d. Increased customer use of ATM, or debit, cards at retailers
a.
b.
c.
d.
7.
Monetary Theory and Policy
Increase
Decrease
Decrease
Increase
(Quantity Theory of Money) The quantity theory states that the impact of money on nominal GDP can be
determined without details about the aggregate demand curve, so long as the velocity of money is
predictable. Discuss the reasoning behind this claim.
According to the quantity theory, if the velocity of money and the money supply are known, then nominal
GDP, or P × Y, is also known. Therefore, it is simply a matter of finding where P × Y equals M × V.
8.
(How Stable Is Velocity?) What factors have led to changes in the velocity of M1 and M2 over the past
three decades?
The velocity of M1and M2 has increased over the past three decades due to changes in inflation rates,
commercial innovations like ATMs and debit cards and institutional factors like the frequency with
which workers are paid. M2 has also been affected by the rise in money market funds with check writing
privileges.
9.
(Money Supply versus Interest Rate Targets) In recent years the Fed’s monetary target has been the
federal funds rate. How does the Fed raise or lower that rate, and how is that rate related to other interest
rates in the economy, such as the prime rate?
The federal funds rate is the rate that banks charge one another for overnight loans. To raise the federal
funds rate, the Fed can announce that it is planning to decrease the money supply enough to push up the
federal funds rate from its present target rate to a higher target rate. When the Fed announces that it is
raising the federal funds rate, major banks raise their prime interest rate, the rate they charge their best
customers.
10.
How did the Fed respond to the financial crisis of 2008? What unusual actions did the Fed undertake to
calm troubled financial markets and stabilize banks?
The Fed's primary policy response was to conduct open-market purchases that caused the federal funds
rate to near zero. Among its unusual policy responses, the Fed began offering interest on bank reserves
at the Fed, bailed out AIG, lent more than $100 billion in discount loans to banks, invested more than $1
trillion in mortgage-backed securities to keep mortgage rates low, and helped financial regulators
perform stress tests on the nation's largest banks. The Fed's was willing do whatever was required to
ensure the survival of the banking system and the economy.
© 2012 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
232
ANSWERS TO ONLINE CASE STUDIES
1.
(CaseStudy: Targeting the Federal Funds Rate) Why has the Federal Reserve chosen to focus on the
federal funds rate rather than some other interest rate as a tool of monetary policy?
By changing bank reserves through open-market operations, the Fed has better control of this rate than
other rates. Also, the rate serves a benchmark for other short-term rates.
2.
(CaseStudy: The Money Supply and Inflation Around the World) What is the relationship between the
rate of money supply growth and the inflation rate? How does this explain the hyperinflation experienced
in some economies?
High inflation is associated with high rates of money growth, and low inflation is associated with low
rates of money growth. Every case of hyperinflation has been preceded by extremely high growth rates
for the supply of money.
© 2012 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.