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The Federal Reserve has a dual mandate to:
Maintain stable prices (fight inflation/deflation)
Maintain full employment (monetary policy to
manage macroeconomic conditions)
The Fed manages
Inter-bank Interest Rates and
Regulates Banks…but does it control
money supply?
Created:
Jan 2008
by Jim Luke.
Monetary Policy
"Inflation is always and everywhere a monetary phenomenon in the sense that
it is and can be produced only by a more rapid increase in the quantity of
money than in output... A steady rate of monetary growth at a moderate
level can provide a framework under which a country can have little
inflation and much growth. It will not produce perfect stability; it will not
produce heaven on earth; but it can make an important contribution to a
stable economic society."
--Milton Friedman
The Bank [of Canada] gave it a college try, it really did. It just doesn't work that
way.
--John Crow, former governor of the Bank of Canada,
on implementing Friedman's theories;
Created:
Jan 2008
by Jim Luke.
What Is Monetary Policy?
Central bank (as representative of government)
manipulation of the
• money supply,
• interest rates
• credit conditions
with an objective of achieving macroeconomic
goals.
Monetarist Theory History –
The Classical School Strikes Back at Keynesianism
Three Theories of Monetary Policy
Strict Monetarist
Neo-classical/New Keynesian
Modern Monetary Theory (MMT)
Equation of Exchange
MxV=PxY
 M: money supply
 V: Velocity
 (how fast money is spent)
 P: Price Level
 Y: Real Income
 Note: sometimes shown as
M*V=P*Q
same concept, different notation
Identity: Must be true for any period of time
Created:
Jan 2008
by Jim Luke.
Both Monetarist and Neo-Classical/New Keynesian
Theories:
Trade-off between unemployment and inflation exists
Controlling Inflation is higher priority
5/14/2017
Money supply concept: (Classical or Milton Friedman
Monetarist version)
Money supply is ‘exogenous’
more bank reserves —>
more lending by banks –>
increased money supply –>
lower interest rates –>
borrowing by consumers/firms –>
more C and I spending –>
faster GDP growth & inflation
Interest rates concept: (Neoclassical version)
central bank open market purchases of bonds –>
higher bond prices = lower interest rates –>
more borrowing by consumers/firms –>
more spending on C and I –>
faster GDP growth –>
But, the Equation of Exchange
MxV=PxY
• M: money supply
• V: Velocity (how fast money is spent)
• P: Price Level
• Y: Real Income
 Note: sometimes shown as M V = P Q
• same concept, different notation
 Equation of Exchanges is an Identity:

Must be true for any period of time after the fact..
Quantity theory of money (QTM):
Based on equation of exchange with added
assumptions about the behavior of
variables.
• assume V is constant
 Conclusions:
• Money supply growth is solely
responsible for determining Inflation

‘Crowding Out’ Theory
Assumptions:
• Fixed amount of money in economy
• QTM holds true
Theory: Gov borrowing takes $ away/raises
interest rate for firm and household borrowers
–> will reduce C and I unless
Central Bank increases M to fund deficit
 inflation
Absolutely not supported by evidence or data in
modern real world.
Current Neoclassical and New Keynesian Views on monetary
policy
 Support for ad hoc policy (policy makers
should make it up as they go)
Modern Monetary Theory (MMT)
 Money growth (M1 – bank credit) is largely
endogenous
 Key is base money growth, not M1
 government deficits enable the private
sector (firms and households) to grow and
yet still accumulate net financial assets
MMT Foundation:
Fiat money system with floating exchange rates eliminates
government budget constraint
 Deficits effective in fighting unemployment
 no financing constraint on deficits
 deficits are limited by the availability of
real, unemployed resources for the
government to purchase
 Inflation threat is at/near full employment is
reached (AD- LRAS model)
5/14/2017
Limitations of Monetary Policy: ‘Pushing on string’

Central bank cannot force banks to make
loans
Limitations of Monetary Policy: Endogenous money supply

Banks, not central bank really determine
supply of money and credit
Limitations of Monetary Policy: Fiscal Policy Coordination
Fiscal and Monetary policy could work at
cross-purposes
 could expect ‘other’ to do it

Limitations of Monetary Policy: Liquidity trap
 At ‘zero lower bound’
 when interest rates approach zero but the
economy is still weak, monetary policy is
largely ineffective.
Limitations of Monetary Policy: Globalization

If interest rates too low or inflation too
high, then value of currency drops –>
capital inflow drops and M drops, even
though X rises