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Macro Chapter 14
Modern Macroeconomics and
Monetary Policy
3 Learning Goals
1) Analyze the impact monetary policy has
on the economy
2) Investigate the claim that a rapid
increase in the money supply leads to
inflation
3) Confirm the ideas presented in the
chapter with data from various countries
Daniel Thornton & David Wheelock:
“The conventional wisdom once held that
money doesn’t matter. Now there is wide
agreement that monetary policy can
significantly affect real economic activity in
the short run, though only price level in the
long run.”
Main points of the chapter:
1) Unanticipated changes in the money
supply can change AD
2) Anticipated changes and long run
changes do NOT change AD; only prices
are affected
3) A more rapid increase in the quantity of
money than in the quantity of goods and
services available for purchase will
produce inflation, raising prices in terms of
that money
The Impact of Monetary
Policy on Output and
Inflation
Review Questions:
(1) What is the primary way the Fed
increases the money supply?
(2) What is the primary way the Fed
decreases the money supply?
(3) Draw the loanable funds market. Show
what happens when the Fed increases the
money supply.
When the Fed increases the money
supply
Interest rates fall
Consumption and Investment increase
The dollar will depreciate, causing
Exports to rise, imports to fall, and net
exports to rise
When the Fed decreases the
money supply
Interest rates rise
Consumption and Investment decrease
The dollar will appreciate, causing
Exports to fall, imports to rise, and net
exports to fall
Unanticipated changes in the
money supply:
Refer back to Chapter 10 regarding the
details of what happens when AD
increases and decreases
The same “story” is told, the only
difference now is the variable that
changed AD
What if AD surprisingly increases?
(1) Firms will increase production (move along
SRAS)
– Actual output > potential output
– Actual unemployment < natural rate
(2) Resources prices will begin to rise
(3) Interest rates will rise as demand for
loanable funds increases
(4) Foreigners will purchase more US assets;
the dollar will appreciate
(5) SRAS will begin to fall (shift left) and
consumers will buy less (move along AD)
(6) The economy will return to long run
equilibrium
What if AD surprisingly decreases?
(1) Firms will decrease production (move along
SRAS)
– Actual output < potential output
– Actual unemployment > natural rate
(2) Resources prices will begin to fall
(3) Interest rates will fall as demand for loanable
funds decreases
(4) Foreigners will purchase fewer US assets;
the dollar will depreciate
(5) SRAS will begin to rise (shift right) and
consumers will buy more (move along AD)
(6) The economy will return to long run
equilibrium
Q14.1 If the Federal Reserve increases its
bond purchases, the short-run effects will be
1. an increase in the money supply and lower real
interest rates.
2. a decrease in the money supply and lower real
interest rates.
3. an increase in the money supply and higher real
interest rates.
4. a decrease in the money supply and higher real
interest rates.
Q14.2 If the Federal Reserve wanted to expand the
money supply in order to increase output, it should
1. sell government bonds, which will increase the money
supply; this will cause interest rates to fall and aggregate
demand to rise.
2. buy government bonds, which will increase the money
supply; this will cause interest rates to fall and aggregate
demand to rise.
3. increase the discount rate, which will raise the market
rate of interest; this will cause both costs and prices to
rise.
4. decrease taxes, which will reduce costs and cause
prices to fall.
Monetary Policy in the
Long Run
Milton Friedman:
“Inflation is always and everywhere a
monetary phenomenon”
“Inflation occurs when the quantity of
money rises appreciably more rapidly than
output, and the more rapid the rise in the
quantity of money per unit of output, the
greater the rate of inflation.”
If your income doubled and the
price level doubled, would anything
really change?
The Quantity Theory of Money is used to
support the hypothesis that a rapid
increase in the money supply causes
inflation
Equation of exchange: M V = P Y
M = money supply
V = velocity, how quickly $1 passes
through the economy
P = price level
Y = GDP = output
M V = Total spending
P Y = Total receipts
Implications:
In the short run, Y and V are assumed to
be constant (or change slowly)
Therefore an increase in M causes an
increase in P
The long run effects:
↑M → ↑AD → ↑resource prices → ↓SRAS
Then
↑M → ↑AD → ↑resource prices → ↓SRAS
Then
↑M → ↑AD → ↑resource prices → ↓SRAS
Then …
Q14.3 Suppose the economy is in long-run
equilibrium at the level of potential output. What
will be the long-run effect of an expansionary
monetary policy?
1. a higher price level
2. a higher level of real output
3. both a higher price level and a higher level of
real output
4. a lower price level
5. a lower level of real output
Do the theories hold up in the real world?
Watch video: Free to Choose-inflation
Q14.4 In the long-run, the primary effect of
rapid monetary growth is
1.
2.
3.
4.
lower nominal interest rates.
reduced unemployment.
inflation.
an increase in real output.
Question Answers
14.1 = 1
14.2 = 2
14.3 = 1
14.4 = 3