Download Economics for Today 2nd edition Irvin B. Tucker

Chapter 26
Monetary Policy
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1
In this chapter, you will
learn to solve these
economic puzzles:
Why would
a
Nobel
Laureate
What
is
a
monetary
Why do people
wish
to
economist
suggest
replacing
policy
transmission
money
balances?
thehold
Federal
Reserve
with
an
mechanism?
intelligent horse?
2
What are the Three Schools
of Economic Thought?
• Classical
• Keynesian
• Monetarist
3
What is the Keynesian
View of Money?
People who hold cash or
checking account balances
incur an opportunity cost in
foregone interest or profits
4
According to Keynes,
why would people
hold money?
• Transactions demand
• Precautionary demand
• Speculative demand
5
What is the Transactions
Demand for Money?
The stock of money people
hold to pay everyday
predictable expenses
6
What is the Precautionary
Demand for Money?
The stock of money
people hold to pay
unpredictable expenses
7
What is the Speculative
Demand for Money?
The stock of money people
hold to take advantage of
expected future changes
in the price of bonds,
stocks, or other
nonmoney financial assets
8
How does a change in
Interest Rates affect
Speculative Demand?
As the interest rate falls,
the opportunity cost of
holding money falls, and
people increase their
speculative balances
9
What is the Demand for
Money Curve?
A curve representing the
quantity of money that
people hold at different
possible interest rates,
ceteris paribus
10
How do Interest
Rates affect the
Demand for Money?
There is an inverse
relationship between
the quantity of money
demanded and the
interest rate
11
What gives the
Demand for Money a
Downward Slope?
The speculative
demand for money at
possible interest rates
12
What determines Interest
Rates in the Market?
The demand and supply
of money in the
loanable funds market
13
The Demand for Money Curve
12%
8%
Interest Rate
16%
A
B
4%
Billions of dollars
500
MD
1,000 1,500 2,000
14
Increase in the
quantity of money
demanded
Decrease in the
interest rate
15
The Equilibrium Interest Rate
12%
8%
MS
Interest Rate
16%
E
4%
Surplus
Shortage
MD
Billions of dollars
500 1,000 1,500 2,000
16
Bond prices fall
and the interest
rate rises
People sell
bonds
Excess
money
demand
17
Bond prices rise
and the interest
rate falls
People buy
bonds
Excess
money
supply
18
Why do Bond Prices Fall
as Interest Rates Rise?
Bond sellers have to offer
higher returns (lower
price) to attract potential
bond buyers, or else they
will go elsewhere to get
higher interest returns
19
Why do Bond Prices Rise
as Interest Rates Fall?
Bond sellers are put in a better
bargaining position as interest
rates fall (higher price);
potential buyers cannot go
elsewhere to get higher
interest returns so easily
20
How can the Fed
influence the Equilibrium
Interest Rate?
It can increase or decrease
the supply of money
21
16%
12%
8%
Interest Rate
Increase in the Money Supply
MS1 MS2 Surplus
E1
E2
MD
4%
Billions of dollars
500 1,000 1,500 2,000
22
16%
12%
8%
Interest Rate
Decrease in the Money Supply
MS2 MS1
Shortage
E2
E1
MD
4%
Billions of dollars
500 1,000 1,500 2,000
23
Decrease the
interest rate
Money
surplus and
people buy
bonds
Increase in
the money
supply
24
Increase in the
interest rate
Money shortage and
people sell bonds
Decrease in
the money
supply
25
In the Keynesian Model,
what do changes in the
Money Supply affect?
Interest rates, which in
turn affect investment
spending, aggregate
demand, and real GDP,
employment, and prices
26
Change in
the money
supply
Keynesian
Change in
prices, real GDP,
Policy
& employment
Change in
the aggregate
demand curve
Change in
interest
rates
Change in
investment
27
16%
12%
8%
Interest Rate
Expansionary Monetary Policy
MS1 MS2 Surplus
E1
E2
MD
4%
Billions of dollars
500 1,000 1,500 2,000
28
16%
12%
8%
Interest Rate
Investment Demand Curve
A
B
I
4%
Billions of dollars
1,000 1,500
29
When will Businesses
make an Investment?
When the investment
projects for which the
expected rate of profit
equals or exceeds the
interest rate
30
155
150
Price Level
Product Market
AS
E2
E1
Full Employment
AD2
AD1
Billions of dollars
6.0
6.1
31
What is the Classical
Economic View?
The economy is stable in the
long-run at full employment
32
How did the Classical
Economists view the
Role of Money?
They believed in the
equation of exchange
33
What is the
Equation of Exchange?
An accounting number of
times per year a dollar of
the money supply is spent
on final goods and services
34
What is the
Velocity of Money?
The average number of
times per year a dollar of
the money supply is spent
on final goods and services
35
Money
Prices
MV = PQ
Velocity
Quantity
36
What is the
Monetarist Theory?
That changes in the money
supply directly determine
changes in prices, real
GDP, and employment
37
Change in
the quantity
of money
Change in
Monetarist
prices, real GDP,
Policy
& employment
Change in
the money
supply
Change in
the aggregate
demand curve
38
What is the Quantity
Theory of Money?
The theory that changes in
the money supply are
directly related to
changes in the price level
39
What is the Conclusion of the
Quantity Theory of Money?
Any change in the money
supply must lead to a
proportional change in
the price level
40
Who are the
Modern Monetarists?
Monetarist argue that velocity
is not unchanging, but is
nevertheless predictable
41
According to the Monetarist,
how do we avoid Inflation
and Unemployment?
We must be sure that
the money supply is
at the proper level
42
Who is
Milton Friedman?
In the 1950’s and 1960’s,
he was a leader in putting
forth the ideas of the
modern-day monetarists
43
What does Milton
Friedman Advocate?
The Federal Reserve should
increase the money supply by
a constant percentage each
year to enhance full
employment and stable prices
44
How do the
Keynesians view the
Velocity of Money?
Over long periods of
time, it can be unstable
and unpredictable
45
The Velocity of Money
7
6
5
4
3
2
1
40
Year
50
60
70
80
90
00
46
What is the Conclusion
of the Keynesians?
A change in the money
supply can lead to a much
larger or smaller change
in GDP than the
monetarists would predict
47
What is the Crux of the
Keynesian Argument?
Because velocity is
unpredictable, a constant
money supply may not
support full employment
and stable prices
48
What is the Conclusion of
the Keynesian Argument?
The Federal Reserve must
be free to change the
money supply to offset
unexpected changes in the
velocity of money
49
What are the main points
of Classical Economics?
50
• Economy tends toward a full
employment equilibrium
• Prices & wages are flexible
• Velocity of money is stable
• Excess money causes inflation
• Short-run price & wage
adjustments cause unemployment
• Monetary policy can change
aggregate demand & prices
• Fiscal policies are not necessary
51
What are the main points
of Keynesian Economics?
52
• The economy is unstable at less than
full employment
• Prices & wages are inflexible
• Velocity of money is stable
• Excess demand causes inflation
• Inadequate demand causes
unemployment
• Monetary policy can change interest
rates and level of GDP
• Fiscal policies may be necessary
53
What are the main points
of the Monetarists?
54
• Economy tends toward a full
employment equilibrium
• Prices & wages are flexible
• Velocity of money is predictable
• Excess money causes inflation
• Short-run price & wage
adjustments cause unemployment
• Monetary policy can change
aggregate demand & prices
• Fiscal policies are not necessary
55
What is the
Crowding-Out Effect?
Too much government
borrowing can crowd
out consumers and
investors from the
loanable funds market
56
What is the Keynesian
View of the CrowdingOut Effect?
The investment demand
curve is rather steep
(vertical), so the crowdingout effect is insignificant
57
What is the Monetarist
View of the CrowdingOut Effect?
The investment demand
curve is flatter (horizontal),
so the crowding-out effect
is significant
58
Key Concepts
59
Key Concepts
• What are the Three Schools of Economic
Thought?
• What is the Keynesian View of Money?
• How can the Fed influence the
Equilibrium Interest Rate?
• In the Keynesian Model, what do changes
in the Money Supply effect?
• What is the Classical Economic View?
60
Key Concepts cont.
• How did the Classical Economists view
the Role of Money?
• What is the Equation of Exchange?
• What is the Velocity of Money?
• What is the Quantity Theory of Money?
• What is the Conclusion of the Quantity
Theory of Money?
• Who are the Modern Monetarists?
61
Key Concepts cont.
• According to the Monetarist, how do we
avoid Inflation and Unemployment?
• Who is Milton Friedman?
• What does Milton Friedman Advocate?
• What is Classical Economists?
• What is Keynesian Economists?
• What is Monetarism?
62
Summary
63
The demand for money in the
Keynesian view consists of three
reasons why people hold money: (1)
Transactions demand is money held
to pay for everyday predictable
expenses. (2) Precautionary demand
is money held to pay unpredictable
expenses. (3) Speculative demand is
money held to take advantage of
price changes in nonmoney assets.
64
The demand for money curve
shows the quantity of money people
wish to hold at various rates of
interest. As the interest rate rises, the
quantity of money demanded is less
than when the interest rate is lower.
65
The Demand for Money Curve
12%
8%
Interest Rate
16%
A
B
4%
Billions of dollars
500
MD
1,000 1,500 2,000
66
The equilibrium interest rate is
determined in the money market by
the intersection of the demand for
money and the supply of money
curves. The money supply (M1),
which is determined by the Fed, is
represented by a vertical line.
67
An excess quantity of money
demanded causes households and
businesses to increase their money
balances by selling bonds. This
causes the price of bonds to fall,
thus driving up the interest rate.
68
The Equilibrium Interest Rate
12%
8%
MS
Interest Rate
16%
E
4%
Surplus
Shortage
MD
Billions of dollars
500 1,000 1,500 2,000
69
An excess quantity of money
supplied causes households and
businesses to reduce their money
balances by purchasing bonds.
The effect is to cause the price of
bonds to rise, and, thereby, the rate
of interest falls.
70
The Keynesian view of the
monetary policy transmission
mechanism operates as follows: First,
the Fed uses its policy tools to change
the money supply. Second, changes in
the money supply change the
equilibrium interest rate, which affects
investment spending. Finally, a change
in investment changes aggregate
demand and determines the level of
prices, real GDP, and employment.
71
Monetarism is the simpler view
that changes in monetary policy
directly change aggregate demand
and thereby prices, real GDP, and
employment. Thus, monetarists
focus on the money supply, rather
than on the rate of interest.
72
The equation of exchange is an
accounting identity that is the
foundation of monetarism. The
equation (MV = PQ) states that the
money supply multiplied by the
velocity of money is equal to the
price level multiplied by real output.
The velocity of money is the number
of times each dollar is spent during a
year. Keynesians view velocity as
volatile but monetarists disagree.
73
The quantity theory of money is a
monetarist argument that the velocity
of money (V) and the output (Q)
variables in the equation of exchange
are relatively constant. Given this
assumption, changes in the money
supply yield proportionate changes in
the price level.
74
The monetarist solution to an
inept Fed tinkering with the money
supply and causing inflation or
recession would be to have the Fed
simply pick a rate of growth in the
money supply that is consistent with
real GDP growth and stick to it.
75
Monetarists’ and Keynesians’
views on fiscal policy are also
different. Keynesians believe the
aggregate supply curve is
relatively flat, and monetarists
view it as relatively vertical.
Because the crowding out effect is
large, monetarists assert that fiscal
policy is ineffective. Keynesians
argue that crowding out is small
and that fiscal policy is effective.
76
Chapter 26 Quiz
©2000 South-Western College Publishing
77
1. Keynes gave which of the following as a motive
for people holding money?
a. Transactions demand.
b. Speculative demand.
c. Precautionary demand.
d. All of the above.
D. These are the three motives for holding
currency and checkable deposits (M1)
rather than stocks, bonds, or other
nonmoney forms of wealth.
78
2. A decrease in the interest rate, other things
being equal, causes a (an)
a. upward movement along the demand curve
for money.
b. downward movement along the demand
curve for money.
c. rightward shift of the demand curve for
money.
d. leftward shift of the demand curve for
money.
B. At a lower interest rate, money is demanded
because the opportunity cost of holding
money is lower.
79
3. Assume the demand for money curve is
stationary and the Fed increases the money
supply. The result is that people
a. increase the supply of bonds, thus driving up
the interest rate.
b. increase the supply of bonds, thus driving
down the interest rate.
c. increase the demand for bonds, thus driving
up the interest rate.
d. increase the demand for bonds, thus driving
down the interest rate.
D.
80
16%
12%
8%
Interest Rate
Expansionary Monetary Policy
MS1 MS2 Surplus
E1
E2
MD
4%
Billions of dollars
500 1,000 1,500 2,000
81
4. Assume the demand for money curve is fixed
and the Fed decreases the money supply. The
result is a temporary
a. excess quantity of money demanded.
b. excess quantity of money supplied.
c. increase in the price of bonds.
d. increase in the demand for bonds.
A.
82
16%
12%
8%
Interest Rate
Decrease in the Money Supply
MS2 MS1
Shortage
E2
E1
MD
4%
Billions of dollars
500 1,000 1,500 2,000
83
5. Assume the demand for money curve is
fixed and the Fed increases the money
supply. The result is that the price of
bonds
a. rises.
b. remains unchanged.
c. falls.
d. none of the above.
A. The result is an excess beyond the amount
people wish to hold and they buy bonds
which drives the price of bonds upward.
84
6. Using the aggregate supply and demand model,
assume the economy is in equilibrium on the
intermediate portion of the aggregate supply
curve. A decrease in the money supply will
decrease the price level and
a. lower both the interest rate and the real
GDP.
b. raise both the interest rate and real GDP.
c. lower the interest rate and raise real GDP.
d. raise the interest rate and lower real GDP.
D. The decrease in money supply increases the
interest rate which decreases investment.
Since investment is a component of
aggregate demand, the aggregate demand
curve shifts leftward and real GDP declines.
85
7. Based on the equation of exchange, the
money supply in the economy is calculated as
a. M = V/PQ.
b. M = V(PQ).
c. MV = PQ.
d. M = PQ - V.
C. The equation of exchange is
MV = PQ rewritten,
M = PQ/V
86
8. The V in the equation of exchange
represents the
a. variation in the GDP.
b. variation in the CPI.
c. variation in real GDP.
d. average number of times per year a
dollar is spent on final goods and services.
D. In the equation of exchange, GDP is
defined as PQ and the CPI is an index to
measure the price level (P).
87
9. Which of the following is not an issue in the
Keynesian-monetarist debate?
a. The importance of monetary vs. fiscal policy.
b. The importance of a change in the money
supply.
c. The importance of a crowding-out effect.
d. All of the above are part of the debate.
D. Monetarists believe the effects of monetary
policy are more powerful than fiscal policy.
They view the shape of the investment
demand curve as less steep, so the crowdingout effect is significant. Keynesians disagree.
88
10. Keynesians reject the influence of monetary
policy on the economy. One argument
supporting this Keynesian view is that the
a. money demand curve is horizontal at any
interest rate.
b. aggregate demand curve is nearly flat.
c. investment demand curve is nearly vertical.
d. money demand curve is vertical.
C. If the investment demand curve is nearly
vertical, changes in money supply and
resulting changes in interest rate have little
effect on investment and aggregate demand.
89
Expansionary Monetary Policy
6%
4%
MS1 MS2
Interest Rate
8%
E1
E2
MD
2%
Billions of dollars
200
400
600
800
90
11. Starting from an equilibrium at E1 in Exhibit
12, a rightward shift of the money supply curve
from MS1 to MS2 would cause an excess
a. demand for money, leading people to sell
bonds.
b. supply of money, leading people to buy
bonds.
c. supply of money, leading people to sell
bonds.
d. demand for money, leading people to buy
bonds.
B. An excess quantity of money supplied
causes people to buy bonds. The greater
demand for bonds causes the price of bonds
91
to increase and the interest rate to decrease.
12. Beginning from an equilibrium at E2 in
Exhibit 12, a decrease in the money supply
from $600 billion to $400 billion causes people
to
a. sell bonds and drive the price of bonds
down.
b. buy bonds and drive the price of bonds up.
c. buy bonds and drive the price of bonds
down.
d. sell bonds and drive the price of bonds up.
A. An excess quantity of money demanded
causes people to sell. The greater supply of
bonds on the market causes the price of
bonds to decrease and the interest rate to 92
increase.
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END
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