Download Chapter 5: Monetary Theory and Policy

Chapter 5: Monetary Theory and
Policy
Chapter 5: Monetary Theory and
Policy
Chapter Outline:
• Monetary Theory.
• Economic Indicators Monitored by the Fed.
• Lags in Monetary Policy.
• Integrating Monetary and Fiscal Policies.
• Global Effects of Monetary Policy.
1-2
Monetary Theory
• Keynesian Theory.
• Quantity Theory and the Monetarist Approach.
• Theory of Rational Expectation.
Keynesian Theory
John Maynard Keynes was a British economist whose
theories were popular during the 1930s and beyond.
• Keynes believed that a market-driven economy is
inherently unstable. Changes in output, prices, or
unemployment would be magnified by the invisible
hand.
• Keynes believed that an economy can’t rely upon the
market mechanism to correct the problem.
Keynesian Theory
Keynes believed that government intervention was needed to
control the instability of a market economy.
If the economy slows down, the government should buy more
output, employ more people, increase income transfers, and make
more money available.
If the economy overheats, then the role of government is to slow
the economy down by increasing taxes, reducing government
spending, and by making money less available.
Keynesian Theory
Effects of an Increase in the Money Supply on
Interest Rates, Investment, and Aggregate Demand
Keynesian Theory
An increase in the
money supply drives
the interest rate down
to i'.
With the cost of borrowing
lower, the amount
invested increases from I
to I‘.
This sets off the spending
multiplier process, so the
aggregate output demanded
at price level P increases
from Y to Y ‘
Quantity Theory and the
Monetarist Approach
• It suggests a particular relationship between the money
supply and the degree of the economic activity.
• It is based on the equation of exchange:
MV= P*Q
M= Amount of money in the economy.
V= Velocity of money.
P= Weighted price level of goods and services in the
economy.
Q= Quantity of goods and services sold.
Comparison of the Monetarist and
Keynesian Theories
• Monetarists are passive.
• Time required to improve the economy.
• Accepting a natural rate of unemployment.
• Relative importance for inflation and
unemployment.
Theory of Rational Expectations
• The public accounts for all existing information
when forming its expectations.
• The public will use this information to forecast
the impact of an existing policy and act
accordingly.
The Tradeoff Faced by the Fed.
• Inflation.
• Unemployment.
• Gross domestic product.
Economic Indicators Monitored
by the Fed.
• Indicators of Economic Growth.
• Indicators of Inflation.
• Index of Leading Economic Indicators.
Indicators of Economic Growth
• GDP
• Level of Production
• National Income
• Unemployment rate
• Industrial production index
• Retail sales index
• Home sales index
• Consumer confidence survey
Indicators of Inflation
• Producer price index
• Consumer price index
• Housing price index.
• Other indicators.
• Oil Prices.
• Price of Gold.
Index of Leading Economic
Indicators
• Leading index.
• Coincident index.
• Lagging index.
Lags in Monetary Policy
• Recognition Lag.
• Implementation Lag.
• Impact Lag.
Assessing the Impact of Monetary
Policy
• Forecasting Money Supply Movements.
• Improved Communication from the Fed.
• Impact of Monetary Policy across Financial
Markets.
Integrating Monetary and Fiscal
Policies
• History.
• Monetizing the Debt.
• Market Assessment of Integrated Policies.
Global Effects of Monetary Policy
• Impact of the Dollar.
• Impact of Global Economic Conditions.
• Transmission of Interest Rates.
End of Chapter 5