Download Mod 6.1: Monetary Policy

Lecture 11 Mod 6.1:
Monetary Policy
C.L. Mattoli
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2008
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This week
Mod 6 part 1: Monetary Policy
 Textbook, Chapter 16
Macroeconomic Policy 1:
Monetary Policy

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2008
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Learning objectives
On successful completion of this part of the
module, you should be able to:
 Explain the nature and operation of monetary
policy
 Discuss differences between ‘classical’ and
‘modern’ monetarist doctrine
 Articulate the ‘rules’ versus ‘discretion’
debate over the role of monetary policy
 Explain how monetary policy is
implemented in Australia
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2008
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Where we are coming from
The last several modules have been
spent looking at macroeconomic
variables, and then using them in an
aggregate model of supply and
demand.
 We found that classical economists
believed that an economy would
always heal itself and forever be able
to give everyone a job. That is the
classical end of the aggregate
supply curve.

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Where we are coming from
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Keynes found another limiting case in
which people would be unemployed and
remain unemployed unless something was
done by the government: a kick start.
In the last lecture, we looked at what
makes money money.
Governments print modern money and
issue it through their central banks and
their banking systems.
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Where we are coming from
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This fiat money is valued against the
economy. The amount in circulation will affect
its value.
For example, if the supply doubled overnight,
no one would be fooled, they would just
revalue everything else at prices twice as
much as yesterday. Thus, keeping a reign on
the supply is important, at least for prices.
Indeed, since there will be both a supply and
a demand for money, there will be an
intersection of those curves and an
equilibrium price.
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Where we are coming from
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We call the price of money the interest
rate.
Since the government is the one who
makes money, by printing it, minting it, and
allowing banks to create it, the
government can also have an affect on
money supply, which can affect other
variables in the economy, like interest
rates, investment, output, prices, and
employment.
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Where we are coming from
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The economy will have demand for
money, and the government can
manipulate supply
In this lecture, we take a closer look at
money and monetary policy, i.e., how
the government views money and uses it
to affect interest rates, and the effects that
are transmitted through the economy from
what the government does about money.
We shall look at money views, theories,
transmission mechanisms, and practical
applications to try to affect an economy.
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On Monetary policy
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Tools available to a central bank
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1.
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There are 2 common means by which the central
bank can affect money supply and demand.
First, it can affect interest rates.
The central bank can change the rate of interest
that it charges to its member banks.
That rate, in turn, will act as a baseline rate for
interest rate costs of banks, in the shortest,
overnight market for money.
That will be transmitted through others interest
rates in the banking system and in the economy
for longer maturities and differing risks and
costs of lending in its various venues.
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Tools available to a central bank
2.
Alternatively, the bank can make it
known what it wants the overnight,
inter-bank loan interest rate to be, and
let the market work it out. The result, in
either case, will be that demand will
adjust to supply of money at the new
price (interest rate) of money and a new
quantity.
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Tools available to a central bank
3.
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It can also affect supply of money in the system
through open market operations.
In open market operations, the central bank either
sells or buys U.S. government securities from its
member banks.
The banks, as part of the system, are obliged to
enter these transactions.
If banks buy securities from the central bank,
they with money, thus, taking money out of the
banking system, thus reducing supply of money
from banks.
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Tools available to a central bank
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Cash is deducted from the bank’s ESA,
immediately reducing the money bas, and
though the multiplier will reduce the other
definitions of money supply.
Dollars are physically removed from the
economy.
The opposite occurs when the central bank
buys securities from banks. More money is
put into circulation.
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Open market operations
RBA
RBA sells
Securities; banks
Buy; bank deposits
at RBA decline
RBA buys
Securities; banks
Sell; deposits at
RBA increase
Banks
Banks have less money
They decrease loans
Raise interest rates
Banks have more money
They increase loans
Interest rates decline
Public
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The RBA’s goals of monetary policy
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As we learned in the last lecture, the RBA
was originally given a mandate of keeping a
stable currency, maintaining full employment,
and ensuring economic prosperity and welfare
of the Australian people.
Then, that goal seemed to be limited to
keeping inflation between 2 and 3 percent on
the CPI in the last decade, but does that mean
that it has abandoned the other 2 goals?
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The RBA’s goals of monetary policy
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1.
In fact, the RBA believes that by pursing that
one goal, it will, in addition, take care of the
other 2 in the medium to long term.
The logic is that: It would take away its focus,
if it went chasing after different problems in
the short run.
Inflation can have other affects on an
economy, like causing bad expectations and
increasing interest rates.
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The RBA’s goals of monetary policy
2.
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If it keeps its eye on inflation and keeps it
low, through ups and downs, then, economic
growth will come. Moreover, with growth,
there will be employment.
We can look at the record of monetary policy
versus history.
We can discuss some theories and some
prescriptions for what monetary policy can
and should do.
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Policy Transmission
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Intro
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The central bank can affect the supply of money,
thus, tinkering with the equilibrium point
between supply and demand for money.
The equilibrium will be a quantity of money and a
price of money, the interest rate.
The bank can change the supply of money or it
might also set the interest rate directly.
By setting supply at a certain vertical quantity, the
bank might be trying to pick a spot on the money
demand schedule, which will be at a certain
interest rate.
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Intro
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If it sets the rate, it is trying to bring the
demand curve to a certain point of implied
supply.
After it becomes clear where the central bank
wants interest rates be, both HH and
businesses will make savings, borrowing, and
investing decisions.
Those decisions will, in turn, affect other
variables in the economy.
For example, when rates are high, both
business and HH will be more unlikely to
borrow.
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Intro
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Consumers buy large durable goods for large
dollar amounts, like appliances, cars, land, and
houses with borrowed money, while business
borrow money to invest in capital.
People will tend to save money and try to take
advantage of the interest rate.
That will take money out of the system.
It will take money out of DI and put it into S,
so C will decrease.
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Intro
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Business will also borrow less and invest less,
causing I to decline
Thus, interest rates will ultimately affect AD.
If the affect is a decrease in AD, then, there may
also be a decrease in employed people.
If AD increases, it may lead to more employment
in the economy.
It may also lead to increased prices and inflation.
We shall examine some ways that monetary
policy can be transmitted through the economy,
so we can understand the consequences of
tinkering with the supply of paper money.
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The Keynesian mechanism
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Suppose an economy is operating near its
capacity and increased inflation has begun to
appear above the previously lower more stable
rate.
The central bank would then tighten money,
reduce supply, and the interest rate would rise.
That would cut private-sector demand in I and C
(for durable goods, at least), which would have a
multiplier effect through the economy, and AD
would decrease.
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The Keynesian mechanism
The fall in AD would slow down
economic activity and reduce the rate of
inflation.
 Thus, in the Keynes view, interest rate
changes are the key to the transmission
process.
 We show the causal chain of events, in
the next slide.

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The Keynes Causal Chain
Change in
Money
Policy
Change in
Price, GDP,
Employment
Change in
Money
Supply
Change in
Aggregate
Demand
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Change in
Interest
Rates
Change in
Investment
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Monetarism
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Monetarist school
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The monetarist school of thought is that
changes in the money variable have far
more direct and vast effects on economic
variables.
In the Keynes transmission, money policy
affects interest rates. Then, investment and
AD. Then, prices, output, and employment.
It is a cascade effect: a chain of events.
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Monetarist school
The monetarist view is that changes in
money supply directly affect prices,
output and employment, in addition to
interest rates.
 We show the causal chain for monetarism
in the next slide.

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The Causal Chain: monetarism
Monetarist Chain
Shortcut
Change in
Money
Policy
Change in
Price, GDP,
Employment
Keynes Route
Change in
Money
Supply
Change in
Aggregate
Demand
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Change in
Interest
Rates
Change in
Investment
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The monetarists’ logic
Modern monetarism has its roots in
classical economics.
 It puts the spotlight on the money supply
as a large determinant in the economic
outlook.
 Simplistically, if the supply expands too
rapidly (whatever that means), prices will
rise and there will be inflation.

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The monetarists’ logic
An extreme example is, if the supply
doubles, overnight, prices will double
because no one is fooled...the money is
worth half as much as it was worth,
yesterday.
 If the supply expands too slowly to meet
the economy’s transaction needs, prices
might fall or people might lose jobs.

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The equation of exchange
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We begin with the classical economics
equation of exchange, a classical notion
from the 19th century.
It is simply an accounting identity relating the
supply of money, M, to the times it is spent,
turned over, in a year (period).
The annual (period) turnover is referred to as
money velocity, V.
Then, the equation relates money spent to
nominal GDP (=PQ) as: MV= PQ.
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A simple economy
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Assume an economy with only one $20 bill in
circulation.
Linlin has the $20 and wants to eat fish, so
she pays $20 to Tintin for fish.
Now, Tintin has the money, and she decides
to go to go to Shadow’s wang bar and spend
her money on internet, tea and crumpets.
Now, Shadow decides to go to Violet’s nail
salon to have a facial and her nails done.
Thus, in our quick little jaunt, the single $20
has paid for $60 in G&S. Money gets around.
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A simple economy: abstracted
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Thus, you can visualize how the equation is
simply a statement of reality.
Money gets around an economy, and the
number of transactions that it is involved in,
during some period of time, determines the
total value of the transactions that are done,
which is the economy’s nominal value of
GDP, during that time.
The question becomes: how are Q and P, in
GDP, separately affected. That would be
more useful information.
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A larger example
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Consider an economy with a GDP of $500
billion and M1 of $100 billion.
Then, solving the exchange equation we
find that the velocity was V = GDP/M1 =
$500 billion/$100 billion = 5.
Thus, M1 was turned over 5 times during
the year, going through an average of 5
transactions for final goods and services,
to pay for total output of the economy in
current dollars.
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Quantity theory of money
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In classical economics, V and Q are regarded
as constants.
It assumes that people have stable spending
habits, and it is also under the broader
assumption that prices are flexible and
everyone is employed.
The resulting quantity theory of money,
then, says that the change in money supply
determines inflation, as MV0 = PQ0, where
V0 and Q0 are now constants.
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Quantity theory of money
It may have been an ok assumption in the
19th century, and the argument has some
appeal, in a certain sense.
 However, it misses supply shock, cost
push inflation, like happened in the
1970’s with oil prices.
 It also loses predictive power, if V is not
actually constant but varies, for one
reason or another.

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Quantity theory of money
 For example, financial innovation,
like occurred in the 1980’s & 90’s
with EFTPOS on the rise, the need
for pocket money changed
substantially.
 If an economy does not have full
employment, changes in money
might translate into increased output,
not prices.
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Modern monetarist thinking
The historical record shows that velocity
is not unwavering.
 Monetarists acknowledge that reality but
argue that V is fairly predictable.
 Then, if predicted V for next year is 6,
GDP will be $600 billion.

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Modern monetarist thinking
Then, predictions of changes in prices
versus output are tempered by where the
economy is in the range between Keynes
and classical on the AS curve.
 The monetarist prescription is, then, do
not let the money supply grow too fast or
too slowly, and you will be able to keep
inflation and unemployment under
control.

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Keynes vs. monetary transmission
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The monetarists deemphasize the
transmission of money changes through the
interest rate as an intermediary.
In that regard, when people find themselves
with extra money in their hands, they will not
just go out and buy bonds, they will also
spend money on more G&S.
Thus, instead of just bidding up bond prices
and changing interest rates, prices of G&S
will be bid up and demand will increase.
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Keynes vs. monetary transmission
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Instead of working through interest rates to
investment to AD, the change in money directly
determines economic activity.
A famous “thought experiment” imagines that a
community wakes up to find $50 bills littered
everywhere.
Some people will invest it, others will rush out
to buy CD players, flat screen TV’s, computers,
cars and new clothing and food.
The result will an increase in bond prices and
nominal GDP, albeit mostly an increase in
prices.
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The Role of Monetary Policy
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Rules vs. Discretion Debate
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Both schools of thought on money agree that
monetary policy will affect the economy.
They would further agree that the short-term
affects, about the first 9 months, will be
responses in output and employment, with
inflation following at about 18 months out.
However, they differ in their views of the role
of monetary policy.
Keynesians believe that the central bank
should have discretion to change its policy to
meet changing perceived problems in the
economy.
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Rules vs. Discretion Debate
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Monetarists, on the other hand, believe that
the banks should adhere to widely-published
rules of engagement. The most common of
which is a target range for money supply
growth.
Monetarists would, for example, argue that
countercyclical monetary policy will suffer
from information lags, decision and
implementation lags, and effectiveness lags,
and such policy pursuit might actually
exaggerate swings in the cycle instead of
damping them.
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Lags & Nags
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First, since information is imperfect and
partially visible, there will be an information
lag about the actual state of the economy.
As the outlook on the economy crystallizes,
policy finally takes shape, but again at a lag,
and implementation thereafter occurs.
Then, there will be the final lags between
implementation of policy and affects in the
economy.
By the time that all follows, it might be the
wrong affect at the wrong time.
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Lags & Nags
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The monetarist would prescribe that the
central banks should announce targets of
monetary growth for a year. Then, use the
tools available to it to keep the growth of
supply in line with the target, and review
the target annually.
For example, if we want GDP growth to be
in the range 5-6%, with real growth and
inflation in the 2-3% range, then, money
supply should be grown at that rate.
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Lags & Nags
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Indeed, even if velocity varies to result in
temporary inflation or slower growth in output,
policy should remain steadfast.
The Keynesian would say: ok, don’t just do
something, stand there!
The monetarist believes the head of the
central banks should be a horse. Each year
the horse would be debuted to the public. He
would tap his foot 4 times for 4% growth in M,
then, not be seen again for another year.
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Velocity instability
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The predictability of velocity is a central
issue in the debate of targeted money
growth or a discretionary approach.
Most economists would agree that velocity
is not stable in the short run. They
disagree on its behavior over the longer
run.
Keynesians do not accept the monetarist
view that velocity evolves in a fairly stable
and predictable manner over the longer
run.
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Velocity instability
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Keynesians believe that velocity is
determined by the community’s demand
for holding money balances, and that
demand for money is not stable in the
short or long run.
If velocity is not stable or predictable, then,
a change in supply could result in a
change in nominal GDP that is either
larger or smaller than monetarists would
predict.
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Velocity instability
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Keynesians argue further that even if the
long term is predictable, the focus of policy
should be on the short term where the
velocity is not stable, and, therefore, the
monetarist approach is worthless.
Suppose, for example, that the money
supply is increasing at a constant rate.
Then, if velocity is greater than predicted,
total spending will be greater than
expected, creating inflation.
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Velocity instability
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If velocity is smaller than predicted, the
economy will expand at a slower pace than
expected, and unemployment will result.
Keynesians believe that the central bank
needs to act to adjust for changes in velocity.
Monetarists argue that predictability of short
term velocity is not possible, so the response
of central banks will be wrong, anyway.
Keynesians argue that the flexibility option
should be kept as a better alternative to
keeping money supply growth constant.
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Case Study
Money & Policy
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Intro
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The cycle of a new economic theory from
inception in academia to acceptance in
academic circle, the, in real world practice
seems to be about 10-15 years.
Keynes theory had its greatest acceptance in
academia in the 1940’s & 50’s, while its use
in policy applications was mostly in the
1960’s.
Monetarism gained academic support in the
late 1950’s with its strongest support, in
academia, coming in the late 1960’s, and its
policy début in the mid-1970’s.
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The Great Depression
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During the 1920’s in the U.S., the
money supply grew at a steady pace
and prices were stable.
The huge stock market crash of 1929
caused bank failures, a decline in GDP
and unemployment.
Through the years 1929-1933, the
central bank allowed M1 to decline by
27%.
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The Great Depression
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The evolution of the story is that foreign
banks, afraid of the state of U.S. banks,
withdrew large amounts of gold from U.S.
bank.
The central bank responded by raising the
interest rate that they charge to banks.
Bank responded by borrowing less. The
result was a sharp contraction in the
money supply.
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The Great Depression
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Monetarist would argue that, assuming
that velocity was fairly stable, GDP,
employment and prices would decline.
The record was that real GDP declined
30%, prices declined 24%, and
unemployment rose from 3.2% to 24.9%.
Monetarists gain further credence from the
fact that after the central bank began using
open market operations to increase supply
in 1931, the economy did begin to move
out of deep recession with a time lag.
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The Great Depression
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The situation was, however, further
exacerbated by fiscal policy, the topic of
the final lecture, as the U.S. president
also tried to have a balanced budget
rather than pursuing a Keynesian policy
of fiscal expansion of spending to kick
start the economy.
Economic data is shown in exhibit 16.3
in the textbook, in graphical form.
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Australia 1976-85: monetarism policy
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Runaway inflation in the 1970’s gave the
monetarist economists their try at
positively affecting the economy in many
countries around the world.
Australia engaged in a form of money
supply growth targeting between 1976 and
1985.
Each year the treasury would announce
conditional projection of growth of M3 in
its budget projection.
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Australia 1976-85: monetarism policy
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The RBA was, then, expected to keep it near
that figure.
The conditional part of the target left leeway
for changing foreign and domestic economic
events.
The record over the period shows that the
RBA had varied degrees of success of
bringing inflation under control. (See exhibit
16.4 in textbook.)
The record also shows that unemployment
rose from 4.1% to 9.6% over the period.
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Post-1985: non-monetarist policy
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Financial institutional flexibility issues that
hamper the RBA during its monetarist policy
experiment were solved by 1985, but the
RBA concurrently abandoned money growth
targeting.
The rationale for the change in policy was
that, due to the financial deregulation that
was taking place all around the world and the
financial innovations that were developing in
the markets, velocity was changing and was
unpredictable.
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Post-1985: non-monetarist policy
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In exhibit 16.5 in the textbook, it can be seen
that velocity of M3 peaked at 0.7 in 1976,
decreased to 0.5 by the end of the 1980’s,
and has continued to decrease to a level of
around 0.4, today.
A change in supply of money will have
predictable effects for interest rates, only if
the demand can be predicted fairly
accurately. If demand cannot be predicted,
changes in supply might actually add volatility
to interest rates, which would adversely affect
business mentality and economic output.
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Post-1985: non-monetarist policy
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A better method in those circumstances
would be to target rates, directly, at whatever
level it is thought will support a certain level
of AD. This type of approach is the one that
has been adopted by the RBA since 1985.
As we mentioned in the last lecture, the
RBA’s current mandate is to keep inflation in
the 2-3% range.
The means of implementing the policy is to
announce a target rate for the overnight cash
rate (inter-bank, overnight rate).
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Post-1985: non-monetarist policy
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In order to enforce this target, the RBA allows
a certain amount of market discipline to
adjust supply and demand to that rate.
In addition, the RBA carries out open market
operations to adjust supply. Decreased
supply will tend to increase interest rates,
while increased supply will tend to reduce
them, ceteris paribus.
Eventually, these cash rates spread through
the wholesale and retail markets and into
other interest rate markets.
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Linking money policy to AD-AS
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AD-AD response example


Suppose that the RBA tightens credit.
Then, AD will shift left, as shown, below.
Real GDP vs. Price level
AD1
AD2
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Graph analysis
Suppose the RBA sells securities to the
banking system, thus, reducing the supply
of money.
 For any price level of the economy, the
supply of money balances will be
reduced, and interest rates will increase.
 As interest rates increase, there will be
less demand for investment and durable
goods.

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Graph analysis




That will have a transmitted affect on
overall aggregate demand through another
multiplier.
Thus, AD will shift from position 1 to 2 on
the graph.
As a final result real GDP will decrease.
Although prices will not fall as a result of a
monetary tightening, the rate of inflation
will be diminished.
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The shape of money supply



When the RBA sets a target rate, that means
that it must be willing to supply the supply
that will result in the target interest rate (the
price of money), no matter what the demand
curve shifts into.
The downward sloping demand curve might
shift due to any number of reasons.
Since the supply must meet any demand at
the target price, the supply curve is
completely horizontal and elastic.
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A blunt instrument


Money policy cannot be focused but
affects the broader economic
community.
For example, if the central bank believes
that a certain part of the economy is
heating up or if it thinks that inflation is
too high, it will raise its target cash rate,
and all rates will be affected.
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A blunt instrument


Thus, there are those who will suffer,
like borrowers with variable rate loans,
or people who were planning on buying
houses.
As a result, some good affects that
might have been in the cards for the
economy may be dashed by rising
rates.
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Foreign Exchange Market ops



Another means by which money supply can
be changed is through the foreign exchange
markets.
Prior to 1983 when the Australian dollar
was allowed to freely float in the markets for
foreign exchange, any imbalance had to be
met by the RBA.
Any action by the RBA in the FOREX
markets would also affect money supply
and, ultimately, interest rates and other
economic variables.
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Foreign Exchange Market ops



For example, if there was excess supply, the
RBA would have to buy AUD. That action had
the affect of taking money out of the system,
lowering the money supply.
Lower money supply would lead to higher
interest rates would lead to unintended
damping of economic growth.
In a floating exchange rate regime, the
central bank does not need to involve itself in
balances between supply and demand for
currency in the foreign exchange markets:
the markets must work out their own
equilibrium.
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Foreign Exchange Market ops



Nowadays the RBA, as do many other central
banks in countries with floating exchange
rates, still does get involved in the markets
when it deems it necessary.
There are two types of intervention that the
RBA, today, employs: smoothing and
testing.
If the markets are excessively volatile, the
RBA might intervene to try to smooth out the
volatility. Such operations might last several
days, at most.
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Foreign Exchange Market ops


When the RBA feels that there is too much
short-term speculative pressure on the
AUD, it will engage in operations to
counteract the pressure.
That is testing. It is leaning against the
wind. It tests the market’s determination
to change rates. If the RBA has a range in
mind for the value of the RBA against
other currencies, it may try to oppose a
change in the market for FX.
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Foreign Exchange Market ops


In the end, the wind might win, and, once it
is clear that the markets are serious about
their perception of the value of the AUD in
terms of other money, there is nothing that
the RBA can do, and operations will
cease.
An example of the latter type of operation
was when the AUD hit a low against the
USD of USD 0.47/AUD.
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Foreign Exchange Market ops
The RBA thought that it was oversold
versus the fundamentals of the
domestic economy, and they
engaged in operations to support and
boost the price.
 The result was that the AUD
eventually moved back to the USD
0.52 level, about 10 % higher.

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Foreign Exchange Market ops
Eventually, the AUD got to where it is
now, in 2007, to the USD 0.70-0.80
range, several years after 2001.
 In these types of operations, central
banks usually try to keep it secret that
they are in the markets, as
information of that sort could affect
the markets.

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Beyond the Book
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Sterilization



If the central bank acts in the foreign
exchange markets, it could affect interest
rates in the domestic market.
Thus, the idea of sterilized intervention has
come about. For example, if the bank buys
foreign currency, it puts more AUD into the
system.
The increased supply of money could act to
lower interest rates.
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Sterilization



To counterbalance the effect on the money
supply, arising from the its transactions in the
FX markets, the RBA can do the opposite in
its open market operations.
In the example above, it would counteract by
selling bonds and take cash out of the
system, in an amount equal to the amount it
put into the system in its FX operations.
Such counterbalancing is referred to as
sterilization.
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Targets & Instruments


Monetary policy is necessary, a priori, but
it has evolved beyond the basic need and
has experimented in different forms to
affect different things.
The objectives of monetary policy, e.g.,
lower inflation, lower unemployment,
higher growth, lower current account
deficit, or the value of the currency vis-àvis others, are commonly referred to as
targets of policy.
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Targets & Instruments



In turn, the central bank tries to achieve its
targets by fixing the values of some
economic variables that are within its
control and that will have an affect on the
targets.
Those variables are called instruments of
policy.
Logic tells us that we will need a number
of instruments at least equal to the number
of targets that we want to affect.
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Targets & Instruments



The two variables that the central bank can
try to set are interest rates or the growth of
money aggregates.
If we set interest rates, we lose control of the
money aggregates (MS is perfectly elastic).
If we control the aggregates, we lose control
of the interest rate (MS vertical).
While the central bank has full control over
interest rates, it does not have full control
over the growth of money aggregates: it is
unwieldy.
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Targets & Instruments



In fact, money aggregates can be
regarded as intermediate targets.
The value of intermediate targets is that
information about them becomes
available before information about the
ultimate targets (they are, effectively,
leading indicators).
The current manner in which the RBA
implements its policy is indirect control of
interest rates.
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Targets & Instruments



Effectively, it is taking a step back away from
interest rates as instruments and making
them, instead, intermediate targets.
Thus, the RBA announces a target rate for
the overnight interbank market, providing
advance information about its intentions for
rates.
That also tells that markets that, if they do not
do it themselves, the RBA will act to impose
discipline through its open market and FX
operations.
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Epilogue



Since money is just paper, and, technically, a
government could print as much as it
pleases, there has to be some sort of control
over the production and supply of money.
Although it is easy to fool people, people are
not so gullible as to not react to changes in
the supply of paper money.
For example, if the money in circulation was
$1 billion yesterday, and it is, suddenly, $2
billion, today, people will value it as half as
much as yesterday.
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Epilogue
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
What they will do is adjust prices of
everything to double what they were
yesterday.
Thus, along with paper money, there must be
some sort of control over the supply of that
money, which means that there is a need for
some sort of monetary policy.
Indeed, it is a difficult task to have enough,
but not too much, money in circulation to
satisfy the various demands for money, for
transactions and investment purposes.
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Epilogue



Too little money will hinder the processes of
the economy.
Too much money will allow for an undue
amount of marginal and speculative
economic activity.
The proposition becomes even more
complicated because money has velocity, so
the amount of money needed in the system is
some fraction of the total transactional needs
of the economy.
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Epilogue



Trying to actually control the supply of
money, as was attempted in the 1970’s, was
a failed experiment.
We have even seen that monetarists argue
that little should be done beyond a once a
year announced target.
Financial innovation and deregulation since
the 1980’s has caused the money multiplier
to change, substantially, while floating
currencies and free flow of funds across
national borders have allowed the monies of
different countries to rationalize one another.
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Epilogue



Thus, monetary policy has evolved into
adjusting interest rates to affect the demand
for money. Thus, it has been limited to the
use of one instrument.
It is carried out through the use of
intermediate target interest rates.
In addition, in Australia, the ultimate target
has also been limited to only one: to keep
inflation under control to add stability to the
economy.
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Ask Yourself
1.
2.
3.
If the RBA wants interest rates to be
exactly equal to one number, e.g., 4%,
what will the MS curve look like?
If, suddenly, the RBA decreases MS from
one quantity at any price to a lesser
quantity at any price, a shortage of
money will exist. What process and
ending will ensue?
What are smoothing and testing and why
are they done?
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Ask Yourself
4.
5.
6.
If money can get around an economy, on
average, four times a year, and nominal
GDP is $10 billion, what is the money
supply, according to classical thinking?
Can you explain, in your own example,
why we say that monetary policy is a blunt
instrument?
Can you explain the differences between
monetary policy transmission according the
Keynesians and Monetarists, using both
words and graphs?
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Exam-caliber Questions
1.
2.
3.
Critically analyse the following statement: “With
inflation high and the economy growing
strongly, the Reserve Bank of Australia has
little choice, but to increase the interest rate”.
If nominal GDP of a country is $4 billion,
explain why the monetary base can be much
less than $4 billion of money in circulation.
Critically analyse the following statement:
“There are two instruments for implementing
money policy: controlling interest rates and
money aggregates: if interest rates, MS must
be totally elastic; if aggregates, MS must be
perfectly inelastic.”
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Homework



Chapter 16
All problems
All multiple choice
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Next week


Final lecture: Fiscal Policy
Chapter 17.
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End
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