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Transcript
The Quantity Theory of Money Connecting Money and Prices: Irving Fisher’s Quantity Equation M×V=P×Y V = Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP. P xY V M We can transform the quantity equation from M xV P x Y to: Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (inflation rate) + Growth rate of real output The Quantity Theory of Money The growth rate of the price level is just the inflation rate •we can rewrite the quantity equation to help us understand the factors that determine inflation: Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output If velocity is constant, Inflation rate = Growth rate of the money supply − Growth rate of real output • If money supply grows at a faster rate than real GDP inflation. • If money supply grows at a slower rate than real GDP, deflation. Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession. What Is Monetary Policy? The Goals of Monetary Policy: Price Stability The Inflation Rate, 1952–2006 Other Goals of Monetary Policy High Employment Economic Growth •Policymakers aim to encourage stable economic growth •Stable growth allows households and firms to plan accurately and encourages the long-run investment sustains growth. Stability of Financial Markets and Institutions •The Fed can’t control unemployment or inflation rates directly •The Fed uses monetary policy targets, that it can control, that in turn, affect variables closely related to its policy goals—real GDP, employment, and the price level. •These monetary policy targets include the growth rate of the money supply and, most importantly now, the federal funds interest rate The Money Market and the Fed’s Choice of Monetary Policy Targets The Demand for Money The Demand for Money The Money Market and the Fed’s Choice of Monetary Policy Targets Shifts in the Money Demand Curve Shifts in the Money Demand Curve The Money Market and the Fed’s Choice of Monetary Policy Targets How the Fed Manages the Money Supply: A Quick Review Equilibrium in the Money Market The Impact on the Interest Rate When the Fed Increases the Money Supply The Relationship between Treasury Bill Prices and Their Interest Rates What is the price of a Treasury bill that pays $1,000 in one year, if its interest rate is 4 percent? $1,000 P x 100 4 P When the price paid for a bond rises, the interest rate earned on the bond falls Monetary Policy and Economic Activity How Interest Rates Affect Aggregate Demand Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: • Consumption: lower rate save less, spend more • Investment: lower rate finance more capital investment • Net exports: lower rate $ depreciation NX increase The Importance of the Federal Funds Rate Federal funds rate The interest rate banks charge each other for overnight loans. Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look Expansionary monetary policy The Federal Reserve’s increasing the money supply and decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation. Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look Monetary Policy Monetary Policy and Economic Activity A Summary of How Monetary Policy Works Expansionary and Contractionary Monetary Policies Making the Connection The Fed Responds to the Terrorist Attacks of September 11, 2001 The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks. Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves Reserves that banks hold over and above the legal requirement. Making the Connection The Inflation and Deflation of the Housing Market “Bubble” Monetary Policy and Economic Activity Can the Fed Get the Timing Right? The Effect of a Poorly Timed Monetary Policy on the Economy Don’t Let This Happen to YOU! Remember That with Monetary Policy, It’s the Interest Rates—Not the Money—That Counts Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? Some economists have argued that rather than use an interest rate as its monetary policy target, the Fed should use the money supply. Milton Friedman and his monetarist followers favored replacing monetary policy with a monetary growth rule. The Fed Can’t Target Both the Money Supply and the Interest Rate A Closer Look at the Fed’s Setting of Monetary Policy Targets Should the Fed Target Inflation? The Taylor Rule Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap Making the Connection How Does the Fed Measure Inflation? Is the Independence of the Federal Reserve a Good Idea? The Case for Fed Independence FIGURE 14.12 The More Independent the Central Bank, the Lower the Inflation Rate Is the Independence of the Federal Reserve a Good Idea? The Case against Fed Independence In democracies, elected representatives usually decide important policy matters. In the United States, however, monetary policy is not decided by elected officials. Instead, it is decided by the unelected FOMC. Because those deciding monetary policy do not have to run for election, they are not accountable for their actions to the ultimate authorities in a democracy: the voters. Key Terms Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule