Download Monetary Policy

Monetary Policy
Purpose
• Monetary policy attempts to establish a
stable environment so the economy
achieves high levels of output and
employment.
• How changes in money supply affect
interest rates, output, and prices.
Monetarists
Group of economists who believe that
1. monetary instability is the major cause of
fluctuations in real GDP
2. rapid growth of money supply is the
major cause of inflation
Erratic monetary policy leads to business
instability and inflation
Demand for money
• There is an opportunity cost to holding
money balances (foregone interest)
• Inverse relationship between interest rate
and quantity of money demanded
Supply of money
• Quantity of money supplied is determined by the Fed
• Fed uses its control over reserve requirements, discount
rate, and open market operations to set money supply
• Changes in interest rate do not alter Fed’s determination
of money supply
Money equilibrium
Expansionary monetary policy
• Fed buys bonds, lowers reserve
requirements, or lowers discount rate
• Real interest rates decrease
• Stimulates AD (investment and
consumption)
• Lower interest rates lead to capital outflow,
so dollar depreciates, and exports
stimulated (higher AD)
• Asset prices increase (housing)
Restrictive monetary policy
• Fed sells bonds, raises reserve
requirements, or raises discount rate
• Real interest rates increase
• Decreases AD (investment and
consumption)
• Higher interest rates lead to capital inflow,
so dollar appreciates, and exports
decrease (lower AD)
• Asset prices decrease
Timing
• As with fiscal policy, timing when to use
monetary policy is critical, and hard to
plan.
• Desired effects usually occur in the short
term, but then can turn out different.
• Monetary policy is effective, but must be
monitored carefully.
Monetary policy in the long run
• Excessive money growth over time leads
to inflation.
• Quantity theory of money indicates that an
increase in the supply of money will cause
a proportional increase in price level.
PY=GDP=MV
P (price level), Y (real GDP or real income),
M (existing money stock), V (velocity of
money)
Velocity of money
• Average number of times a dollar is used
to purchase a final product or service
during the year
• Equals nominal GDP divided by money
stock
• Closely related to demand for money
• MV=PY indicates that an increase in
money supply leads to proportional
increase in price level