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Chapter 33 – Monetary Policy
A. Terms and Concepts
1. Objectives
Note that the objective of monetary policy is very similar to fiscal policy in that we want the
economy to be operating efficiently.
a. Want FE or maximum employment; they try and keep the output gap (potential –actual GDP)
to a minimum to avoid either recessionary gaps or inflationary gaps.
b. Stable Prices – so this means we want to keep inflation low; the FED monitors a core
inflation rate which amounts to looking at the personal consumptions deflator (i.e. how HH
spend less food and fuel costs) to get a sense of how inflation is behaving.
c. Moderate Interest Rates – this is to ensure that the financial markets as well as spending based
on borrowing are working well.
2. Monetary Policy Instruments
a. Monetary Policy Instrument –this is essentially something in the economy that is easily
identifiable, measurable, and controllable that the FED can use to influence the macroeconomy.
b. federal funds rate – the rate that banks borrow and lend federal funds. This is the preferred
instrument of the FED since they control the reserve account and they can monitor it very
closely.
c. Instrument Rule vs. Targeting Rule
i. instrument rule – when the FED would uses a formula to set the instrument value (i.e. the
federal funds rate) based on how it relates to the state in the economy.
Example: Taylor Rule which relates federal funds rate to the rate of inflation
ii. targeting rule – when the FED sets the instrument at a level and uses its forecast as its target.
This is the more commonly used of the two since the dynamics in the economy are sufficiently
volatile that an instrument rule would need to constantly be updated to meet the reality of the
every changing economy.
Graph 1: Supply and Demand For Reserves
Supply Reserves - RS
Federal Funds Rate -r
So the FED changes reserves and
monitors the FF-Rate in the
Reserve Market as seen below.
rE
Demand Reserves - DR
Reserves @ FED
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B. Money Market, Monetary Policy, & How it Affects GDP
-now we want to take closer look at the money market and see the particulars of exactly how the
things mentioned in previous sections above effect overall interest rates and GDP overall.
1. Changes in Equilibrium Via Monetary Policy and Affect on GDP
If there is a shift out in MS (i.e. from MS1 to MS2) this will cause the interest rate to go down. For
the money supply to increase the FED must buy bonds which changes the FF-Rate which
immediately alters the overall interest rates in the economy as all markets for financial
instruments adjusts. This is what monetary policy is. The FED engaging in purchasing or selling
bonds, controlling money supply, and therefore altering interest rates. This ends up having an
increasing effect on spending in the economy and therefore increases overall GDP (see below).
Graph 1: FED increasing Money Supply
r
MS1 MS2
r1
MD
r2
$
Graph 2: Supply of Loanable Funds Increasing as Money Supply increases
r
SFunds-1
SFunds - 2
rE1
rE2
DFunds
Q$
QE1 QE2
So we can see that as the loanable funds market has an increase in S-funds we get an increase in
the amount borrowed and a drop in the interest rate.
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Graph 3: Change in AE/GDP due change in r. We can see this effect in the
AE-Line. As AE rises we get an increase in GDP. This is what happens as we get a decrease in
r.
45o
AE
AE2
AE1
AE1 to AE2 is an
increase in spending due
to a decrease in r
GDP
GDP1 GDP2
Q: Why does the AE-line Shift when interest rate shifts?
Recall that Investment spending and HH spending on large items depend on the interest rate so
we can expect that the following 3 types of spending will be affected by interest rate changes.
a) Investment spending on plants and equipment
b) New housing
c) Spending on consumer durables such as autos
2. Putting it all Together – Money Market/AE/AD & AS – Keynesian View of the Economy
Step 1: Money Market
We start out in the money market. So let’s examine the result if there is a shift out in MS (i.e.
from MS1 to MS2)
**For simplicity I will drop the loanable funds market since the result is the same in that interest
rates are changing.
This will cause the interest rate to go down. For the money supply to increase the FED must buy
bonds. This is what monetary policy is primarily (note: we discussed other forms, but this is the
main one used by the FED). So monetary policy is when the FED engages in purchasing or
selling bonds, controlling money supply, and therefore altering interest rates. This ends up
having an increasing effect on spending in the economy and therefore increases overall GDP. So
we go to the AE-Line next.
r
MS1 MS2
r1
MD
r2
$
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Note: To show what would happen if we had an increase in r resulting from a decrease in money
supply which happens when the FED sells bonds we would run through the same process but in
reverse (i.e. this would be a drop in money supply and shift the AE-line down)
Step 2: Going to the AE-Line
AE
45-degree line
AE2 ( r = r2)
AE1 ( r = r1)
GDP
GDP1 GDP2
So as we get a lower interest rate the cost of borrowing decreases. This increases spending in the
economy. So the AE line shifts up and we get an increase in GDP.
Step 3: AD-AS Curves
P-level
AS
P2
AD2
P1
AD1
GDP1 GDP2
GDP
GDP
So as we can see we get the same change in GDP as before. This occurs because as AE shifts
up, so does the AD curve. They always shift in the same direction. Finally, an increase in GDP
caused from the AD-shift also causes an increase in price level from P1 to P2.
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Summary of above Results:
1. Money Supply Increases –FED bought bonds and S-Fund increases
2. Interest Rate Decreases
3. AE Increases because cost of borrowing is lower.
4. GDP increases due to the shift out in AE
5. AD increases
6. Price Level increases as a result of the change in AD.
3. Monetarist View of Money
a. Monetarism – the school of thought that changing money supply directly (not indirectly
through interest rates) changes prices, real GDP, and employment. It is essentially the idea that
you simply can look at the amount of money in the economy to determine its viability.
-note: it has its roots in the classical school of economics
b. equation of exchange – an accounting identity which gives us:
MV = PQ
M= money supply
V = velocity of money  the average number of times per year a dollar of money is spent on
final goods and services.
P= price level in the economy
Q =quantity of money
Note: P*Q is total revenue or total spending in the economy. This is our approximation for real
GDP. So the above equation basically says that the total spending in the economy should equal
total output.
Example: Find the velocity of money (V) if real GDP is 14.5 Trillion and money supply (M) is
750 Billion
MV = PQ  V =
=
= 19.3
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c. Quantity Theory of Money - any change in price level is caused by a direct change in money
supply. We assume that the velocity of money and real output are constant (i.e. and )
This means Q and V are merely constants, so any change in M would give you a proportional
change in P.
M* = P*
Example: Given that V = 4 and Money Supply increases by 10 Billion find the change in GDP
M*
= P*
 4*10B = 40 B increase in real GDP.
d. Modern Monetarism – in this view modern monetarists argue that V is not constant, but
predictable. So, based on this idea you simply need to increase money supply to the correct level
in order to avoid inflation and unemployment.
-Buoyed by Milton Friedman in the 50’s and 60’s monetarists argued that it is not necessary to
follow interest rate to keep the economy going, but to rather concentrate on the rate of increase in
money supply. For this reason they argued it is better to simply pick an interest rate (i.e. fix it at
one value or within a given range) and simply monitor the money supply.
Monetarists argue that either V is fixed or at least predictable and for this reason they advocate a
monetary rule when it comes to money supply in the economy.
4. Alternate Strategies and Terms
a. discretionary monetary policy – deliberate monetary policy aimed at altering interest rates in
order to affect GDP based on current expert assessment about current economic
variables/measurements.
b. monetary base rule – also called the McCallum rule which says to increase the monetary base
sufficiently in order to track the average annual growth rate of GDP. This is based on quantity
theory of money and outlined above.
c. k-percent rule for monetary base – this is also which says to increase the monetary base
sufficiently in order to alter growth rate. It is done at k percent with k being the current annual
growth of potential GDP.
d. gold standard – a monetary policy rule that pegs the value of dollar at a specified level. This is
not used currently because inflation and deflation is then dependent upon the discovery or loss of
gold in the world economy rather than how people purchase G/S.
e. inflation targeting – when a monetary authority solely looks at inflation and attempts to keep
inflation permanently at that level.
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