Chapter 26 Monetary Policy Key Concepts Summary Practice

Chapter 26 Monetary Policy • Key Concepts • Summary • Practice Quiz • Internet Exercises © 2000 South-Western College Publishing 1

In this chapter, you will learn to solve these economic puzzles: Why would a Nobel Laureate What is a monetary Why do people wish to economist suggest replacing policy transmission money balances? thehold Federal Reserve with an mechanism? intelligent horse? 2

What are the Three Schools of Economic Thought? • Classical • Keynesian • Monetarist 3

What is the Keynesian View of Money? People who hold cash or checking account balances incur an opportunity cost in foregone interest or profits 4

According to Keynes, why would people hold money? • Transactions demand • Precautionary demand • Speculative demand 5

What is the Transactions Demand for Money? The stock of money people hold to pay everyday predictable expenses 6

What is the Precautionary Demand for Money? The stock of money people hold to pay unpredictable expenses 7

What is the Speculative Demand for Money? The stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other nonmoney financial assets 8

How does a change in Interest Rates affect Speculative Demand? As the interest rate falls, the opportunity cost of holding money falls, and people increase their speculative balances 9

What is the Demand for Money Curve? A curve representing the quantity of money that people hold at different possible interest rates, ceteris paribus 10

How do Interest Rates affect the Demand for Money? There is an inverse relationship between the quantity of money demanded and the interest rate 11

What gives the Demand for Money a Downward Slope? The speculative demand for money at possible interest rates 12

What determines Interest Rates in the Market? The demand supply of money in the loanable funds market 13

The Demand for Money Curve 12% 8% Interest Rate 16% A B 4% Billions of dollars 500 MD 1, 000 1, 500 2, 000 14

Increase in the quantity of money demanded Decrease in the interest rate 15

The Equilibrium Interest Rate 12% 8% MS Interest Rate 16% E 4% Billions of dollars Surplus Shortage MD 500 1, 000 1, 500 2, 000 16

Bond prices fall and the interest rate rises People sell bonds Excess money demand 17

Bond prices rise and the interest rate falls People buy bonds Excess money supply 18

Why do Bond Prices Fall as Interest Rates Rise? Bond sellers have to offer higher returns (lower price) to attract potential bond buyers, or else they will go elsewhere to get higher interest returns 19

Why do Bond Prices Rise as Interest Rates Fall? Bond sellers are put in a better bargaining position as interest rates fall (higher price); potential buyers cannot go elsewhere to get higher interest returns so easily 20

How can the Fed influence the Equilibrium Interest Rate? It can increase or decrease the supply of money 21

16% 12% 8% Interest Rate Increase in the Money Supply MS 1 MS 2 Surplus E 1 E 2 MD 4% Billions of dollars 500 1, 000 1, 500 2, 000 22

16% 12% 8% Interest Rate Decrease in the Money Supply MS 2 MS 1 Shortage E 2 E 1 MD 4% Billions of dollars 500 1, 000 1, 500 2, 000 23

Decrease the interest rate Money surplus and people buy bonds Increase in the money supply 24

Increase in the interest rate Money shortage and people sell bonds Decrease in the money supply 25

In the Keynesian Model, what do changes in the Money Supply affect? Interest rates, which in turn affect investment spending, aggregate demand, and real GDP, employment, and prices 26

Change in the money supply Keynesian Change in prices, real GDP, Policy & employment Change in the aggregate demand curve Change in interest rates Change in investment 27

16% 12% 8% Interest Rate Expansionary Monetary Policy MS 1 MS 2 Surplus E 1 E 2 MD 4% Billions of dollars 500 1, 000 1, 500 2, 000 28

16% 12% 8% Interest Rate Investment Demand Curve A B I 4% Billions of dollars 1, 000 1, 500 29

When will Businesses make an Investment? When the investment projects for which the expected rate of profit equals or exceeds the interest rate 30

155 150 Price Level Product Market AS E 2 E 1 Full Employment AD 2 AD 1 Billions of dollars 6. 0 6. 1 31

What is the Classical Economic View? The economy is stable in the long-run at full employment 32

How did the Classical Economists view the Role of Money? They believed in the equation of exchange 33

What is the Equation of Exchange? An accounting number of times per year a dollar of the money supply is spent on final goods and services 34

What is the Velocity of Money? The average number of times per year a dollar of the money supply is spent on final goods and services 35

Money Prices MV = PQ Velocity Quantity 36

What is the Monetarist Theory? That changes in the money supply directly determine changes in prices, real GDP, and employment 37

Change in the quantity of money Change in Monetarist prices, real GDP, Policy & employment Change in the money supply Change in the aggregate demand curve 38

What is the Quantity Theory of Money? The theory that changes in the money supply are directly related to changes in the price level 39

What is the Conclusion of the Quantity Theory of Money? Any change in the money supply must lead to a proportional change in the price level 40

Who are the Modern Monetarists? Monetarist argue that velocity is not unchanging, but is nevertheless predictable 41

According to the Monetarist, how do we avoid Inflation and Unemployment? We must be sure that the money supply is at the proper level 42

Who is Milton Friedman? In the 1950’s and 1960’s, he was a leader in putting forth the ideas of the modern-day monetarists 43

What does Milton Friedman Advocate? The Federal Reserve should increase the money supply by a constant percentage each year to enhance full employment and stable prices 44

How do the Keynesians view the Velocity of Money? Over long periods of time, it can be unstable and unpredictable 45

GDP/M 1 7 6 5 4 3 2 1 The Velocity of Money 40 Year 50 60 70 80 90 00 46

What is the Conclusion of the Keynesians? A change in the money supply can lead to a much larger or smaller change in GDP than the monetarists would predict 47

What is the Crux of the Keynesian Argument? Because velocity is unpredictable, a constant money supply may not support full employment and stable prices 48

What is the Conclusion of the Keynesian Argument? The Federal Reserve must be free to change the money supply to offset unexpected changes in the velocity of money 49

What are the main points of Classical Economics? 50

• Economy tends toward a full employment equilibrium • Prices & wages are flexible • Velocity of money is stable • Excess money causes inflation • Short-run price & wage adjustments cause unemployment • Monetary policy can change aggregate demand & prices • Fiscal policies are not necessary 51

What are the main points of Keynesian Economics? 52

• The economy is unstable at less than full employment • Prices & wages are inflexible • Velocity of money is stable • Excess demand causes inflation • Inadequate demand causes unemployment • Monetary policy can change interest rates and level of GDP • Fiscal policies may be necessary 53

What are the main points of the Monetarists? 54

• Economy tends toward a full employment equilibrium • Prices & wages are flexible • Velocity of money is predictable • Excess money causes inflation • Short-run price & wage adjustments cause unemployment • Monetary policy can change aggregate demand & prices • Fiscal policies are not necessary 55

What is the Crowding-Out Effect? Too much government borrowing can crowd out consumers and investors from the loanable funds market 56

What is the Keynesian View of the Crowding. Out Effect? The investment demand curve is rather steep (vertical), so the crowdingout effect is insignificant 57

What is the Monetarist View of the Crowding. Out Effect? The investment demand curve is flatter (horizontal), so the crowding-out effect is significant 58

Key Concepts 59

Key Concepts • What are the Three Schools of Economic Thought? • What is the Keynesian View of Money? • How can the Fed influence the Equilibrium Interest Rate? • In the Keynesian Model, what do changes in the Money Supply effect? • What is the Classical Economic View? 60

Key Concepts cont. • How did the Classical Economists view the Role of Money? • What is the Equation of Exchange? • What is the Velocity of Money? • What is the Quantity Theory of Money? • What is the Conclusion of the Quantity Theory of Money? • Who are the Modern Monetarists? 61

Key Concepts cont. • According to the Monetarist, how do we avoid Inflation and Unemployment? • Who is Milton Friedman? • What does Milton Friedman Advocate? • What is Classical Economists? • What is Keynesian Economists? • What is Monetarism? 62

Summary 63

The demand for money in the Keynesian view consists of three reasons why people hold money: (1) Transactions demand is money held to pay for everyday predictable expenses. (2) Precautionary demand is money held to pay unpredictable expenses. (3) Speculative demand is money held to take advantage of price changes in nonmoney assets. 64

The demand for money curve shows the quantity of money people wish to hold at various rates of interest. As the interest rate rises, the quantity of money demanded is less than when the interest rate is lower. 65

The Demand for Money Curve 12% 8% Interest Rate 16% A B 4% Billions of dollars 500 MD 1, 000 1, 500 2, 000 66

The equilibrium interest rate is determined in the money market by the intersection of the demand for money and the supply of money curves. The money supply (M 1), which is determined by the Fed, is represented by a vertical line. 67

An excess quantity of money demanded causes households and businesses to increase their money balances by selling bonds. This causes the price of bonds to fall, thus driving up the interest rate. 68

The Equilibrium Interest Rate 12% 8% MS Interest Rate 16% E 4% Billions of dollars Surplus Shortage MD 500 1, 000 1, 500 2, 000 69

An excess quantity of money supplied causes households and businesses to reduce their money balances by purchasing bonds. The effect is to cause the price of bonds to rise, and, thereby, the rate of interest falls. 70

The Keynesian view of the monetary policy transmission mechanism operates as follows: First, the Fed uses its policy tools to change the money supply. Second, changes in the money supply change the equilibrium interest rate, which affects investment spending. Finally, a change in investment changes aggregate demand determines the level of prices, real GDP, and employment. 71

Monetarism is the simpler view that changes in monetary policy directly change aggregate demand thereby prices, real GDP, and employment. Thus, monetarists focus on the money supply, rather than on the rate of interest. 72

The equation of exchange is an accounting identity that is the foundation of monetarism. The equation (MV = PQ) states that the money supply multiplied by the velocity of money is equal to the price level multiplied by real output. The velocity of money is the number of times each dollar is spent during a year. Keynesians view velocity as volatile but monetarists disagree. 73

The quantity theory of money is a monetarist argument that the velocity of money (V) and the output (Q) variables in the equation of exchange are relatively constant. Given this assumption, changes in the money supply yield proportionate changes in the price level. 74

The monetarist solution to an inept Fed tinkering with the money supply and causing inflation or recession would be to have the Fed simply pick a rate of growth in the money supply that is consistent with real GDP growth and stick to it. 75

Monetarists’ and Keynesians’ views on fiscal policy are also different. Keynesians believe the aggregate supply curve is relatively flat, and monetarists view it as relatively vertical. Because the crowding out effect is large, monetarists assert that fiscal policy is ineffective. Keynesians argue that crowding out is small and that fiscal policy is effective. 76

Chapter 26 Quiz © 2000 South-Western College Publishing 77

1. Keynes gave which of the following as a motive for people holding money? a. Transactions demand. b. Speculative demand. c. Precautionary demand. d. All of the above. D. These are three motives for holding currency and checkable deposits (M 1) rather than stocks, bonds, or other nonmoney forms of wealth. 78

2. A decrease in the interest rate, other things being equal, causes a (an) a. upward movement along the demand curve for money. b. downward movement along the demand curve for money. c. rightward shift of the demand curve for money. d. leftward shift of the demand curve for money. B. At a lower interest rate, money is demanded because the opportunity cost of holding money is lower. 79

3. Assume the demand for money curve is stationary and the Fed increases the money supply. The result is that people a. increase the supply of bonds, thus driving up the interest rate. b. increase the supply of bonds, thus driving down the interest rate. c. increase the demand for bonds, thus driving up the interest rate. d. increase the demand for bonds, thus driving down the interest rate. D. 80

16% 12% 8% Interest Rate Expansionary Monetary Policy MS 1 MS 2 Surplus E 1 E 2 MD 4% Billions of dollars 500 1, 000 1, 500 2, 000 81

4. Assume the demand for money curve is fixed and the Fed decreases the money supply. The result is a temporary a. excess quantity of money demanded. b. excess quantity of money supplied. c. increase in the price of bonds. d. increase in the demand for bonds. A. 82

16% 12% 8% Interest Rate Decrease in the Money Supply MS 2 MS 1 Shortage E 2 E 1 MD 4% Billions of dollars 500 1, 000 1, 500 2, 000 83

5. Assume the demand for money curve is fixed and the Fed increases the money supply. The result is that the price of bonds a. rises. b. remains unchanged. c. falls. d. none of the above. A. The result is an excess beyond the amount people wish to hold and they buy bonds which drives the price of bonds upward. 84

6. Using the aggregate supply and demand model, assume the economy is in equilibrium on the intermediate portion of the aggregate supply curve. A decrease in the money supply will decrease the price level and a. lower both the interest rate and the real GDP. b. raise both the interest rate and real GDP. c. lower the interest rate and raise real GDP. d. raise the interest rate and lower real GDP. D. The decrease in money supply increases the interest rate which decreases investment. Since investment is a component of aggregate demand, the aggregate demand curve shifts leftward and real GDP declines. 85

7. Based on the equation of exchange, the money supply in the economy is calculated as a. M = V/PQ. b. M = V(PQ). c. MV = PQ. d. M = PQ - V. C. The equation of exchange is MV = PQ rewritten, M = PQ/V 86

8. The V in the equation of exchange represents the a. variation in the GDP. b. variation in the CPI. c. variation in real GDP. d. average number of times per year a dollar is spent on final goods and services. D. In the equation of exchange, GDP is defined as PQ and the CPI is an index to measure the price level (P). 87

9. Which of the following is not an issue in the Keynesian-monetarist debate? a. The importance of monetary vs. fiscal policy. b. The importance of a change in the money supply. c. The importance of a crowding-out effect. d. All of the above are part of the debate. D. Monetarists believe the effects of monetary policy are more powerful than fiscal policy. They view the shape of the investment demand curve as less steep, so the crowdingout effect is significant. Keynesians disagree. 88

10. Keynesians reject the influence of monetary policy on the economy. One argument supporting this Keynesian view is that the a. money demand curve is horizontal at any interest rate. b. aggregate demand curve is nearly flat. c. investment demand curve is nearly vertical. d. money demand curve is vertical. C. If the investment demand curve is nearly vertical, changes in money supply and resulting changes in interest rate have little effect on investment and aggregate demand. 89

Expansionary Monetary Policy 6% 4% Interest Rate 8% MS 1 MS 2 E 1 E 2 MD 2% Billions of dollars 200 400 600 800 90

11. Starting from an equilibrium at E 1 in Exhibit 12, a rightward shift of the money supply curve from MS 1 to MS 2 would cause an excess a. demand for money, leading people to sell bonds. b. supply of money, leading people to buy bonds. c. supply of money, leading people to sell bonds. d. demand for money, leading people to buy bonds. B. An excess quantity of money supplied causes people to buy bonds. The greater demand for bonds causes the price of bonds to increase 91 and the interest rate to decrease.

12. Beginning from an equilibrium at E 2 in Exhibit 12, a decrease in the money supply from $600 billion to $400 billion causes people to a. sell bonds and drive the price of bonds down. b. buy bonds and drive the price of bonds up. c. buy bonds and drive the price of bonds down. d. sell bonds and drive the price of bonds up. A. An excess quantity of money demanded causes people to sell. The greater supply of bonds on the market causes the price of bonds to decrease and the interest rate to 92 increase.

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